Roth conversions shift retirement taxes from later to now

A Roth conversion moves existing retirement savings from an eligible pre-tax account, such as a traditional IRA, into a Roth IRA. The pre-tax amount converted generally becomes ordinary taxable income for that year. In return, future growth and qualified withdrawals from the Roth may be tax-free.

For an investor, a Roth conversion is a choice about when to pay tax, not a new investment or a way to avoid tax altogether. The decision depends on the tax cost now, the tax rate that may apply when money would otherwise be withdrawn, how long the assets can stay invested, and whether cash outside retirement accounts is available to pay the tax.

What is a Roth conversion?

Traditional retirement accounts commonly hold pre-tax money, meaning taxes are generally deferred until withdrawal. A Roth IRA holds money under different tax rules. A conversion shifts all or part of an eligible balance from the pre-tax treatment to the Roth treatment.

Traditional, SEP and SIMPLE IRAs are common sources for conversions. Other eligible retirement accounts may also be convertible, subject to the account and plan rules.

The tax trade-off

Suppose an investor converts $10,000 of entirely pre-tax traditional IRA assets. That $10,000 is generally added to the investor's ordinary taxable income for the conversion year.

If the money remains in the Roth IRA and withdrawal requirements are met, later qualified withdrawals may be tax-free. A conversion can cover the full account balance or only part of it.

Partial conversions can be spread across multiple years to help manage how much taxable income is added in each year. There is no annual dollar cap on conversion amounts, although a larger conversion generally creates more taxable income at once.

A conversion versus a Roth IRA contribution

• Roth IRA contribution: New money goes into a Roth IRA. Direct contributions are subject to annual limits, earned-income requirements and income rules.
• Roth conversion: Existing eligible retirement assets move into a Roth IRA. The income limits that restrict direct Roth contributions do not apply to conversions.

This distinction is relevant for people who cannot contribute directly to a Roth IRA because of income. A conversion can still create a tax bill even though no new money is being invested.

Four checks before a Roth conversion

1. What income will it add this year? The converted pre-tax amount generally counts as ordinary income. It can push part of income into a higher marginal tax bracket and may affect income-based items, including Medicare premiums, taxation of Social Security benefits, and eligibility for certain credits or deductions.
2. How will the tax be paid? Cash outside retirement accounts can allow the full intended amount to enter the Roth. Consider the available cash alongside the conversion's tax cost.
3. How long can the money stay put? A longer holding period gives tax-free growth more time to matter. Roth withdrawal rules still apply: qualified distributions generally require a five-year holding period and another qualifying condition, such as reaching age 59½. Conversions also have a separate five-year rule that can matter for penalty purposes.
4. Does an RMD apply? A required minimum distribution, or RMD, is a withdrawal certain retirement-account owners must take. An RMD cannot be converted to a Roth IRA and generally must be taken before further eligible assets are converted.

Potential advantages and constraints

A Roth IRA has no lifetime RMDs for its original owner. That can provide flexibility over retirement withdrawals and allow assets to remain invested if they are not needed.

The cost is immediate and can be substantial. A conversion may be more appealing when an investor expects a higher tax rate later than the rate paid on the conversion, but future tax rates and personal income are uncertain. A market decline after conversion can also leave the account worth less than its value at conversion.

Roth conversions completed in 2018 or later generally cannot be recharacterized, meaning changed back into a traditional IRA. Review the account's eligibility and the effect on your taxable income before converting. A tax professional can assess those effects in the context of a specific tax return.

Frequently asked questions

Does a Roth conversion count as a Roth IRA contribution?

No. A direct Roth IRA contribution adds new money and is subject to annual contribution limits and income rules. A Roth conversion moves existing eligible retirement assets into a Roth IRA, and the direct-contribution income limits do not apply to it.

How much tax would I owe on a Roth conversion?

The pre-tax amount converted is generally included in ordinary taxable income for the conversion year. The actual tax effect depends on your broader income and tax situation, and conversion income can also affect some income-based costs, credits or deductions.

Can I convert only part of a traditional IRA to a Roth IRA?

Generally, yes. A conversion does not have to include the full account balance, and partial conversions across multiple years may help manage how much taxable income is added in a given year.

Can required minimum distributions be converted to a Roth IRA?

No. An RMD is not eligible for conversion and generally must be taken before other eligible assets are converted during that year.

Sources

• Is a Roth IRA conversion right for you? - Vanguard — investor.vanguard.com
• What Is a Roth Conversion? Rules, Taxes, and More - Charles Schwab — www.schwab.com
• Convert Retirement Savings to a Roth IRA - Fidelity Investments — www.fidelity.com
• What is a Roth IRA conversion? How it works - Ameriprise Financial — www.ameriprise.com