Roth IRA Conversion Guide – What You Need to Know Before Converting Your IRA

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Should you do a Roth IRA conversion?Should you convert your Traditional IRA to a Roth?
A Roth IRA conversion is when you convert money from a Traditional IRA into a Roth IRA. Why would you want to convert to a Roth IRA? Because depending on your financial and tax situation, Roth IRAs have advantages over Traditional IRAs due to how and when the funds are taxed. When you complete a…

A Roth IRA conversion is when you convert money from a Traditional IRA into a Roth IRA. Why would you want to convert to a Roth IRA? Because depending on your financial and tax situation, Roth IRAs have advantages over Traditional IRAs due to how and when the funds are taxed.

When you complete a Roth IRA conversion and rollover funds from a Traditional IRA into a Roth IRA, the amount of money rolled over is added to your taxable income for the year. Essentially, you’re paying taxes now on the current value of the funds so that your future distributions will be nontaxable. Roth IRA conversions can have many benefits (and complications)! Take a look through this Roth IRA Conversion Guide to understand how you can use these rules to your advantage!

Differences Between Traditional & Roth IRAs, and Why Converting Might be a Good Idea

Roth IRA Conversion GuideLet’s take a quick look at the differences between Traditional IRAs and Roth IRAs, then we can have a better understanding of how and why taxes are charged when you convert from a Traditional to Roth IRA.

Traditional IRA: Contributions are made before taxes have been paid on the contribution amount (the amount of your contribution is tax-deductible if you qualify based on your income; there are also non-deductible Traditional IRAs, described below). The funds in your Traditional IRA grow without the drag of taxes until you reach retirement age. Then you are taxed when you make qualified withdrawals in retirement. Traditional IRAs are also subject to Required Minimum Distributions (RMDs) starting at age 70.5.

Roth IRA: Contributions are made after taxes have been paid on the contribution amount. The funds in your Roth IRA grow without the drag of taxes until you reach retirement age. Funds are not taxed when you make qualified withdrawals in retirement. Roth IRAs are not subject to Required Minimum Distributions. So you can leave your money in your account as long as you wish to take advantage of tax-free growth.

Traditional & Roth IRA Qualifications, Contribution Limits, and Income Limits. The IRS has certain stipulations regarding who can contribute to these accounts, and how much, based on their Adjusted Gross Income. Here is more information about annual IRA contribution limits and other rules.

See the following note if you are ineligible for a deduction on a Traditional IRA contribution or ineligible to contribute to a Roth IRA.

Note: There are also Non-deductible Traditional IRAs. These follow the same rules as Traditional IRAs, with the exception that your income is too high to deduct the amount of your contribution. These are popular with investors who make too much for either a deductible Traditional IRA or Roth IRA, but who still want to invest in a tax-advantaged retirement account. They are also popular with people who want to do a Back-Door Roth IRA, which is discussed in greater detail below.

Benefits of Roth IRAs over Traditional IRAs

As you can see, the difference essentially boils down to paying no taxes now while paying taxes in retirement (Traditional IRA), or paying taxes now, then paying no taxes in retirement (Roth IRA). And Required Minimum Distributions. Don’t forget about those.

Don’t underestimate the importance of the RMDs, especially if most of your retirement investments are in Traditional accounts, such as Traditional IRAs and a 401k plan. RMDs dictate the percentage of your retirement account you must withdraw each year. And since these apply to Traditional accounts, you will have to pay taxes on those withdrawals.

Having your money in a Roth account gives you more flexibility on when and how you make withdrawals or distributions. Being able to make tax-free withdrawals can also help you better plan your retirement spending. Here is more info on the benefits of tax diversification in retirement.

Tax Considerations of a Roth IRA Conversion

OK, now that we have established the differences between a Traditional and Roth IRA, we have to discuss the impact of converting from a Traditional IRA to a Roth IRA.

In a perfect world, we could transfer all of our money from Traditional retirement accounts to Roth accounts and be done with it (and never pay taxes on our Roth distributions!). But there are no free meals when it comes to taxes.

When you convert a Traditional IRA, you are essentially moving retirement funds that have not been taxed (but will be taxed in the future) to a Roth account in which funds have already been taxed, but won’t be taxed again in the future.

See the difference? The taxes need to be paid. And in the case of a Roth IRA conversion, you must pay taxes at the time you make the conversion.

