You can shift money from a tax-deferred retirement account into an after-tax account—but how much tax do you pay on that Roth IRA conversion? And does it always make financial sense to do so?

Key Takeaways

  • You can shift money from a traditional IRA or 401(k) into a Roth IRA by doing a Roth IRA conversion.
  • If you do a Roth IRA conversion, you’ll owe income tax on any amount you convert—and it could be significant.
  • If you'll be in a higher tax bracket in retirement, the long-term benefits can outweigh any tax you pay on the conversion now.

The biggest difference between Roth IRAs and tax-deferred retirement accounts like traditional IRAs and 401(k)s is when you pay the tax:

  • Traditional IRA and 401(k) contributions are tax-deductible the year you make them, and you pay income tax on withdrawals in retirement.
  • Roth IRA contributions don't offer an upfront tax break, but withdrawals in retirement are tax-free.

Why Do a Roth IRA Conversion?

There are a couple of reasons to consider a Roth IRA conversion (also called a rollover). If you'd like to contribute to a Roth directly—but make too much money to do so—you can legally get around the income limits by doing a Roth IRA conversion. This strategy is often called a backdoor Roth. 

Another good reason to make the switch: You expect to be in a higher tax bracket in retirement than you're in now. Remember, Roth IRA withdrawals are tax-free in retirement—even when you take out earnings. You can pay taxes now while you're in a lower tax bracket and enjoy tax-free withdrawals later.

How to Do a Roth IRA Conversion

If you decide a Roth IRA conversion makes sense for you, here's what you need to do to make it happen:

  • Put money into a traditional IRA (or another retirement account). You’ll have to open and fund a new account if you don’t have one already.
  • Pay taxes on your IRA contributions and earnings. If you deducted your traditional IRA contributions (which you did if you met income limits), you have to give back that tax deduction now.
  • Convert the account to a Roth IRA. If you don’t have a Roth IRA yet, you’ll open one during the conversion.

There are a few ways to do the conversion:

  • Indirect rollover. You get a distribution from your traditional IRA and put it in your Roth IRA within 60 days.
  • Trustee-to-trustee rollover. Ask your traditional IRA provider to transfer the funds directly to your Roth IRA provider.
  • Same trustee transfer. If the same provider maintains both of your IRAs, you can ask them to make the transfer.

How Much Tax Will You Owe on a Roth IRA Conversion?

When you convert from a traditional IRA to a Roth, the amount you convert is added to your gross income for that tax year. It increases your income and you pay your ordinary tax rate on the conversion.

Say you’re in the 22% tax bracket and convert $20,000. Your income for the tax year will increase by $20,000. Assuming this doesn’t push you into a higher tax bracket, you’ll owe $4,400 in taxes on the conversion.

But be careful here. It’s never a good idea to use your retirement account to cover the tax you owe on the conversion. Doing so would lower your retirement balance, which could cost you thousands of dollars in growth over the long-term. Instead, save up enough cash in a savings account to cover your conversion taxes.

Converting From a 401(k)

If you want to shift money from your 401(k) to a Roth IRA, make sure the money is transferred directly to your Roth IRA provider. If not, your company will withhold 20% of the amount for tax purposes.

If your company does issue a check to you (instead of transferring it to your Roth IRA provider), here's what happens. You have only 60 days to deposit all the money into a new Roth—including the 20% you didn’t receive. If you don't meet this deadline—and you're younger than 59 ½—you'll owe a 10% early withdrawal penalty on any money that hasn't made its way into the Roth.

Either way, you're still on the hook for income taxes on the entire amount you convert.

Don’t Wait All Year to Pay

Most people pay their income tax to the government with every paycheck. It’s automatically withheld, based on the withholdings you claim on Form W-4. As the year goes on, your taxes are withheld for you. You don’t have to write a separate check to the government until you file your taxes. And that’s only if you didn’t have enough money taken out and you still owe.

But small business owners and corporations make estimated quarterly tax payments. These entities must estimate how much tax they’ll owe based on their income and expenses. And then, each quarter—typically on the 15th of April, June, Sept., and Jan. of the following year—they fill out a form and send in their payments.

Why is this important to note? If you convert a substantial traditional IRA to a Roth IRA early in the year, your quarterly income—and therefore, your quarterly taxes—will increase.

Say you convert during the first quarter of the year. You would need to pay the tax triggered by the conversion when your quarterlies are due. In this example, that would be by April 15.

If you wait until the end of the year or when you file your taxes, you could owe penalties and interest.

Safe Harbor Rules

If you’re used to paying estimated taxes, you may be wondering about safe harbor rules. Safe harbor rules mean that if you pay at least 100% (or 110%, depending on the situation) of your previous year’s taxes in estimated taxes this year, you won’t pay any fees or interest by underpaying.

This is to protect individuals and businesses whose income may skyrocket—thanks to a great year—following a poor year. Provided you’ve paid at least as much as you did last year, you're pulled into the “safe harbor.” And you won’t have to worry about penalties and interest.

Still, this is where things can get sticky, and it's a good idea to speak with a tax advisor. Of course, if you pay your estimated taxes, you won’t have anything to worry about. If you end up paying too much into the tax system, you’ll get a refund when you file your taxes at the end of the year.

Should I Do a Roth IRA Conversion?

A Roth IRA offers huge benefits—tax-free withdrawals during retirement and no RMDs, to name just two. Still, a conversion isn't always a good idea.

In general, you should consider a conversion only if:

  • You can pay the taxes out of your savings account without tapping the IRA funds, and
  • You're confident you'll be in a higher tax bracket in retirement.

Keep in mind, you could be in a higher tax bracket later in life even if you don't earn more money at work. Your income might be higher due to any combination of:

Be sure to consider these other income sources when you estimate your future tax bracket.  

The Bottom Line

If you're interested in doing a Roth IRA conversion, be sure to consider the current and future tax consequences before making any decisions. If you can cover the taxes and think you'll be in a higher tax bracket later on, it can make great financial sense. If not, you may be better off leaving your money in a traditional IRA. 

It's helpful to consult a financial planner or advisor who can help you decide if—and when—a conversion might benefit you.