Roth Conversions: Everything You Need To Know

If you already have a traditional IRA, you may have wondered if you should initiate a Roth conversion. Doing so can help increase your retirement savings with tax-free investment growth, and it also means access to tax-free withdrawals when you ultimately retire.

However, the Roth conversion process can come at a cost: it’s what the IRS likes to call a “taxable event,” which could make for a tidy income tax bill the year you make the conversion.

So are Roth IRA conversions a good idea? How do you get them started in the first place?

Here’s what you need to know about converting your traditional IRA to a Roth, including whether or not you should consider one and a step-by-step guide to the conversion process.

What is a Roth IRA conversion?

A Roth IRA conversion allows you to convert a pre-tax traditional IRA, or individual retirement account, to an after-tax Roth IRA. Although both of these accounts can help you save for retirement with or without the help of an employer-sponsored plan like a 401(k), Roth IRAs have become popular account types for a number of reasons.

For starters, Roth investments are allowed to grow tax-free and no tax is paid on withdrawals once you hit retirement age. Roth IRAs also don’t come with the required minimum distributions (RMDs) that other retirement accounts do, making them a preferred vehicle for passing tax-free cash on to your beneficiaries.

But just because you won’t pay taxes when you take money out of an IRA doesn’t mean you won’t pay taxes on the money at all. Make no mistake, the IRS wants its cut — which means only after-tax funds can go into a Roth account in the first place. And since the IRA contributions you made to your traditional IRA were likely tax-deductible, you’ll have to pay the previously deferred taxes at the time you make the conversion.

This can lead to a potentially heavy tax bill, depending on your income bracket and the untaxed balance of your traditional IRA. But the benefits of a Roth can still outweigh these costs for some, and there are ways to minimize the cost of the conversion.

Also, remember that a Roth IRA conversion is wholly different from a Roth IRA rollover and a Roth IRA withdrawal:

• An IRA rollover involves moving like-tax funds from one account to another, while a Roth IRA conversion means moving money from a pre-tax account to an after-tax Roth IRA account.
• An IRA withdrawal refers to taking money out of your account to use for other purposes.

When should you convert to a Roth?

Before learning how to convert your traditional IRA to a Roth, you should probably first ask yourself the question: Should I convert my traditional IRA to a Roth?  As with all things financial, the answer is, “It depends!” A Roth IRA can be a great tool for those craving more flexibility in their retirement plans, but in some cases, it actually does make more sense to stick with a traditional IRA.  Here’s a basic rule of thumb: you’re going to pay taxes either way, so try to think about when you’d rather pay them.

• If you’re planning to have a higher gross income — and thus be in a higher tax bracket when you start making withdrawals — a Roth IRA could help you save money overall. That’s because you’ll pay taxes now in a lower bracket than you might later on.
• If you suspect your tax bracket will be lower at retirement, then a traditional IRA might be a better choice — because you’ll only pay taxes at withdrawal, when your bracket will be lower.

You should also consider whether or not you can afford the tax burden of the Roth conversion today, as converting a large balance could easily lead to a four-figure tax bill or higher. There are, however, ways to time your Roth IRA conversion to minimize the damage. Make sure you know how to check your 401(k) balance before deciding to move forward with a conversion.

Reducing the Tax Burden of a Roth IRA Conversion

If you decide a Roth conversion is right for you, doing it at one of the following times might make it more affordable:

• During a lower-income year. Because the money you convert from your traditional IRA to a Roth account will be considered taxable income, choosing a year when the rest of your income is low will help keep your overall tax rate from skyrocketing. Of course, you’ll still need to weigh this benefit against your ability to actually afford the state and/or federal tax bill, especially if things are a little tight for now.
• While the untaxed balance of your traditional IRA is relatively low. A lower untaxed balance means a lower total tax bill — and also more tax-free growth potential for your retirement fund. Win-win.