The IRS considers a Roth IRA conversion to be a distribution from your retirement account. Your financial institution will send you a 1099-R stating you received the funds from your Traditional IRA. It is up to you to then follow up and convert those funds to a Roth IRA within a certain amount of time, otherwise, you will not only pay taxes on the distribution but also early withdrawal penalties.

Note: If you keep the Roth IRA conversion within the same company or brokerage firm, then you shouldn’t have to worry about early withdrawal penalties since the funds will be transferred directly from your Traditional account to your Roth account. Things can get more complicated if you are converting an IRA from one company to another, especially if the funds can’t be transferred directly to the new account. If that happens, you may receive a physical check. Be sure to deposit this in your Roth IRA ASAP to avoid early withdrawal penalties!

How Much Will You Pay in Taxes?

This is a great question, and it will be specific to each person. The IRS requires you to pay taxes on the full amount that has not already been taxed. If all of your Traditional IRAs were deductible IRAs, then you will pay taxes on the full amount of the conversion, including the contribution and all gains.

Things are different if you have non-deductible Traditional IRAs. Since you aren’t able to deduct the contribution amount with a non-deductible IRA, you won’t pay taxes on the amount of the contribution. But you will have to pay taxes on any gains.

  • It is essential that you properly document your non-deductible IRA contributions when you file your taxes each year. Use IRS Form 8606 to document these contributions. Failing to do so can cause expensive problems if you later convert to a Roth IRA.

However, converting a non-deductible Traditional IRA may not be as simple as only paying taxes on the gains. This will be the case if you only have non-deductible IRAs in your account. But if you have both tax-deductible Traditional IRA and non-deductible IRAs, then you need to pay attention to the Pro-Rate Rule, described below.

Be Aware of the Pro-Rata Rule When Converting a Roth IRA

The Pro-Rata Rule basically states that all of your Traditional IRAs are consider as one big, happy IRA. This includes your Traditional IRA, non-deductible Traditional IRA, SEP IRA, or SIMPLE IRA if you happen to have one.

Since these are considered one big account, you will have to pro-rate the amount of your conversion and pay taxes on the portion that has not yet been taxed.

  • If all of your Traditional IRAs were tax-deductible contributions, then you don’t have to worry about this rule. You simply pay taxes on the full amount you convert to a Roth IRA.
  • If you only have non-deductible IRAs, then you only pay taxes on the gains.

The Pro-Rata Rule comes into play when you have both deductible Traditional IRAs and non-deductible Traditional IRA contributions. You can’t simply convert the non-deductible Traditional IRA into a Roth IRA. You have to pro-rate the amount of the conversion.

Pro-Rata Rule Example

Let’s say you have two Traditional IRAs. One has $10,000 in contributions and earnings. You also have a non-deductible Traditional IRA that also has $10,000, but no earnings. The IRS considers this as one IRA with $20,000. The portion of your IRA that is made with after-tax money is 50% ($10,000 / $20,000 = 50%).

All distributions will need to be made on a prorated basis. This includes Roth IRA conversions.

So if you go to convert $10,000 of this to a Roth IRA, you would have to convert it on a 50/50 basis. That means you would need to pay taxes on $5,000 of the conversion, and you would be able to convert $5,000 of your non-deductible IRA to the Roth without paying taxes.

This is a very clean and simplified example. It can get very complicated if you have multiple IRAs, SEP IRAs, SIMPLE IRAs, etc. It’s also more complicated if you have a non-deductible IRA that has earnings.

Some people try to simplify their Traditional accounts first, by rolling their Traditional IRA into a 401k plan or other tax-deferred retirement account to simplify bookkeeping and avoid having to figure out the Pro-Rata rule.*

This is an advanced strategy and something you will want to discuss with a tax professional or financial planner before you take action. I also recommend reading Michael Kitces overview of the Pro-Rata Rule for more information. Michael Kitces is a very well-respected thought leader in the financial planning industry.

*Transferring retirement accounts can be very advantageous, based on your situation. It can make a lot of sense to transfer a 401k into an IRA to avoid high-cost 401k plans, or to provide more flexible investment options. But as you can see from above, it can also be advantageous to roll your IRA into a 401k to provide a clean slate for converting Roth IRAs, or doing Back Door IRAs (see below). Always keep an open mind with financial planning.

