Roth Conversion

Pros and cons of a Roth IRA conversion

Roth IRAs are available to people who earn a specific amount of money, which means if you make more than the earnings threshold, you're not eligible for a Roth IRA. Unfortunately, you're stuck paying taxes on withdrawals from your retirement account when you finally retire. Or, maybe you're not.

Many retirement savers not eligible for a Roth IRA do a conversion to reduce the taxes that they pay in retirement by moving their money from a traditional IRA to the Roth variety. This strategy is known as a Roth conversion. It's also called a backdoor Roth IRA conversion because it allows people not ordinarily eligible for a Roth IRA due to their income to set up a Roth—sneaking in the back door, so to speak.

Key Takeaways

  • A Roth individual retirement account (Roth IRA) conversion lets you turn a traditional IRA into a Roth IRA.
  • Roth IRA conversions are also known as backdoor Roth IRA conversions.
  • There’s no upfront tax break with a Roth IRA, but contributions and earnings grow tax free.
  • You’ll owe ordinary income tax on any amount that you convert.
  • Plan to pay the taxes from another account so that you don't reduce your converted retirement account's earning power.

What Is a Roth IRA Conversion?

A Roth IRA conversion occurs when you move funds from a traditional IRA, simplified employee pension (SEP) IRA, or savings incentive match for employees (SIMPLE) IRA into a Roth IRA. In 2010, the federal government began allowing people to convert their accounts from traditional IRAs into Roth IRAs, regardless of their income.

In general, people can invest in a Roth IRA only if their modified adjusted gross income (MAGI) falls below a specific limit. For example, if you’re married filing jointly and earn $214,000 or more per year in 2022 ($228,000 in 2023), you can’t invest in a Roth IRA. Single and head of household filers, and married filing separately, have a cutoff of $144,000 ( $153,000 in 2023).

But there are no income limits for conversions.

Sound good? It can be. But, like most investment choices, a Roth IRA conversion has advantages and disadvantages.

Advantages of a Roth IRA Conversion

A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. While there’s no upfront tax break with Roth IRAs, your contributions and earnings grow tax free.

In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided that you take qualified distributions. While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money and, therefore, be in a higher bracket.

Another perk to a Roth IRA is that you can withdraw contributions (not earnings) at any time, for any reason, generally tax free. Still, you shouldn’t use your Roth IRA as a bank account. Any money you take out now will never get the opportunity to grow. Even a small withdrawal today can have a big impact on the size of your nest egg in the future.

Moving to a Roth IRA also means you won’t have to take required minimum distributions (RMDs) on your account once you reach age 72. If you don’t need the money, you can keep your money intact and pass it to your heirs.

Important

You must pay the tax bill on your conversion in the year that the conversion takes place.

Making the Case for a Roth Conversion

A Roth conversion makes sense in specific situations. For example, say that you have a traditional IRA that you've been paying into for years. You've finally retired and have more income from your savings and investment account withdrawals than you believed you would have.

You and your spouse also will begin drawing social security in one year. You realize that your taxable income will increase—and your tax bracket along with it. Your IRA withdrawals will then be taxed at a higher rate.

You decide to convert your IRA to a Roth IRA because doing so would reduce your overall tax burden due to a higher tax bracket.

Disadvantages of a Roth IRA Conversion

The most significant disadvantage of converting to a Roth IRA is the whopping tax bill. If, for example, you have $100,000 in a traditional IRA and convert that amount to a Roth IRA, you would owe $24,000 in taxes (assuming your effective tax rate is 24%). Convert enough, and it could even push you into a higher tax bracket.

Of course, when you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. While you can make some educated guesses, there’s no way to know what future tax rates (or your income) will be.

Yet another common issue that many taxpayers face is contributing the full amount and then converting it when they have other traditional IRA, SEP, or SIMPLE IRA balances elsewhere.

When this happens, you’re required to compute a ratio of the monies in these accounts that have been taxed already vs. the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you deducted your contributions vs. those for which you didn’t). This percentage is counted as taxable income. It’s complicated, so you should get professional help.

Another drawback: If you’re younger, you must keep the funds in your new Roth IRA for five years and ensure that you’ve reached age 59½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings but also a 10% early distribution penalty (unless you qualify for the few exceptions).

Making the Case Against a Roth Conversion

While a Roth conversion may seem to be a great idea at first, there are situations in which you wouldn't want to convert. For instance, say you're 55 and earning the most you ever have. You believe that the next five years will be your peak earning years, so you want to take advantage of it and keep contributing.

However, you're in a higher tax bracket because you're making more, so you'll end up paying more taxes if you convert. In this case, you might want to wait until you're in a lower tax bracket or not convert at all.

Remember, you must also wait five years after converting before beginning withdrawals. So if you think you'll need to access the funds before that, the conversion might not be a good idea.

Roth Conversion Pro and Cons

Pros
  • Contributions and earnings grow tax free.

  • You can withdraw contributions at any time, for any reason, tax free.

  • You don’t have to take required minimum distributions.

  • Those normally ineligible for a Roth IRA can convert savings to a tax-free pool of cash.

Cons
  • You must pay potentially substantial tax on the conversion in the year that it occurs.

  • You may not benefit if your tax rate is lower in the future.

  • You must wait five years to take penalty-free withdrawals, even if you’re already age 59½.

