A Roth IRA conversion lets you shift money from a traditional IRA into a Roth IRA. Doing so lets you take advantage of a Roth IRA's many benefits, including tax-free withdrawals in retirement and no required minimum distributions during your lifetime. But is a Roth IRA conversion always a smart move, financially speaking?

Key Takeaways

  • A Roth IRA conversion lets you convert a traditional IRA into a Roth IRA.
  • You will immediately owe taxes due on the converted amount, but qualified withdrawals in retirement will then be tax-free.
  • A conversion makes the most sense if you expect to be in a higher tax bracket in the future.
  • Due to new tax laws passed in 2017, a conversion can no longer be reversed back to a traditional IRA.

Since Roth IRAs were first introduced in 1998, many owners of traditional IRAs have looked on them with envy. That’s because Roth IRAs have at least two advantages over the traditional kind.

Benefits of Roth IRAs

For one thing, any money you withdraw from a Roth is tax-free, provided you are 59 1/2 or older and it's been at least five years since you first contributed to a Roth. By contrast, the withdrawals you make from a traditional IRA are taxed as ordinary income. 

For another, traditional IRA owners must start taking required minimum distributions (RMDs) from their accounts by "April 1 of the year following the calendar year in which you reach age 70 1/2," according to the IRS. Roth owners, however, can leave their accounts untouched until they need the money. And they can pass the entire account to their heirs. 

There is a tradeoff, though. Traditional IRA owners who qualify get a tax break for the money they put into their accounts. Roth owners do not; they put post-tax money into their account. 

Fortunately, for traditional IRA holders who yearn for a Roth, the law allows for conversions. At one time, only people with incomes under a certain amount could do Roth IRA conversions, but the limits were lifted as of 2010. Income limits still apply to Roth contributions, however. 

Of course, just because you can convert, should you? Here are some of the pros and cons.

The Case for Roth IRA Conversions

1. You might save on taxes in the long run.

When you convert some or all of the money in your traditional IRA to a Roth, you have to pay income tax that year on the converted amount. Even so, converting could be a smart move if you end up in a higher marginal tax bracket in later years or if tax rates rise overall.

Once you pay tax on that money, it’s tax-free ever after, no matter how tax rates may change. And all the money you earn in that account is tax-free as well. Money in a traditional IRA grows tax-free until you withdraw it. But once you take it out, you have to pay taxes on both the original contributions and what they earned over time.

“When it comes to converting, time is of the essence for at least three reasons,” says Matthew J. Ure, VP, Anthony Capital, LLC-Southwest Region, in San Antonio, Texas.

“First, the money put into a Roth must have five years to mature in order to protect any growth from taxes. Second, often by staging the conversion over several years you can minimize disruption to your current tax situation. Finally, the ability to convert is not a right guaranteed by the Constitution – rather, it is a loophole that opened up after the original legislative prohibition expired, and a loophole that has come under attack recently. Although the new administration seems more amenable to keeping conversions alive for now, the statements by both political parties highlight the risk one takes in deferring a desirable conversion.”

2. You’ll escape RMDs and harsh penalties.

With traditional IRAs, you must start taking RMDs at age 70 1/2. Otherwise, you’ll face a big tax penalty—50% of the amount you failed to withdraw. And, of course, you’ll owe income tax on whatever you take out.

With a Roth, on the other hand, RMDs are never necessary during your lifetime. If you have other sources of income and don’t need the money in your Roth for living expenses, you can keep it intact for your grateful heirs.

“Roth IRAs can be a good estate and tax planning tool because they are not subject to RMDs. And so long as you have earned income, you may continue making contributions at any age,” says Stephen Rischall, a retirement planning expert and founding partner at 1080 Financial Group in Los Angeles, Calif.

If you do need money, on the other hand, and you’re under 59 1/2, you can withdraw your contributions—but not the earnings—without any penalty.

3. It could be the only way to get one.

If you want a Roth, for inheritance or other purposes, but earn too much to contribute to one, converting the money you already have in a traditional IRA is your only option.

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Converting Traditional IRA Savings To A Roth IRA

The Case Against Roth IRA Conversions

1. You might pay more in taxes in the long run.

Converting from a traditional IRA to a Roth can make sense if income tax rates (yours personally or the whole country’s) go up in the future. But if you’re likely to be in a lower tax bracket later, as many people are after they retire, you would do better to wait.

2. You’ll face a big tax bill now.

Depending on how much you convert, your tax bill could be substantial, and the money to pay it will have to come from somewhere. If you plan to cover the taxes by withdrawing extra money from your traditional IRA, you’ll generally be subject to a 10% early withdrawal penalty if you’re under age 59 1/2.

Even if you aren’t penalized, you’ll still be reducing your retirement savings to pay the taxes. Taking the money from nonretirement accounts is a better idea, but not a perfect one. By giving it to the IRS now, you’ll be sacrificing whatever it might have earned if you’d kept it invested. 

“If you do a conversion, you should be able to pay the taxes with an outside source. Otherwise, the math does not favor the conversion. Always remember that you are not converting in a vacuum and the total picture needs to be evaluated,” says Morris Armstrong, founder of Armstrong Financial Strategies, Cheshire, Conn. 

Pros

  • Even though you'll owe tax on the converted amount, you might save on taxes in the long run.

  • There are no required minimum distributions during your lifetime.

  • You can withdraw your contributions at any time.

Cons

  • You owe tax on the converted amount—and it could be substantial

  • You may not benefit if your future tax bracket is lower than it is now.

  • You must wait five years to take tax-free withdrawals, even if you're already age 59 1/2 or older.

How to Do a Roth IRA Conversion

If you decide you want to convert, the simplest way is to have the financial institution that currently holds your traditional IRA transfer some or all of that money into a Roth. If you’d rather move your account to another institution, the new one should be more than happy to help you.

You could also do the rollover yourself, withdrawing money from your traditional IRA and depositing it in a Roth account. This is the riskiest option, however. If you don’t complete the rollover within 60 days, the money becomes taxable and may be subject to penalties.

What’s more, it will no longer be in an IRA—Roth or traditional —and it will have lost the advantage of tax-deferred or tax-free growth.

Recharactarization

Recharactarization was the reversal of an IRA conversion, such as from a Roth IRA back to a traditional IRA, generally to achieve better tax treatment. The strategy of recharacterizing from a Roth back to a traditional IRA was banned by the Tax Cuts and Jobs Act of 2017.

Recharacterizations were mostly performed after a conversion from a traditional Individual Retirement Account (IRA) to a Roth IRA , though they could go the other way, as well. A traditional-to-Roth conversion, also known as a "rollover," could result in a significant and unexpected tax burden—so much so that the individual who had done the conversion could decide to undo it, which resulting in a recharacterization. 

The Bottom Line

Converting a traditional IRA into a Roth IRA can provide tax-free income and estate-planning advantages in the future. But you’ll have to pay taxes on the money now, at what could be a higher rate than you’ll owe in retirement.

“On a planning note, it is always nice to have tax diversification among the types of retirement accounts you have—primarily because without a crystal ball, we cannot guarantee what tax rates will be in the future. Better to have the tools to react to any tax environment than to make an all-in bet on what the rates will be,” advises David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, N.C.