Some people also choose to break up their Roth IRA conversion process into smaller sections, converting a little bit of their retirement balance at a time so as to make for more affordable tax bills each year they do so. There’s no rule stating you have to convert the whole balance at once, so this is a good workaround to consider!

That said, it’s always worth consulting with a tax professional or fiduciary advisor before making major money decisions.

How to Convert a Traditional IRA to a Roth IRA

If you’ve decided it’s the right move for you, here’s how to convert a traditional IRA to a Roth IRA.

Notify your IRA provider. In most cases, for the conversion you can keep your funds at the same financial institution, and even invested in the same assets. If you decide to perform your Roth conversion piecemeal — which can have additional tax advantages since you’ll spread your tax burden over several tax years — you may need to open a separate Roth IRA account and initiate smaller conversion transfers one by one. Your IRA provider will have all the specific instructions you need.

Prepare for tax time. The amount of untaxed funds you convert from a traditional to a Roth IRA will be taxed as ordinary income on your tax return, so be sure you have money on hand to pay the IRS when the time comes. This can come back to bite taxpayers if they’re not careful.

Maintain your new account. Make sure you’re comfortable with the investments that are in your Roth account once the conversion has happened (ideally, these investments are in line with your overall asset allocation). If you don’t have an employer-sponsored account like a 401(k), consider making regular IRA contributions to the Roth account (assuming you earn under the IRS-prescribed income limits). One way to keep your retirement fund growing is to set up an automatic transfer into the account from each paycheck.

Can I convert an old traditional 401(k) into a Roth IRA?

While you can’t convert your old traditional 401(k) (or another tax-deferred employer-sponsored retirement plan) into a Roth IRA directly, you can do so with a two-step process.

First, you’d roll your 401(k) over into a traditional IRA. This way, your new IRA will match the tax status of your old 401(k).

You’d then initiate a separate Roth conversion process through your IRA provider. Again, however, doing so means you’ll have to pay taxes on the tax-deferred contributions you convert.

You can, however, roll a Roth 401(k) directly into a Roth IRA without any tax consequences or penalty worries. You can even do this via a direct rollover, and it’s generally a better idea than cashing out a 401(k) from old job.

It’s not uncommon to wonder how to find my 401(k) accounts – you can use your Social Security Number to track it down.

Key Roth Conversion Rules

Here are some key rules to be aware of when you convert a traditional IRA to a Roth:

• You don’t have to convert the full account balance of your traditional IRA to a Roth IRA, but you can — even if your income exceeds the limits set by the IRS regarding who’s allowed to contribute to a Roth. This process is also sometimes known as a “backdoor Roth.”
• You will be responsible for paying taxes on untaxed traditional IRA assets in the year they are converted to Roth status. These tax consequences are critical to understanding the potential viability of any Roth conversion.
• You’ll need to have your Roth IRA account open for at least five years — and be over age 59.5 — before you can access any earnings tax and penalty-free. You can access Roth IRA contributions at any time without penalty. Adhering to this “five-year rule” can help avoid unnecessary expenses in the form of taxes and/or penalties.
• Finally, keep in mind that if you choose to initiate an indirect rollover — that is, if you take the funds from your traditional IRA in the form of a check in order to deposit them into a new account — you must complete the manual conversion within 60 days and contribute the full amount to your new Roth account. Otherwise, you’ll be responsible not only for the regular taxes due, but also a 10% early withdrawal penalty if you’re under the withdrawal age of 59.5.

A Roth IRA conversion can be a great way to help your retirement funds grow tax-free (and penalty-free!) and allows you to enjoy the other benefits Roth accounts offer. You just have to plan it right to make sure you can cover the taxes you’ll incur in the process.

Timing your Roth conversion to occur on a lower-income year or while your traditional IRA balance is still relatively low can help minimize any tax implications. As always, we suggest enlisting the help of a qualified financial or tax advisor, like a CFP or a CPA, about major financial decisions.