Roth IRA Conversion

What Is a Roth IRA Conversion?

A Roth IRA conversion is a transfer of retirement assets from a Traditional, SEP, or SIMPLE IRA into a Roth IRA, which creates a taxable event. 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.

Key Takeaways

  • A Roth IRA conversion involves transferring retirement funds from a traditional IRA or 401(k) into a Roth account.
  • Since the former is tax-deferred while a Roth is tax-exempt, the deferred income taxes due must be paid on the converted funds at that time. There is no early withdrawal penalty.
  • This strategy makes sense if a saver believes that the deferred tax liability in the traditional account will grow as retirement approaches, where it is better to pay those taxes now than later.

How a Roth IRA Conversion Works

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 Dec. 31, 2017, can no longer be recharacterized—in other words, it can't be reverted back to a traditional IRA later.

When Conversions Make Sense

The big advantage of Roth IRA conversions is having tax-free withdrawals in retirement. This can be appealing if you expect to be in a higher marginal tax bracket in retirement, which is typically 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, the amount of taxes paid for those conversions would be minimized.

Tax considerations are the key to a Roth IRA conversion. It makes little sense to convert if you'll be handed a tax bill now that will be much larger than if you had waited to withdraw the funds. In addition, the time value of money is important. A dollar in your hand today is worth more than a dollar coming at some time in the future. Another factor is that you don't want a large conversion in any one year to bump you into a higher tax bracket.

Another aspect to consider is making a charitable deduction with the assets from an IRA. The 2018 changes in the tax law have in effect taken these deductions off the table for many taxpayers. But if you were to use money from an IRA to make a charitable contribution, the tax deduction for a contribution to a public charity can be up to 60% of a couple's adjusted gross income (AGI) for cash donations, and up to 30% for donations of securities such as those in an IRA. If your contribution exceeds these limits, the IRS​​​​​​​ allows you to carry the excess forward for up to five years. 

If RMDs are creating cash flow surpluses that are not being spent due to normal reoccurring retirement expenses, it may make sense to use those surpluses as an opportunity to do conversions. It may also make sense so as to reduce the magnitude of future RMDs by shifting assets from tax-deferred assets in a Roth IRA.

Example of a Roth Conversion

For example, if a married couple who expect to file jointly with $115,000 in taxable income convert up to $50,000 to a Roth IRA they could stay within the 22% marginal tax bracket for 2021, which applies to taxable income between $81,051 to $172,750. A dollar above that limit would kick the couple into the 24% bracket.