Back Door Roth IRAs

The Back Door Roth IRA is a popular strategy among those who earn too much to contribute to a Roth IRA. If your Adjusted Gross Income (AGI) is too high to qualify for a Roth IRA, you also earn too much to deduct Traditional IRA contributions. So that leaves a non-deductible Traditional IRA as an option for maxing out your IRA contributions for the year.

How to make a Back Door Roth IRA Contribution: 

Those with a high AGI can simply contribute to a non-deductible Traditional IRA. Since this is an after-tax contribution, you can then convert the non-deductible IRA to a Roth IRA. If you don’t have any gains in the account, then your conversion will be tax-free. This is the “back door” to being able to contribute to a Roth IRA, even when your income is too high.

Again, you need to pay attention to the Pro-Rata rule as described above. The cleanest way to make a Back Door Roth IRA contribution is to do so when you do not have any other Traditional IRA funds (Traditional IRA, SEP IRA, SIMPLE IRA, etc.). Again, an advanced strategy would be to either convert all of those accounts to Roth accounts and pay the taxes at that time or to try and move Traditional IRAs into your 401k or another retirement account.

More info on Back Door Roth conversions from Michael Kitces.

Who Should Consider a Roth IRA Conversion

Roth IRA conversions can be very useful for tax planning purposes. They are a great way to contribute to a Roth IRA if your AGI is too high (Back Door Roth IRA). They are also helpful with estate planning, avoiding Required Minimum Distributions, or taking advantage of being in a lower tax bracket than you anticipate being in the future.

Many retirees take advantage of their early retirement years to begin converting their Traditional IRAs to Roth IRAs. If this is their only income, they can convert their IRAs at very low tax brackets to reduce their future tax obligations and allow their investments to continue growing tax-free in a Roth account. This is an excellent strategy for those who have large IRAs and/or 401k plans, Thrift Savings Plans, or other tax-advantaged retirement accounts.

Reducing the amount of money held in their Traditional accounts and converting them to Roth accounts significantly reduces the amount of Required Minimum Distributions they will be required to take. Paying taxes now could make for large tax savings, depending on the size of their retirement accounts and potential RMDs.

On the other hand, if you are already in a higher tax bracket and expect to remain in that tax bracket or perhaps even be in a lower tax bracket by the time you retire – then a Roth IRA conversion may not be a good financial decision for you.

A good time to convert to a Roth IRA is when your Traditional IRA has less value – like during troubled economic times – because you will make your current taxable amount smaller.

How to Set Up a Roth IRA Conversion

You will need to open a Roth IRA before you make the conversion (you may be able to do both at the same time, depending on where you open your Roth IRA). There are two options for executing a Roth IRA conversion; rollover or transfer.

  • Rollover – if you choose the rollover option, you can choose to take a distribution of funds from your Traditional IRA and “roll it over” into a Roth IRA within 60 days.
  • Transfer – if you choose the transfer option, you can simply tell the broker or bank that holds the Traditional IRA to transfer the money directly to your Roth IRA (several Ally Invest reviews show them having a $150 transfer reimbursement).

Regardless of the option you use to convert to a Roth IRA, you must move the entire amount of money you get from the Traditional IRA into your Roth IRA. Do not keep the cash or do anything else with any of the money or you will be penalized with an early withdrawal penalty and income tax penalties.

Roth IRA Conversion Eligibility

There are a few eligibility requirements you must meet to convert a Traditional IRA to a Roth IRA, including:

  • If you are over the age of 70 and a half years and receiving minimum distributions from the Traditional IRA, you are not allowed to roll over those distributions into the Roth IRA.
  • Your income tax filing status cannot be “married filing separately” unless you didn’t live with your spouse for an entire year, then you may still be eligible if you meet the other requirements.
  • If you inherited an IRA from someone other than a spouse, it cannot be converted from a Traditional IRA to a Roth IRA.

Should you do a Roth IRA Conversion?

There are many factors that can complicate Roth IRA conversions, so it is a good idea to look at the total situation including your current financial position, current tax rates, potential future tax rates, and other issues. You may also find it a good idea to consider hiring a financial advisor or hiring an accountant for assistance with decisions regarding your Roth IRA and making sure you fully understand the ins and out of the Roth IRA contribution limits and rules you need to follow to maximize your benefits.

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About Ryan Guina

Ryan Guina is the founder and editor of Cash Money Life. He is a writer, small business owner, and entrepreneur. He served over 6 years on active duty in the USAF and is a current member of the IL Air National Guard.

