Roth IRA Conversion

DEFINITION of 'Roth IRA Conversion'

A Roth IRA Conversion is a reportable movement of assets from a Traditional, SEP or SIMPLE IRA to a Roth IRA, which can be subject to taxes. A Roth IRA conversion can be advantageous for individuals with large traditional IRA accounts who expect their future tax bills to stay at the same level or grow at the time they plan to start withdrawing from their tax-advantaged account, as a Roth IRA allows for tax-free withdrawals of qualified distributions.

BREAKING DOWN 'Roth IRA Conversion'

A conversion may be accomplished by a rollover of assets directly between the trustees of the Traditional and Roth IRAs, or by the IRA owner distributing the assets from the Traditional, SEP or SIMPLE IRA and rolling over the amount to the Roth IRA within 60 days of receiving the distributed amount. Any such conversions should be done with due diligence, possibly consulting a financial planner or personal tax professional, as there may be major tax implications if not done appropriately. This is even more important because a Roth conversion completed after December 31, 2017, can no longer be recharacterized—in other words, it can't be reverted to a traditional IRA later.

When Conversions Make Sense

The big advantage of conversions of course is having tax-free withdrawals in retirement. This can be appealing only if you expect to be in a higher marginal tax bracket in retirement, which is not the case for most people. But there's another aspect to conversions that gets less attention: By timing a series of conversions to coincide with years when your tax bracket is lower, taxpayers can avoid paying more to Uncle Sam.

"A common way to manage taxes on a Roth IRA conversion is to spread the conversion over a few years. This spreads the taxes too, and it may also prevent the income from the conversion causing a bump into a higher tax bracket," notes investment company Fidelity. "Consider this hypothetical example: Imagine a married couple, the Mullens, who expect to file jointly with $100,000 in taxable income. They could convert up to $50,000 to a Roth IRA and stay within their current tax bracket, which applies to taxable income between $90,000 and $150,000."

Another aspect to consider is making a charitable deduction, although the 2018 changes in the tax law have in effect taken these deductions off the table for many taxpayers. "The tax deduction for a contribution to a public charity can be up to 60% of adjusted gross income (AGI) for cash donations and up to 30% for donations of securities (generally deductible at fair market value when long-term appreciated securities are gifted) in a given year. And if a contribution exceeds these limits, the excess can generally be carried forward for up to five years," reports Fidelity.