Roth conversions explained

A Roth conversion is a transfer of money from a pre-tax retirement account, such as a traditional IRA, into a Roth IRA. The person pays income tax on the pre-tax amount now. In exchange, the money and its later growth can come out tax-free if the Roth rules are met. It is a trade of a known tax bill today for the possibility of a smaller one later.

How a conversion works

IRS Publication 590-A describes three ways to convert a traditional IRA to a Roth IRA:

1. Rollover. The owner receives a distribution from the traditional IRA and contributes it to a Roth IRA within 60 days.
2. Trustee-to-trustee transfer. The institution holding the traditional IRA sends the money directly to the institution holding the Roth IRA.
3. Same-trustee transfer. If one institution holds both accounts, it moves the money between them, or simply redesignates the account.

Money in a workplace plan, such as a 401(k), can also be rolled into a Roth IRA when the plan permits a distribution, and the publication says the same tax rules apply. All or only part of an account can be converted, and conversions can be spread over several years.

Unlike regular Roth IRA contributions, conversions are not subject to an annual dollar limit or to the income phase-out that restricts direct contributions.

How the converted amount is taxed

Publication 590-A states that a person must include in gross income the amounts that would have been taxable if they had simply been withdrawn. That income is generally reported in the year of the conversion and taxed at ordinary rates. The 10% additional tax on early distributions does not apply to an amount that is properly converted.

If the traditional IRA holds only deductible contributions and earnings, the full converted amount is taxable. If the owner has ever made nondeductible contributions, part of each conversion is a tax-free return of that basis. The split is figured on Form 8606 using all of the person's traditional IRAs together, a calculation explained in the backdoor Roth IRA.

A hypothetical example

Suppose someone with $70,000 of other taxable income converts $30,000 from a fully pre-tax traditional IRA. Their taxable income for that year becomes $100,000. The $30,000 is taxed at whatever rates apply to income between $70,000 and $100,000 for their filing status, which may include more than one bracket. This example uses round numbers for illustration only.

Where the tax money comes from

The tax on a conversion is not settled automatically when the money moves. Publication 590-A notes that a person who must include an amount in income may have to increase withholding or make estimated tax payments.

The source of the tax payment matters. If part of the withdrawal is kept to cover the tax rather than deposited in the Roth IRA, that part is not converted. The publication says the amount kept is generally taxable and may be subject to the 10% additional tax on early distributions if the owner is under 59½. For that reason some people prefer to pay the tax from savings outside the retirement account, which also leaves more money in the Roth.

Rules that limit flexibility

Conversions cannot be reversed. Before 2018 a conversion could be undone through a process called recharacterization. Publication 590-A states that conversions made in tax years beginning after December 31, 2017, cannot be recharacterized. Once the transfer is complete, the income is on that year's return.

Required distributions cannot be converted. Starting with the year a traditional IRA owner reaches age 73, the required minimum distribution for the year has to be taken first. Publication 590-A says amounts that must be distributed under those rules cannot be converted.

Each conversion has a five-year period. Publication 590-B explains that if converted money is withdrawn within five years, starting January 1 of the year of the conversion, a person under 59½ may owe the 10% additional tax on the part that was taxable when converted. A separate period applies to each conversion. See the Roth IRA five-year rules.

The calendar year matters. A conversion counts for the year in which the money leaves the traditional IRA, so one completed in December is income for that year. There is no grace period into the following spring as there is for regular contributions.

Side effects of the extra income

A conversion raises adjusted gross income for the year, and several other calculations depend on that number.

• More of a person's Social Security benefits may become taxable. See how Social Security benefits are taxed.
• Medicare Part B and Part D premiums are higher for people above certain income levels, based on income reported on an earlier tax return. See IRMAA: how income affects Medicare premiums.
• A large conversion can push part of the income into a higher tax bracket.

When people consider converting

Whether a conversion makes sense depends on facts that differ from person to person, especially the tax rate paid on the conversion compared with the rate that would otherwise apply when the money is withdrawn. Some common situations in which people look at the idea:

• A year with unusually low income, such as a gap between jobs or the early years of retirement before Social Security and required distributions begin.
• A wish to reduce future required minimum distributions, since Roth IRAs have none during the owner's lifetime.
• A plan to leave the account to heirs, who would generally receive Roth money without income tax.
• A desire to hold both pre-tax and tax-free money, as discussed in the three account buckets.

Questions worth asking before converting include how the tax will be paid, how long the money is likely to stay invested, and what else on the tax return changes when income goes up. Because the result depends on future tax rates and personal circumstances that cannot be known in advance, a conversion is a judgment call, not a guaranteed gain.