Roth IRA Conversion: Definition And Rules

One of the best features of a Roth IRA is tax-free withdrawals during retirement. Unlike a traditional IRA, you also aren’t forced to take distributions after a certain age, so the money can keep growing.

But there are caveats as well. In addition to paying taxes upfront on Roth IRA contributions, there are also income restrictions. If this applies to you, and you want to keep growing your Roth IRA, consider a Roth IRA conversion.

Roth IRA conversion rules

A Roth IRA conversion shifts money from a traditional IRA or a qualified employer sponsored retirement plan into a Roth IRA. These conversions are ideal for people who want tax-free investment earnings, to lower taxable income in retirement, or people who don't want to bother with required minimum distributions.

» Learn more: Also sometimes called a backdoor IRA conversion, Roth IRA conversions are accessible to almost anyone.

To stay in sync with IRS Roth IRA conversion rules, you’ll need to convert your traditional IRA to a Roth IRA in one of the following ways:

• Indirect rollover: You receive a distribution from a traditional IRA and contribute it to a Roth IRA within 60 days.

• Trustee-to-trustee or direct rollover: You tell the financial institution holding your traditional IRA assets to transfer an amount directly to the trustee of your Roth IRA at a different financial institution.

• Same trustee transfer: If your traditional and Roth IRAs are maintained at the same financial institution, you can tell the trustee to transfer an amount from your traditional IRA to your Roth IRA.

You may be able to do a rollover of a 401(k), 403(b) or other employer-sponsored retirement fund to a Roth if you are no longer working for the company, but as with the traditional-IRA-to-Roth rollover, you’re likely to trigger a tax bill here, too, unless you’re starting with a Roth 401(k).

A Roth IRA conversion could be right for you if...

• You like the idea of your investment earnings growing tax-free.

• You want the ability to lower your taxable income in retirement.

• You think your tax rate in retirement may be higher than it is now.

• You want to avoid required minimum distributions, which the IRS mandates at age 73 from a traditional IRA.

» Use our Roth IRA calculator to discover how much you could save in taxes by converting

A Roth IRA conversion might be wrong for you if...

• You lack the cash to pay the likely tax bill generated by the conversion. Some people pay the tax bill with part of the converted balance, but that sacrifices some of the tax-free investment growth. And if you’re under 59½, you may open yourself up to a 10% tax penalty on that money.

• You need the money in the next five years. Distributions of earnings and rolled-over amounts risk being hit with income taxes and even that 10% penalty from the IRS if they’re withdrawn before the five-year mark. Learn more about the Roth five-year rules if you fall into this category.

• The rollover will subject you to a higher marginal tax bracket the year of the switch. This increase may make the strategy less attractive.

How to do a Roth IRA conversion

Here are the essential steps in a Roth IRA conversion. You can skip step No. 1 if you already have a traditional IRA.

1. Put money in a traditional IRA account. If you don’t already have an account, you will need to open an IRA and fund it.

2. Pay taxes on your IRA contributions and gains. Only post-tax dollars get to go into Roth IRAs. So if you deducted your traditional IRA contributions, you’ll need to give that tax deduction back, effectively. Those IRA contributions, and any investment gains, will be added to your taxable income when you file your tax return for the year.

3. Convert the account to a Roth IRA. If you don’t already have a Roth IRA, you’ll open a new account during the conversion. Your IRA administrator will give you the instructions and paperwork.

» Ready to get started? See our picks for the best Roth IRA providers.

How do I avoid taxes on a Roth IRA conversion?

You can't necessarily avoid taxes altogether when doing a Roth conversion, but you can reduce the amount of taxes you owe on the rollover. Consider timing it in one of these ways:

• In a year you fall in a lower tax rate than normal. Maybe you switched jobs, had a period of unemployment or didn’t qualify for your usual bonus.

• When your traditional IRA account balance is down. If the market takes a hit and your IRA feels the aftershock, that could be an opportune time to launch this strategy.

• Early in the tax year. Taxes don’t have to be paid in full until the filing deadline (usually in mid-April the following year), so converting early in the calendar year gives you more time to pay Uncle Sam. (If you pay estimated taxes, you might have to make payments sooner.)

• Bit by bit, as you can afford to pay the taxes. You do not have to convert your full balance. (You can’t, however, convert only the portion of your balance that wouldn’t be taxed, such as nondeductible contributions. The IRS is on to that strategy.)