Roth IRA Conversion: Definition, Methods, and Example

What Is a Roth IRA Conversion?

A Roth IRA conversion involves the transfer of retirement assets from a traditional, simplified employee pension (SEP), or SIMPLE IRA, or from a defined-contribution plan such as a 401(k), into a Roth IRA. While the account owner has to pay income tax on the money they convert, they will be eligible to make tax-free withdrawals from the account in the future.

Key Takeaways

  • A Roth IRA conversion involves transferring retirement funds from a traditional-type IRA or 401(k) into a Roth account.
  • The account holder must pay tax on the money they convert, but their withdrawals from the Roth account can be tax-free in the future.
  • If an investor believes they will be in a higher tax bracket in the future, they'll save money by paying taxes now rather than later.

How a Roth IRA Conversion Works

A conversion may be accomplished in several ways.

  1. A direct rollover from a defined-contribution plan, such as a 401(k) or 403(b), if you're leaving your job or if you left an account behind with a former employer. The plan's administrator can send the money to your new account or give you a check made out to the new account that you can then deposit.
  2. A trustee-to-trustee transfer, in which the assets are directly transferred from the financial institution, or trustee, where your traditional IRA is held and the one where your new Roth IRA will be held or it can be the same financial institution, a same-trustee transfer.
  3. A 60-day rollover, in which the money is paid to you and you then deposit all or part of it in a Roth IRA within 60 days.

The first two methods are generally the safest and most practical. With a 60-day rollover, if you fail to deposit the money within that time, it will be treated as taxable income and you may also face a 10% tax on early distributions if you're under age 59½.

In addition, 60-day rollovers can be subject to 10% tax withholding. If you're rolling over a $10,000 IRA, you'd only receive $9,000 and if you wanted to put the full $10,000 into your Roth account, you'd have to come up with $1,000 from another source.

When Roth IRA Conversions Make Sense

The major advantage of converting a traditional IRA or 401(k) into a Roth IRA is the ability to make tax-free withdrawals in the future. That can be particularly appealing if you expect to be in a higher marginal tax bracket in retirement.

While most people's incomes and tax brackets decline in retirement, that isn't always the case. For example, if you have a lot of money in traditional IRAs, your required minimum distributions (RMDs) starting at age 72 could boost your income substantially.

In addition, there is no predicting what the tax brackets and tax rates will be in the future. If taxes go up by the time you retire, converting a traditional IRA and taking the tax hit now rather than later could make sense in the long run.

Another consideration involves estate planning. Roth IRAs, unlike other types of retirement accounts, are never subject to required minimum distributions during your lifetime. So if you don't need the money for living expenses, you can allow it to grow undisturbed and leave it to your heirs someday.

If the account beneficiary is your spouse, they won't have to take RMDs either. Other types of beneficiaries, such as children, will eventually have to take distributions, but as long as they follow the rules, those distributions will be tax-free.

Example of a Roth IRA Conversion

By timing your conversion carefully, and possibly spreading it over several years, you may be able to ease the tax burden.

Suppose, for example, that you're single, will earn a taxable income of $80,000 in 2023, and have $100,000 in a traditional IRA that you'd like to convert into a Roth. Based on your taxable income, your highest marginal tax bracket is 22%.

Because the 22% bracket ends at $95,375, you could convert up to $15,375 this year ($95,375 minus $80,000) and pay no more than 22% tax on the money. If you were to convert the entire $100,000, the remaining $84,625 would be taxed at the next highest tax bracket of 24%.

In this case, you could save some money by spreading your conversion over several tax years.

What Is the Purpose of a Roth IRA Conversion?

The main reason people convert traditional IRAs or other retirement accounts into Roth IRAs is so they can enjoy tax-free income in retirement. They also have the flexibility to not make withdrawals if they don't need the money. That's because Roth IRAs, unlike traditional ones, aren't subject to required minimum distributions during the owner's lifetime.

How Much Tax Do You Pay on a Roth IRA Conversion?

The amount of tax you have to pay on a Roth IRA conversion will depend on your tax bracket at the time and how much money you convert. It is taxed as ordinary income.

How Do I Avoid Taxes on a Roth IRA Conversion?

You can't avoid taxes altogether, but you may be able to reduce the tax burden by converting just enough money to stay under the limit for the next marginal tax bracket. For that reason, it can pay to spread the conversion over several tax years. Another potential way to reduce your taxes is by doing the conversion in a year when your other income is unusually low, such as after a layoff. 

What Is a Backdoor Roth IRA Conversion?

A backdoor Roth IRA is a colloquial term for a technique wealthier taxpayers can use to get around the income limits for opening a Roth IRA. Because traditional IRAs have no income limits on eligibility, high-income taxpayers can contribute to traditional IRAs, then convert those accounts into Roth IRAs.

The Bottom Line

A Roth IRA conversion allows you to turn a traditional IRA or 401(k) plan account into a Roth. You'll have to pay income tax on the money you convert, but you'll be able to take tax-free withdrawals from the Roth account in the years to come. Roth IRA conversions make the most sense if you expect to be in a higher tax bracket after you retire or if tax rates in general rise significantly in the future.

Article Sources
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  1. Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distribution."

  2. Internal Revenue Service. "Retirement Plans FAQs Relating to Waivers of the 60-Day Rollover Requirement."

  3. Internal Revenue Service. "Publication 590-B (2021), Distributions from Individual Retirement Arrangements (IRAs)."

  4. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2023."

  5. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."

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