A Traditional IRA or 401(k)can be an excellent retirement tool. However, you might be missing out on additional tax benefits that can only be acquired in a Roth. For example, if you anticipate entering into a higher tax bracket or plan to invest your retirement in alternative assets, like real estate, then a Roth account would be better for you.

Thankfully, switching from a Traditional retirement plan to a Roth plan is easy with a Roth conversion.

This quick review of Roth conversions will cover the process, rules, benefits, and potential drawbacks of a Roth conversion to help you decide if it is right for you.

What Is a Roth Conversion?

A Roth Conversion is the process of moving money from one pre-tax retirement account, such as a Traditional IRA, SIMPLE IRA, or 401(k), to a Roth (post-tax) account.  However, because both types of accounts are funded and taxed differently, the conversion requires additional considerations that aren’t present when moving funds between pre-tax accounts. Specifically, you’ll need to pay taxes on the converted amount.

Why You Should Consider a Roth Conversion

You may want to consider a Roth conversion if one or more of the following are true:

• You want to avoid required minimum distributions (RMDs). If you have a Traditional IRA, 401(k), or a similarly structured account, you must take RMDs each year once you turn 73. Taking RMDs in retirement can help you manage everyday expenses during retirement, but removing that money from your account can also reduce overall growth. Roth account holders are not required to take RMDs.

• You want to leverage tax-free withdrawals during retirement. Traditional IRA and 401(k) withdrawals are subject to taxes. Since Roth accounts are funded with after-tax dollars, withdrawals aren’t taxed.  That does not suggest there are no tax obligations when converting a Traditional account to a Roth account. You’ll need to pay income tax on the converted amount. But, after that point, withdrawals are tax-free.
• Tax diversification. Many financial experts recommend diversifying your investment portfolio, but the benefits of diversification exceed a single account. If you have traditional investment accounts, converting one or more accounts to a Roth IRA or 401(k) provides flexibility should your tax rate fluctuate in the future.
• You want to pass on your retirement account to heirs. If you maintain a Traditional account, you’ll need to pay RMDs, which will diminish your beneficiary’s inheritance. By converting to a Roth account, you can side-step RMD requirements and increase account growth over time.

Roth IRA Income Limits

Unlike Traditional IRAs, Roth accounts have income limits that may reduce the amount you can contribute or prevent you from contributing altogether. For instance, if you are married and filing separately, you won’t be able to contribute to a Roth IRA if your annual income exceeds $10,000.

Traditional IRAs don’t have income limitations, nor do Roth conversions. As such, a Roth conversion allows you to leverage Roth IRA benefits, even if your income and tax-filing status prevent you from directly contributing to a Roth.

Roth Conversion Rules

Roth conversions are subject to IRS rules, as is the case for many other retirement account activities. Before you convert your account, it’s wise to speak to a financial or tax expert who can help you understand the implications of such rules as they apply to your circumstances. However, here are a few common rules to keep in mind:

• Tax requirements. All Roth conversions are subject to income tax based on your income tax obligations in the year you complete the conversion.
• The 5-year rule: Each time you convert a Traditional account to a Roth IRA, any withdrawals from that amount made within the first five years of the conversion are subject to a penalty.
• Partial conversions. You don’t need to convert an entire account. You can choose to make a partial conversion, maintaining the original traditional account while leveraging Roth benefits on a portion of the funds. This can help diversify your retirement portfolio by leveraging different tax structures.

When a Roth Conversion Might Not Be Worth It

Despite the benefits of a Roth conversion, it may not be right for everyone.  This is particularly true if you anticipate being in a lower tax bracket during retirement. When you convert your Roth IRA, you must pay income taxes on the converted amount. If you’re in a lower tax bracket, that can lead to a significant tax burden.

If you believe that to be true, maintaining a Traditional account may save you money in the long run. However, each situation is different, and discussing your specific needs and circumstances with a financial advisor can help you determine whether a conversion is worth it or not.

Another reason you may not want to convert your account is if you need the funds within the next five years. Because earnings removed from a Roth account within the first five years are subject to a 10% penalty, and you’d have to pay income tax on the conversion in the first place. A conversion may not be worth it if you think you’re going to tap into those funds in that short time frame.

How to Execute a Roth Conversion

If you think a Roth conversion is right for you, follow these simple steps to complete the process.

• Make sure the account you’re converting is eligible. Traditional IRAs, SIMPLE IRAs, and SEP IRAs, as well as 401(k) and 403(b), are generally eligible for a Roth conversion. If you’re not sure, contact your account custodian.
• Open a Roth IRA account. If your current account custodian offers Roth accounts, you can complete the conversion without seeking out another financial entity. However, if you aren’t happy with your current financial entity or prefer to maintain accounts with different entities, you’ll need to open an account elsewhere.
• Determine how and when you’ll move your funds. As mentioned, conversions are subject to income tax. Depending on your income, the size of your conversion, and your current tax bracket, a conversion can push you into a higher tax bracket.  If that’s the case, you may want to consider making the conversion in increments over several years, to reduce the tax implications. 
• Pay your taxes.  Make sure that you account for your conversion on your tax returns for the year it was made. Failure to do so can lead to penalties.

Converting to a Roth account can be beneficial for many reasons. Talk to your financial advisor to see if it is the right move for you.

FAQs

How is a Roth conversion taxed?

A Roth conversion is taxed based on income in the year in which the conversion was completed.  Since it’s taxed as income, it’s important to determine how the conversion may impact your current income tax bracket, as the converted amount may push you into a higher bracket and increase your tax obligations in that year.

Can I convert a traditional IRA to a Roth IRA at any age?

Yes, you can convert a Traditional IRA to a Roth IRA at any age, but it may not always make sense to do so. Consider your tax bracket, retirement needs, and your financial goals before you complete a conversion, especially if you’re nearing retirement age or think you’ll be in a lower tax bracket at retirement.

When is the best time to do a Roth conversion?

The best time to complete a Roth conversion is when you’re in a lower tax bracket, as the total amount converted will be considered taxable income for the year the conversion was completed.

It’s also wise to complete a conversion before age 73, which is when the required minimum distributions start. RMDs decrease your account balance over time and can prohibit growth potential.