Converting Traditional IRA Savings to a Roth IRA

A Roth individual retirement account (IRA) conversion lets you shift money from a traditional IRA into a Roth IRA. Doing so lets you take advantage of a Roth IRA’s many benefits, including tax-free withdrawals in retirement and no required minimum distributions (RMDs) during your lifetime.

However, Roth IRA conversions also have costs. Specifically, you’ll have to pay tax on the money that you convert. Because of this, you need to plan conversions carefully.

The Benefits of Roth IRAs

Since Roth IRAs were first introduced in 1998, many owners of traditional IRAs have looked at them with envy. That’s because Roth IRAs have at least two advantages over the traditional kind:

1. Any money that you withdraw from a Roth is tax free, provided you are age 59½ or older and it has been at least five years since you first contributed to a Roth. By contrast, the withdrawals that you make from a traditional IRA are taxed as ordinary income.
2. Traditional IRA owners must start taking RMDs from their accounts at age 73 if they were born between 1951 and 1959 or at age 75 if they were born in 1960 or after (an increase from the previous age of 72). Roth owners, however, can leave their accounts untouched until they need the money. And if they don’t need it, then they can pass the entire account to their heirs.

There is a tradeoff, though. Traditional IRA owners who qualify get a tax break for the money that they put into their accounts. Roth owners do not; they put post-tax money into their accounts.

Fortunately, for traditional IRA holders who would like to take advantage of a Roth, the law allows for conversions. At one time, only people with incomes under a certain amount could perform Roth IRA conversions, but the limits were lifted in 2010. Income limits still apply to Roth contributions, however.

Whether a Roth conversion makes sense for you depends on a variety of factors.

Advantages of Roth IRA Conversions

1. You Might Save on Taxes in the Long Run

When you convert some or all of the money in your traditional IRA to a Roth, you have to pay income tax that year on the converted amount. Even so, converting could be a smart move if you end up in a higher marginal tax bracket in later years or if tax rates rise overall.

Once you pay tax on that money, it’s tax free ever after, no matter how tax rates may change. And all the money that you earn in that account is tax free as well. Money in a traditional IRA grows tax free until you withdraw it. But once you take it out, you have to pay taxes on both the original contributions and what they earned over time.

“When it comes to converting, time is of the essence for at least three reasons,” says Matthew J. Ure, a retirement management analyst and financial planner in San Antonio.

First, Ure explains, the money put into a Roth must have five years to mature to protect any growth from taxes. “Second, by staging the conversion over several years, you can minimize disruption to your current tax situation,” Ure says. “Finally, the ability to convert is not a right guaranteed by the Constitution—rather, it is a loophole that opened up after the original legislative prohibition expired and a loophole that has come under attack recently.”

Although the Biden administration seems amenable to keeping conversions in play for now, statements by both political parties highlight the risk that one takes in deferring a desirable conversion, Ure adds.

2. You’ll Escape RMDs and Harsh Penalties

With traditional IRAs, you must start taking RMDs at age 73 if you were born between 1951 and 1959 or at age 75 if you were born in 1960 or after (an increase from the previous age of 72). Otherwise, you’ll face a big tax penalty: 50% of the amount that you failed to withdraw. And, of course, you’ll owe income tax on whatever you take out.

With a Roth, on the other hand, RMDs are never necessary during your lifetime. If you have other sources of income and don’t need the money in your Roth for living expenses, you can keep it intact for your grateful heirs.

“Roth IRAs can be a good estate and tax planning tool because they are not subject to RMDs. And so long as you have earned income, you may continue making contributions at any age,” says Stephen Rischall, a retirement planning expert and founding partner at Navalign Wealth Partners in Los Angeles.

But if you do need money, and you’re under age 59½, you can withdraw your contributions (although not the earnings) without any penalty.

3. It Could Be the Only Way to Get One

If you want a Roth, for inheritance or other purposes, but earn too much to contribute to one, converting the money that you already have in a traditional IRA is your only option.

Disadvantages of Roth IRA Conversions

1. You Might Pay More in Taxes in the Long Run

Converting from a traditional IRA to a Roth can make sense if income tax rates (yours personally, or the whole country’s) go up in the future. But if you’re likely to be in a lower tax bracket later, as many people are after they retire, then you would do better to wait.

2. You’ll Face a Big Tax Bill Now

Depending on how much you convert, your tax bill could be substantial, and the money to pay it will have to come from somewhere. If you plan to cover the taxes by withdrawing extra money from your traditional IRA, you generally will be subject to a 10% early withdrawal penalty if you’re under age 59½.

Even if you aren’t penalized, you still will be reducing your retirement savings to pay the taxes. Taking the money from non-retirement accounts is a better idea, but not a perfect one. By giving it to the Internal Revenue Service (IRS) now, you’ll be sacrificing whatever it might have earned if you had kept it invested.

“If you do a conversion, you should be able to pay the taxes with an outside source,” says Morris Armstrong, founder of Armstrong Financial Strategies in Cheshire, Conn. “Otherwise, the math does not favor the conversion. Always remember that you are not converting in a vacuum and the total picture needs to be evaluated.”

How to Do a Roth IRA Conversion

If you decide to convert, the simplest way is to have the financial institution that currently holds your traditional IRA transfer some or all of that money into a Roth. If you would rather move your account to another institution, the new one should be more than happy to help you.

You also could do the rollover yourself, withdrawing money from your traditional IRA and depositing it in a Roth account. This is the riskiest option, however. If you don’t complete the rollover within 60 days, the money becomes taxable and may be subject to penalties.

What’s more, it will no longer be in an IRA—Roth or traditional—and it will have lost the advantage of tax-deferred or tax-free growth.

Recharacterization: The Opposite of Conversion

Recharacterization was the reversal of an IRA conversion, such as from a Roth IRA back to a traditional IRA, generally to achieve better tax treatment. The strategy of recharacterizing from a Roth back to a traditional IRA was banned by the Tax Cuts and Jobs Act of 2017.

Recharacterizations were mostly performed after a conversion from a traditional IRA to a Roth IRA, though they could go the other way as well. A traditional-to-Roth conversion could result in a significant and unexpected tax burden, so much so that the individual who had done the conversion could decide to undo it, which resulted in a recharacterization.

The Bottom Line

Converting a traditional IRA into a Roth IRA can provide tax-free income and estate planning advantages in the future. But you’ll have to pay taxes on the money now, at what could be a higher rate than you’ll owe in retirement.

“On a planning note, it is always nice to have tax diversification among the types of retirement accounts you have,” says David S. Hunter, a certified financial planner and president of Horizons Wealth Management in Asheville, N.C. Hunter says that this is primarily because “without a crystal ball, we cannot guarantee what tax rates will be in the future. Better to have the tools to react to any tax environment than to make an all-in bet on what the rates will be.”