  • Figuring taxes can be complicated if you have other traditional, SEP, or SIMPLE IRAs that you’re not converting.

Paying the Tax Bill on a Roth IRA Conversion

If you do a Roth IRA conversion, how and when will you pay that tax bill?

The money in your IRA has grown tax deferred, which means it hasn't been taxed yet. When you convert a traditional IRA to a Roth, the money in your account is considered additional income for that year. It's possible that that added income could push you into a higher tax bracket for that year. Be sure to consider that when planning.

However, you shouldn't use funds from the account to pay the taxes. The best way to pay the tax bill is to use money from a different account—such as from your savings or by cashing out a certificate of deposit (CD) when it matures. Here’s why:

Paying your taxes from your IRA funds instead of from a separate account will erode your future earning power. Say you convert a $100,000 traditional IRA. After paying taxes, you deposit only $76,000 into the new Roth IRA. From then on, you’ll miss out on all the money you would have earned on the original balance.

While $24,000 may not seem like a lot, compounding interest means that money could grow to almost $112,000 over 20 years at an interest rate of 8%. That’s a lot of money to forgo to pay a $24,000 tax bill.

Use the tax brackets for 2022 and 2023 below as you consider converting to a Roth IRA.

2022 Tax Brackets
 Tax Rate Single Filer   Married Filing Separately Married Filing Jointly  Head of Household
10% $10,275 or less $10,275 or less $20,550 or less $14,650 or less
12%  $10,276 to $41,775 $10,276 to $41,775 $20,551 to $83,550  $14,651 to $55,900
22%  $41,776 to $89,075 $41,776 to $89,075 $83,551 to $178,150  $55,901 to $89,050
24%  $89,076 to $170,050  $89,076 to $170,050 $178,151 to $340,100  $89,051 to $170,050
32%  $170,051 to $215,950  $170,051 to $215,950 $340,101 to $431,900  $170,051 to $215,950
35%  $215,951 to $539,900  $215,951 to $323,925 $431,901 to $647,580  $215,951 to $539,900
37%  Over $539,900  Over $323,925 Over $647,580  Over $539,900

Source: Internal Revenue Service

2023 Tax Brackets
 Tax Rate Single Filer   Married Filing Separately Married Filing Jointly  Head of Household
10% $11,000 or less $11,000 or less $22,000 or less $15,700 or less
12%  $11,001 to $44,725 $11,001 to $44,725 $22,001 to $89,450  $15,701 to $59,850
22%  $44,726 to $95,375 $44,726 to $95,375 $89,451 to $190,750  $59,851 to $95,350
24%  $95,376 to $182,100  $95,376 to $182,100 $190,751 to $364,200  $95,351 to $182,100
32%  $182,101 to $231,250  $182,101 to $231,250 $364,201 to $462,500  $182,101 to $231,250
35%  $231,251 to $578,125  $231,251 to $346,875 $462,501 to $693,750  $231,251 to $578,100
37%  Over $578,125  Over $346,875 Over $693,750  Over $578,100

Source: Internal Revenue Service

What Is the Downside of a Roth Conversion?

The most significant disadvantage to converting a traditional IRA to a Roth is that you could have a large tax bill when you complete the conversion.

Is a Roth Conversion a Good Idea?

It depends on your financial situation. It might be a good idea if you're in a position where the taxes you pay at conversion are lower than the total amount of taxes you'd pay on traditional IRA withdrawals. It could also make sense if you simply want to cut the taxes that you pay once you're in retirement.

How Do I Avoid Taxes on a Roth IRA Conversion?

There is no way to avoid paying taxes on a Roth conversion. However, you can lower your tax burden by timing the conversion right. For example, you might convert in a year when your taxable income is lower than it has been. Or, when your current tax bracket has enough room for the added income that the conversion represents (so that you don't get pushed into a higher tax bracket).

The Bottom Line

A Roth IRA conversion can be a very powerful tool for your retirement. If you believe that your taxes will rise after you begin withdrawing from your traditional IRA because of increases in marginal tax rates—or because you'll earn more—then a Roth IRA conversion can save you considerable money in taxes over the long term.

In addition, the backdoor strategy makes the Roth accessible to high-earners who normally would be ineligible for a Roth or who cannot move money into a tax-free account by any other means.

However, several conversion drawbacks should be considered. In particular, a potentially big tax bill could be tricky to calculate, especially if you have other retirement accounts funded with pretax dollars.

Therefore, it’s essential to weigh the tax benefits of doing a conversion and consult with a tax advisor about your specific situation.

Article Sources
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  1. Internal Revenue Service. “IRS Nationwide 2010 Tax Forum: Roth Conversions.”

  2. Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make for 2022."

  3. Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make for 2023."

  4. Internal Revenue Service. “Traditional and Roth IRAs.”

  5. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Page 28.

  6. Internal Revenue Service. “Instructions for Form 8606,” Pages 8–9.

  7. Internal Revenue Service. “Publication 590-B: Distributions from Individual Retirement Arrangements (IRAs),” Page 31.

  8. Internal Revenue Service. "26 CFR 601.602: Tax forms and instructions,Rev. Proc. 2021-45."

  9. Internal Revenue Service. "Part III Administrative, Procedural, and Miscellaneous, 26 CFR 601.602: Tax forms and instructions, Rev. Proc. 2022-38."

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