Ryan started Cash Money Life in 2007 after separating from active duty military service and has been writing about financial, small business, and military benefits topics since then. He also writes about military money topics and military and veterans benefits at The Military Wallet.

Ryan uses Personal Capital to track and manage his finances. Personal Capital is a free software program that allows him to track his net worth, balance his investment portfolio, track his income and expenses, and much more. You can open a free account here.

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  1. myfinancialobjectives says

    hmm, makes me think I should convert! I hope to be in a higher tax bracket by the time I retire, but there’s the thing, you can never be sure!

    I guess considering I JUST started my IRA, I could easily convert to a Roth IRA, I may mention this to my broker. I read about this a few months back, they seemed attractive then, and even more now considering I actually have an IRA now…

  2. Doug Warshauer says

    @myfinancialobjectives and Ryan,

    While you hope to be in a higher tax bracket by the time you retire, AFTER you retire won’t you drop down to a lower tax bracket?

    After you retire your only income would be your annual distribution from your IRA, plus your Social Security benefits and taxes on any investment income in taxable accounts. Seems like this would probably be less taxable income than you have while you’re working.

    Does this line of thinking make sense, or am I missing something?

    • Ryan says

      It depends, Doug. Many people also have 401k plans, Traditional IRAs, or similar retirement plans that are taxed upon withdrawal (403b, 457b, Thrift Savings Plan, and a host of self-employed retirement plans).

      I also know retirees who continue earning money after they “retire,” from things such as real estate rental, dividends, consulting, freelance work, etc.

      This is a situation where it is probably a good idea to sit down with a financial planner and/or tax professional to look at your total financial picture, and what you think it may be in the future – knowing full well the future is unpredictable!

  3. Robert says

    If at all possible, you should probably go for a ROTH IRA conversion. As expected, with all the spending the government is doing and the debt the government is running up, there is no way taxes are going down – its just not possible. What is happening in Europe is a foreshadowing of what is going to happen here. To put your money in a tax free account is a smart move in my opinion.

    • Ryan says

      Absolutely! I have no idea where are taxes will be in 5 years, let alone the 30 before I will be eligible to withdraw my my IRAs!

    • dima says

      It is a good point, however, the problem is that there is no guarantee that the tax laws won’t be rewritten to go ahead and tax Roth IRA distributions at some point in the future (yet another way to make up for government spending), just look at the changes to HSAs that are being forced on everyone starting next year. Will it happen? Nobody knows, but you might get double taxed at some point, so it still might be vise to have both, the Roth and Traditional IRA/401ks…

      • Ryan says

        Dima, you’re right. No one knows what will happen in the future in regard to taxes. I would hate to be the Congressman/woman who recommends changing the taxability or Roth IRA distributions though – they are almost seen as sacred!

        Many financial planners recommend have tax diversification in your investment portfolio, which for many people would mean using Roth IRAs and a traditional 401k, but there are many other ways to go about getting a tax diversified retirement portfolio.

  4. Douglas Wilson says

    There is nothing to consider before converting to a Roth IRA. I thought there were certain things to assess before converting just like everyone else; but after I read The Gospel of Roth by John Bledsoe, it was clear that I should convert. The book completely contradicts what I had been reading off every news site and explains how converting as soon as you can is the best option. Because you don’t have to decide whether you want to keep it as a Roth IRA or convert it back to a regular IRA until October 17th, 2011, converting now is like having a free look at the future. If it proves better to convert, then you already converted. If you should have left it as an IRA to save taxes, then convert it back free of penalty. The Gospel of Roth is easy to read and straight forward, and practically made my decision for me.

  5. vgpajj says

    Hello Ryan,

    I have IRA account with Fidelity. Some reason, Fidelity is not letting me buy puts to protect my investment. They are only allowing me to sell calls against the equity investments. I want to move my money to other brokerage companys who would let me trade options to protect my investment. I would appreciate if you can recommend a good brokerage.



  6. Al Hayden says

    Question, can a fiduciary (who Tis also the beneficiary) of an IRA convert the IRA to a ROTH? The underlying reason would be to save taxes in anticipation of death of the owner. The owner is in a lower tax bracket than the fiduciary/beneficiary.

    • Ryan Guina says

      Hello Al, I’m not sure what the legal issues are surrounding this. I understand the tax benefit, and it makes sense to do this. However, I do not know what kind of legal authority is required. This question is better answered by an estate planner or someone else who understands the potential legal implications. Best wishes.

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