Is a Roth IRA Conversion Right for You?

Investing, IRA, Retirement Planning, Roth IRA
Roth IRA conversion

There are a lot of reasons you might consider a Roth IRA conversion, which shifts money from a traditional IRA into a Roth IRA account.

Maybe your income or account balance is down this year, potentially lowering the tax on the conversion. Maybe you chose the wrong account from the start. Or maybe you earn too much to otherwise be eligible for a Roth. After all, for high-earners, the Roth IRA is a little like a sold-out concert: Everyone’s talking about it, but you can’t get in — unless you sneak in the backdoor through a conversion.

Whatever your reasoning, a Roth conversion — often called a backdoor Roth IRA, especially when it’s done as a way around Roth IRA income limits — is an IRS-approved method for getting traditional IRA money into a Roth IRA. But just because you can, doesn’t mean you should.

» Know the basics: What is a Roth IRA?

Yes, the Roth IRA is sought-after — it offers tax-free distributions in retirement, because contributions are made with after-tax dollars — but it isn’t for everyone, and neither is a Roth IRA conversion.

Here’s what to consider before following the crowd:

1. Your current and future tax rates

2. Cash to pay taxes generated by the conversion

3. Value of your traditional IRA

4. When you plan to tap converted funds

1. Your current and future tax rates

When investors eligible for both the Roth and traditional IRA decide between the two, they primarily consider paying taxes now versus later. The decision to convert from a traditional to a Roth IRA hinges on many of the same factors.

Generally speaking, a Roth IRA is a stellar deal if you believe your tax rate is lower now than it will be when you withdraw the money in retirement. That’s because by making after-tax contributions today, you’re locking in that lower rate. When you hit a higher tax rate in retirement, no big deal: That rate doesn’t apply to money you pull out of a Roth IRA.

A traditional IRA takes the opposite approach: Contributions today are deductible; distributions in retirement are taxed as ordinary income. For a traditional IRA to trump a Roth, your tax rate today needs to be higher than it will be in retirement. That means you’d save on taxes by pushing them off until you’re eligible for a lower rate.

» Which IRA is best for you? Roth vs. traditional IRA

If your taxes are on the “high now, low later” trajectory, you can exit stage right — don’t convert. Keep this strategy in your pocket, though, especially if your income fluctuates. Some investors also find a Roth IRA conversion early in retirement makes sense, either to avoid required minimum distributions — mandated by the IRS from a traditional IRA at age 70½, but not from a Roth IRA — or to lower income throughout retirement, which may, in turn, lower taxes on Social Security benefits. Income pulled from a Roth IRA does not count toward your taxable income.

2. Cash on hand to pay Roth IRA conversion taxes

The squeaky hinge in the backdoor Roth IRA plan: Turning tax-deferred contributions into after-tax contributions isn’t magic. It typically requires an additional investment on your part: You have to pay taxes on the amount converted.

The exception is if you’ve made after-tax contributions to your traditional IRA, either because you were priming the account for this conversion or because you weren’t eligible to deduct your contributions (likely, if you have a 401(k) at work and you earn too much to walk in the front door of a Roth). In that case, you’ll only pay taxes on the portion of the converted amount that is untaxed, like investment earnings or contributions you did deduct.

That taxable amount will be added to your gross income for the year, and when the tax bill comes due, you want to be able to pay it with outside dollars. If you instead pull that tax money out of the balance converted, you’ll give up some of the tax-free investment growth you’re after, and — if you’re under 59½ — open yourself up to a 10% early distribution penalty on that money.

Taxes owed on a Roth IRA conversion can amount to a lot or a little, depending on factors like the amount converted and your tax rate. It pays, quite literally, to be prepared for that sting in advance. In fact, you may need to make estimated tax payments in the year you convert, or change your withholding at work to make up for the increase in income.

» Learn the rules: Roth IRA rules

3. The value of your traditional IRA

It also pays to reduce the taxes you’ll owe on the conversion. You can do that by timing the conversion for 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 — or by converting 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. The other option to reduce the tax blow is to convert 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, like nondeductible contributions. The IRS is on to that strategy.)

A good tax advisor is a worthwhile investment, especially if you’re converting a large amount, planning a series of conversions or converting an account that contains both nondeductible and deductible contributions. He or she could help you time the maneuver to reduce the tax hit, and make sure taxes owed are paid.

4. When you plan to tap converted funds

One perk of the Roth IRA is that because you’ve already paid taxes on that money, the IRS isn’t itching for you to start distributions so they can collect. That means the Roth IRA isn’t subject to required minimum distributions at age 70½ the way tax-deferred accounts like a traditional IRA or a 401(k) are.

This is a benefit if you don’t need that money — if you want to leave it be as long as possible so it continues to grow or so you can pass it on to heirs. You can continue to contribute to a Roth IRA through retirement if you’d like. If, on the other hand, you plan to take distributions as soon as the clock strikes 59½, the ability to skirt required minimum distributions may not matter.

The other thing you should know comes into play if you need to tap that money soon. Roth IRAs have a five-year holding rule; you must have the account for five years for a distribution of earnings to be qualified, even if you’ve reached that 59½ milestone when distributions from retirement accounts are typically allowed free and clear. If you take a distribution before the five-year mark, that money could be hit with a 10% penalty and income taxes.

If you’re doing the Roth IRA conversion near or in retirement and you want to pull money out of the account within five years, that’s a significant factor. Each conversion amount starts its own five-year time block, so if you convert multiple amounts into a Roth IRA, you may end up with several five-year periods to track. Distributions from Roth IRAs are always taken from amounts directly contributed first, then from conversions — which come out on a first in, first out basis — and then from earnings on contributions.

Potential for a do-over

If you’re still straddling the traditional-Roth IRA line, this might help quell your hesitations: You can roll back this conversion, provided you do it by the deadline for filing the prior year’s tax return extensions, typically Oct. 15.

You won’t pay a penalty for unraveling your work, and you’ll get a refund of taxes paid. This might be a good option if your income ended up higher than you expected or the Roth IRA conversion unexpectedly bumped you into a higher tax bracket. It’s also worth considering if you can’t come up with the cash to pay those taxes.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.