Learn what a Roth IRA Conversion is and whether it is right for you. Plus, learn the logistics of how and when to execute a Roth IRA Conversion.

A Primer on the Roth IRA Conversion

For most of us, the Roth IRA is the best way to save for retirement. But, many of us started saving in other types of accounts. So, what should you do if you have money saved for retirement that is not inside a Roth IRA?

In some circumstances, the IRS allows you to transfer money out of your old Traditional IRA accounts and into a Roth IRA. This process is called a Roth IRA Conversion.

Yes, a Roth IRA Conversion is a great tool for some, but not everyone qualifies. Plus, it does not make sense for everyone.

The rest of this article will help you understand the differences between the types of retirement accounts, how to determine if a Roth IRA Conversion is right for you, and how to execute a Roth IRA Conversion.

Let’s start by understanding the differences between the types of retirement accounts that exist.



Types of IRAs

A Roth IRA Conversion is simply transferring funds from a Traditional IRA to a Roth IRA. To understand why you might do that, you need to know the difference between the two.

The only difference between a Traditional IRA and a Roth IRA is the way it is taxed. You have two options:

  • Option 1: Avoid taxes on the contributions now, and pay taxes on the contributions and the growth later. This is how a Traditional IRA is taxed.
  • Option 2: Pay taxes on the contributions now, and never pay taxes on the growth. This is how a Roth IRA is taxed.

Traditional IRA Taxation

With a Traditional IRA, you deduct your contributions from your income when calculating your taxes. That will lower your tax bill now.

But, with few exceptions, any amount you withdraw from your IRA will be counted as income. That means that during retirement you will be taxed on both the contributions you made when you were younger and the growth that happened over time.

Roth IRA Taxation

With a Roth IRA, you do not deduct your contributions from your income. That means contributing to a Roth IRA will not lower your tax bill now.

But, after retirement, any amount you withdraw from your Roth IRA will be absolutely 100% tax free. You already paid taxes on the contributions. Plus, with a Roth IRA you never pay taxes on the growth. Ever.

That is the miracle that makes the Roth IRA such a powerful tool: you never pay taxes on the growth!

If you fully fund a Roth IRA starting at 30, then you can expect about 85% of the value of the account to be growth by age 65! You will have put in about $200k and the account will have grown to about $1.2 million. With a Roth IRA you can have that $1 million completely tax free!

A Roth IRA Conversion would take a taxable distribution from a Traditional IRA and put the funds directly into a Roth IRA. You pay the taxes on the distribution now, but you will never pay taxes on the contents of the account ever again… no matter how much it grows to be!

As a result, a Roth IRA Conversion can be a great way to reduce your lifetime tax liability. But, not every IRA qualifies.


Employer Sponsored IRAs

Most Employer Sponsored Retirement Plans do not allow Roth IRA Conversions. This includes 401(k), 403(b) 457(b), SIMPLE, SEP, and SARSEP plans.

As a result, you generally cannot do a Roth IRA Conversion with the retirement savings at your current employer. Roth IRA Conversions are generally available if you have left an employer and moved your retirement account to a self-directed Traditional IRA Rollover.

This is one of the many reasons you never leave money in your old retirement plan when you leave an employer. Always roll your money into a self-directed IRA Rollover when you change employers. You can Convert a Traditional IRA Rollover to a Roth IRA at any time.

Also, if you have been contributing to a self-directed Traditional IRA, you can convert that to a Roth IRA any time.


The Roth IRA Conversion

So, if you have money in a Self-Directed Traditional IRA or Rollover, you are likely eligible to execute a Roth IRA Conversion.

At any point, you can take money out of your Self Directed Traditional IRA and move it into a Self Directed Roth IRA. This is called a Roth IRA Conversion.

But, remember that any money removed from a Traditional IRA counts as taxable income. So, you pay income taxes on the amount of the Conversion. That money then becomes the contribution portion of your Roth IRA. If you follow the rules, you will never pay taxes on that money again. And, you will also never pay taxes on the growth that money generates.

When to do a Roth IRA Conversion

Even if your account is eligible, a Roth IRA Conversion is not for everyone. They can be a bit tricky to manage correctly and not end up with a massive tax bill. Plus, depending on where you are in your journey to eliminate debt and build wealth, it may not be a good time to create an optional tax bill.

Eliminate High Interest Debt First

When you execute a Roth IRA Conversion, you have to add the amount of the conversion to your taxable income. And, that will create a tax bill, which you will have to pay out of pocket.

If you have high-interest debt, then it is a much better use of your precious resources to pay extra on your debt than to do a Roth IRA Conversion.

Buckle down, work hard, and eliminate all of your high interest debt first! Then, make sure you have a solid emergency fund. Only then should you consider a Roth IRA Conversion.

Manage Your Tax Bracket

The benefit of doing a Roth IRA Conversion is that you can pay taxes on the amount you convert now, and never have to pay taxes on the money in that account again.

But, that means that the higher the income tax rate you pay at the time of the conversion, the lower the benefit of doing the conversion.

Therefore, I generally don’t recommend Roth IRA Conversions for people whose marginal tax rate is over 12%. In 2020, that means single tax filers in the US who make more than about $52k gross income (about $104k gross income for married couples).

For income above that amount, the federal income tax rate jumps from 12% to 22%.

