Roth IRA Conversions with guidebook icon

As you move through different seasons of life, it’s a good idea to periodically reevaluate your retirement investment strategy and look for opportunities to make the most of your dollars — both now and in the future. One strategy that could be worth exploring? A Roth IRA (Individual Retirement Account) conversion.

What is a Roth IRA conversion?

A Roth IRA conversion occurs when you take funds out of a traditional IRA and move them into a Roth IRA. Because traditional IRAs and Roth IRAs present different tax advantages, transferring money to a Roth could save you money under the right circumstances. And it’s a good idea to consult with a tax professional when deciding what’s right for you.

Traditional vs. Roth IRA

Before deciding if a Roth IRA conversion makes sense, it’s important to understand the differences between traditional and Roth IRAs.

Tax timing: Traditional IRA contributions are tax-deductible, and you pay taxes when you make withdrawals. Roth IRA contributions are made with money that you’ve already paid tax on, so you can take your distributions tax-free once you’ve reached age 59 ½.

Income limits: Roth IRAs have income limits that prevent high income earners (individuals making more than $140,000 adjusted gross income (AGI) filing as a single person or $208,000 AGI if you file jointly) from making direct contributions. Traditional IRAs have no income limits.

Early withdrawals: If you withdraw money from a traditional IRA before age 59 ½, you’ll be charged a 10% early withdrawal fee. You can withdraw Roth IRA contributions penalty-free at any age, but if you want to withdraw Roth earnings, you need to meet certain qualifications (such as being at least 59 ½ with a five-year-old account), otherwise you may owe taxes and/or a 10% penalty.

Contribution limits: Both accounts have a maximum yearly contribution limit of $6,000 in 2021. If you’re over 50, you can add an extra $1,000 a year in catch-up contributions.

Required distributions: With a traditional IRA, you’re subject to annual mandatory, taxable distributions (a.k.a. withdrawals) beginning at age 72 (if your 70th birthday falls on or after July 1, 2019). Roth IRAs don’t have required distributions.

Keep reading: Compare the various types of IRAs.

Should you convert a traditional IRA to Roth IRA?

Depending on your current situation, you might find that the tax benefits of one type of IRA are more advantageous to you in the long run — and should your income or work circumstances change in the future, the other could be a better fit.

When does a Roth conversion make sense?

You might consider converting to a Roth IRA if you’re able to pay a lower tax rate now than when you make a withdrawal from your IRA later on. For example, if …

  • You’ll retire in a higher income bracket than the one you’re in now, or if tax rates are currently considerably low.
  • Your income has been reduced and you’ve dropped to a lower tax bracket.
  • You plan to retire in a state with a higher income tax than your current one.
  • You plan to leave unused funds with a child, spouse, etc. as an inheritance.

If you need the funds for retirement within the next five years, can’t cover the tax bill that comes with conversion, or anticipate you’ll be in a lower tax bracket in the future, it may not be the right time for a Roth conversion.

Advantages and Disadvantages of Roth IRA Conversions

Weighing the benefits and drawbacks of a Roth IRA conversion will help you see what comes with the switch.

Advantages include …

  • You contribute after-tax dollars, so you won’t have to pay taxes when it comes time to withdraw.
  • You’re able to withdraw your contributions tax-free at any time after five years, meaning you can dip into your retirement savings if a more pressing money issue arises.
  • There’s no income limit when converting a traditional IRA to a Roth IRA.

Disadvantages include …

  • Paying taxes at the time of a Roth conversion can mean a hefty tax bill.
  • Even if you convert funds when you’re 59 ½, you’ll still have to wait five years before you can withdraw your earnings tax-free.
  • You can’t always anticipate what your future tax bracket will be. And if your tax rate in the future is lower than your current one, a Roth conversion might not pay off.

Backdoor Roth IRA Conversions

Income limits prevent high earners from making direct contributions to a Roth IRA, but there’s no income limit for converting to one. When earners above the income limit convert a traditional IRA or 401(k) to a Roth IRA, it’s called a backdoor Roth IRA. Doing this lets you take advantage of Roth IRA benefits, like tax-free growth and no required minimum distributions.

Mega backdoor Roth conversions are a more complicated rollover strategy that allows you to contribute up to $37,500 in a Roth IRA.

Roth Conversion Example

Now that you understand the technical side of Roth vs. traditional IRAs, let’s look at a scenario in which converting could pay off.

Sally just started an entry level job, and her current federal tax rate is 12% due to her taxable income bracket. She anticipates doubling her salary over the course of her career, which would increase her tax rate to at least 24%. With $10,000 in a traditional IRA, she decides to convert the funds to a Roth IRA and pay 12% tax on them now, rather than 24% when she makes withdrawals in the future, as she would have to with a traditional IRA.

How to Convert to a Roth IRA

If you think a Roth conversion makes sense for you, the steps to convert are pretty simple:

  1. Have an existing traditional IRA account or open a new one.
  2. Pay taxes on the funds you’ve contributed to your traditional IRA and the gains you’ve made.
  3. Convert the traditional account to a Roth IRA.

Alternatives to Roth IRA Conversions

If a Roth IRA conversion isn’t right for your situation, there are other ways you can manage IRA balances:

  • Indirect rollovers let you move money from your 401(k) to a Roth.
  • Direct IRA transfers help you move funds from one provider to another.
  • If your traditional IRA and Roth are managed by the same financial institution, same trustee transfer allows your trustee to move money from your traditional IRA to a Roth. Keep in mind there are still tax implications for contributions you’ve already deducted from your traditional IRA.

Consider a Roth IRA Conversion

Saving for retirement requires strategic planning, and you want to get the most bang for your buck. Converting to a Roth IRA may be a profitable decision when timed correctly and under the right circumstances. If you, after consulting with a tax professional, think making the switch will help you reap a bigger retirement reward, it may be worth considering.

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