The main advantage of a Roth IRA, unlike a traditional IRA, is that you won’t have to pay income tax on the money you withdraw in retirement. While you can't contribute to a Roth IRA if your income exceeds the limits set by the IRS, you can convert a traditional IRA into a Roth—a process that's sometimes referred to as a "backdoor Roth IRA."
- You can convert all or part of the money in a traditional IRA into a Roth IRA.
- Even if your income exceeds the limits for making contributions to a Roth IRA, you can still do a Roth conversion, sometimes called a "backdoor Roth IRA."
- You will owe taxes on the money you convert, but you'll be able to take tax-free withdrawals from the Roth IRA in the future.
How to Convert a Traditional IRA to a Roth IRA
Converting all or part of a traditional IRA to a Roth IRA is a fairly straightforward process. The IRS describes three ways to go about it:
- A rollover, in which you take a distribution from your traditional IRA in the form of a check and deposit that money in a Roth account within 60 days.
- A trustee-to-trustee transfer, in which you direct the financial institution that holds your traditional IRA to transfer the money to your Roth account at another financial institution.
- A same-trustee transfer, in which you tell the financial institution that holds your traditional IRA to transfer the money into a Roth account at that same institution.
Of the three methods, the two types of transfers are likely to be the most foolproof. If you take a rollover and, for whatever reason, don't deposit the money within the required 60 days, you could be subject to a 10% penalty tax on early distributions in addition to the other taxes you'll owe as a result of the conversion. The 10% penalty tax doesn't apply if you are over age 59½.
Whatever method you use, you will need to report the conversion to the IRS using Form 8606 when you file your income taxes for the year.
If the value of your retirement account has dropped—such as has happened during the pandemic—it is a good time to convert to a Roth IRA because the tax impact will be less onerous than when your account is worth more.
The Tax Implications
When you convert a traditional IRA to a Roth, you will owe taxes on any money in the traditional IRA that would have been taxed when you withdrew it. That includes the tax-deductible contributions you made to the account as well as the tax-deferred earnings that have built up in the account over the years. That money will be taxed as income for the year you make the conversion.
Does a Roth IRA Conversion Make Sense for You?
When you convert from a traditional IRA to a Roth, there's a trade-off. You will face a tax bill—possibly a big one—as a result of the conversion, but you'll be able to make tax-free withdrawals from the Roth account in the future.
One advantage Roth IRAs have over traditional IRAs is you won't have to take required minimum distributions—something to think about if you hope to leave the money to your heirs.
One reason that a conversion might make sense for you is if you expect to be in a higher tax bracket after you retire than you are now. That might happen, for example, if your income is unusually low during a particular year (for example, you were furloughed or lost your job during the COVID-19 pandemic) or if the government raises tax rates substantially in the future.
Another reason that a Roth conversion might make sense is that Roths, unlike traditional IRAs, are not subject to required minimum distributions (RMD) after you reach age 72. So, if you're fortunate enough not to need to take money from your Roth IRA, you can just let it continue to grow and leave it to your heirs someday.
And speaking of older age, if you end up still earning eligible income at that age, you can continue to contribute to a Roth IRA and gain tax-free growth on that money. As of 2020, you can also keep contributing to a traditional IRA, which was previously capped at 70½ years old.