So, if you converted $10k in the 12% bracket, you would be creating a $1,200 federal income tax bill. But, if you have higher income, you could create a $2,200 tax bill with the same conversion. That means that more than 1 out of every 5 of the dollars you convert goes to the government. At that rate, it is probably wiser to just keep your money in a Traditional IRA instead.

Roth IRA Conversion Ladder

If your household income is such that you could convert some of your Traditional IRA to a Roth IRA at the 12% tax rate, but not all, then I generally recommend a Roth IRA Conversion Ladder.

Let’s say you are married and your combined household income is $75,000. And, let’s say you have $50k in a Self Directed Traditional IRA. If you convert the whole thing this year, you will pay 12% on about $30k ($3,600), and 22% on about $20k ($4,400). That brings the total tax bill for the conversion to $8,000, all due at once.

In that circumstance, I would do some this year and some next year, to bring the total tax bill down.

For example, if you converted $25k this year, and the rest next year, you would stay inside the 12% bracket both years. You would pay 12% on $25k this year ($3,000) and the same next year. That brings the total tax bill for the conversion to $6,000, due over two years.

This Roth IRA Conversion Ladder would save you $2,000 in total taxes, and allow you to push half of the taxes out for a year, making it easier to save up for the bill.

Logistics of a Roth IRA Conversion

Executing a Roth IRA Conversion is super easy. If you have a Self Directed Traditional IRA, simply contact your administrator and have them move the amount you want to Convert into a Roth IRA. Then, invest the money in the same way it was invested before the conversion.

At the beginning of the next year, your administrator will send you a Form 1099R showing that you had a taxable withdrawal from your Traditional IRA. And, you will receive a Form 5498 showing that you put that same amount into a Roth IRA.

The amount on the 1099R is added to your income, but the Roth IRA contribution is not tax deductible. This is why your tax bill goes up.

Withdrawals from a Roth IRA Conversion

A Roth IRA Conversion is meant to be a long-term investment. So, there are penalties for using that money too soon.

If you withdraw a conversion before 5-tax-years have elapsed, you will have to pay a penalty. Therefore, you will need to keep track of how much you convert to a Roth IRA each year. Every conversion has its own 5-tax-year clock.

Generally, this won’t matter if you follow my advice. Roth IRA Conversions are generally best executed in your 30s, 40s, and sometimes 50s. Which is more than 5 years before you would start drawing from the account.

The rules regarding early withdrawals from Roth IRAs can be a bit tricky, and Investopedia.com has the best explanation of how it works. Feel free to familiarize yourself with the rules if you’d like. However, if you think you may need the money relatively soon, then you probably shouldn’t be doing a Roth IRA Conversion anyway.

Deciding if a Roth IRA Conversion is Right for You

Only do a Roth IRA Conversion if all of the following are true.

  • You have a self-directed Traditional IRA or Rollover.
  • You have no high-interest debt.
  • Your household is in the 10% or 12% Federal Income Tax Bracket.
  • You are less than about 55 years old.
  • And, the amount of your Roth IRA Conversion will not push you into the 22% tax bracket.

When and How Much to Convert

If you meet all five criteria for a Roth IRA Conversion, then you will need to decide when and how much to convert.

I generally recommend doing Roth IRA Conversions in December. By that time you can get a pretty good idea what your total household income will be for the year. If you are single, subtract your total income from $52k. A married couple would subtract from $104k. Then, round down to the nearest $5k or $10k, and start the conversion.

So, if you are married and your income is $72k, the most I would convert is $30k.

But, make sure you can set aside enough to pay the taxes. In that example your tax bill will increase by $3,600, and be due in April. If you cannot easily pay those extra taxes, then you are not ready to do a Roth IRA Conversion.

Watch out for State Taxes

One final note on the taxation of Roth IRA Conversions: double check your state rules before starting. Some states count IRA distributions toward taxable income, which may make a Roth IRA Conversion more expensive than it is worth.

There are currently 7 states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Plus, New Hampshire and Tennessee treat retirement income different than regular income. For the other 41 states, retirement income tax rules vary widely, and it is up to you and your tax professional to navigate the nuances.

But, if your retirement plans include moving to one of the nine states where retirement income is not taxed and you currently live in a relatively high state-income tax jurisdiction, it may not make sense to do a Roth IRA Conversion. For example, in California if you are in the 12% Federal Income Tax Bracket, you are likely also in the 6% State Income Tax Bracket, so doing a Roth IRA Conversion would cost you an additional 6% in State Income Tax.

I would definitely not do that if you are planning to move to Nevada, Texas, or Florida in the next few years!

Final Thoughts

A Roth IRA Conversion can be a valuable tool to help reduce the total amount of taxes you pay during your life. It is a relatively advanced technique and it is not for everyone.

Basically, a Roth IRA Conversion allows you to move money out of a Traditional IRA, pay taxes on it, and put it into a Roth, where it will never be taxed again… if you follow the rules.

This only makes sense if you have a self-directed Traditional IRA, have paid off all of your high-interest debt, are in a relatively low income tax bracket, have the cash available to pay the tax bill, and you are young enough that your Roth will have time to grow significantly before you start withdrawing.

What to Read Next

For more information, check out these articles that offer more detail about these topics. Enjoy!


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