How to Do a Roth Conversion

Roth IRAs can offer a number of advantages as you approach retirement. Money in a Roth IRA isn’t subject to required minimum distributions (RMDs). In many cases, money in a Roth IRA can be withdrawn tax-free once you reach age 59 ½. Additionally, funds in a Roth IRA can be passed to non-spousal beneficiaries tax-free if the account owner has satisfied the five-year rules for the account.

For all of these reasons, people may prefer to have their retirement funds in a Roth IRA as opposed to a traditional IRA. This is where a Roth conversion comes in.

A Roth conversion entails converting all or a portion of a traditional IRA account into a Roth IRA, whether because you’d like to trade in the restrictions of a traditional IRA for the flexibility of a Roth IRA, or because you want to contribute more to a Roth IRA than the annual contribution limits allow.

The steps to execute Roth conversion are relatively straightforward, but the decision-making process around whether to do a Roth conversion can be more complex. We’ll start with the basic steps. 

How to do a Roth conversion

In order to do a Roth IRA conversion, you’ll need to have a traditional IRA with assets in the account, and an active Roth IRA account.

• Decide how much you want to convert from your traditional IRA account to your Roth IRA. We’ll discuss the factors that may affect that decision below.
• Check with your institution(s) to understand what they require for the conversion. If both accounts are at the same institution, you may be able to do the Roth conversion online. If not, the steps will likely be more involved.
• Complete any paperwork for either or both accounts and submit.
• Monitor the traditional and Roth IRA accounts to track the completion of the conversion.
• Decide how to invest the newly converted funds inside the Roth IRA.

The "how" is straightforward. The "why" is more complicated, largely because of the tax implications.

Tax ramifications

The money you transfer from a traditional IRA to a Roth IRA will generally be taxed at your ordinary income tax rate. Given that many people want to do a Roth conversion in order to save on taxes over time, we believe it’s important to calculate the current year tax ramifications versus the potential tax savings flexibility the conversion could provide down the road.

A Roth conversion likely makes the most sense for investors who are in a lower-than-usual tax bracket the year of the conversion. A common example is someone who has retired, but has not yet claimed their Social Security benefits.

Conversely, investors who are not in a lower-than-usual tax bracket the year of the conversion may find themselves pushed into a higher tax bracket, paying more for that conversion than is likely ideal.

The Pro-Rata Rule

There’s an additional tax consideration if the balance across all of your traditional IRA accounts (this also includes SEP-IRAs and SIMPLE IRAs) includes both money that was contributed on a pre-tax and after-tax basis, known as non-deductible contributions.

In this case, the total non-deductible contributions will be divided by the total non-Roth IRA account balances, and that percentage will be the percentage of the conversion that is not subject to taxes.

For example, let’s say you’re converting $10,000. The total balance in all non-Roth IRA accounts is $200,000, and $15,000 of that was contributed on an after-tax basis. 7.5% of the $10,000 conversion ($15,000/$200,000) would be exempt; you’d pay taxes on $9,250 instead of the whole $10,000.

While non-deductible contributions are not common for traditional IRAs, they can happen if you’re covered by a workplace retirement plan such as a 401(k), your income exceeds certain limits, you’ve maxed out your Roth IRA contributions, and you still want to contribute to your retirement accounts. Additionally, some investors may find after-contributions to be more advantageous in the long-run and will choose this option. 

There is, however, a way to contribute to a Roth IRA when your income is too high to contribute directly by contributing after-tax funds to a traditional IRA. 

The backdoor Roth IRA

One option for those whose income is too high to contribute directly to a Roth IRA is the backdoor Roth IRA. You would make an after-tax contribution to a traditional IRA, and then immediately convert that amount to a Roth IRA.

The upper income limits (modified adjusted gross income) for 2024 for Roth contributions above which no contributions can be made are:

• Married filing jointly and qualifying widow(er): $230,000 or more
• Single, head of household, or married filing separately (and you didn’t live with your spouse at all during the year): $161,000 or more
• Married, filing separately, and you lived with your spouse at any point during the year: $10,000 or more¹

Like any Roth conversion, some or all of the converted amount during a backdoor Roth conversion may be taxable.

• If this is your only traditional IRA (including SEP-IRAs and SIMPLE IRAs), it has no other funds, and you convert the contributions before any additional earnings accrue in the account, then the conversion would not be taxed at all.
• If you already have money in a traditional IRA, then the pro-rata rule discussed above would apply, meaning some portion of those contributions would be taxed as a result of the conversion. However, you won’t have to pay taxes on the earnings that accrue from that money in the Roth IRA.

There is one additional rule that investors need to account for in their decision making...

The five-year rule

At least five years must elapse between the beginning of the tax year for your first contribution to a Roth IRA account and the withdrawal of earnings. Withdrawal of any earnings in the account before the five-year mark will be considered a non-qualified withdrawal and could be subject to taxes and/or a withdrawal penalty.

In the case of a Roth conversion, each conversion has its own five-year rule, so it's important to keep track.² In other words, if you convert $10,000 into your Roth IRA from a traditional IRA, then the earnings from that $10,000 can’t be withdrawn until five years after the conversion without taxes and/or a penalty.

As always, earnings in a Roth IRA can’t be withdrawn if you’re under 59 ½ without a penalty, even if the five-year rule is satisfied.

Potential benefits of a Roth conversion

Despite the potential taxes and the difficulty of tracking the five-year rule on conversions, converting some or all of your traditional IRA to a Roth IRA can have a number of potential benefits.

• Converting some of your traditional IRA assets to a Roth IRA can provide tax diversification and additional planning options for your retirement accounts.
• Roth IRAs that are left to non-spousal beneficiaries will not be taxable to the beneficiaries if certain requirements, such as the five-year rule, have been satisfied.
• Money converted to a Roth IRA will not be subject to required minimum distributions, giving you potentially more flexibility in when you withdraw funds.

Alternatives to a Roth conversion

For those whose income exceeds the limits and who also want to build a balance in a Roth account, there are some alternatives to doing a Roth conversion.

If you’re working and your employer offers a retirement plan such as a 401(k) with a Roth option, consider making some or all of your contributions to the Roth option of this account. Similarly, if you are self-employed and have a solo 401(k) or SEP-IRA with a Roth option, you can contribute directly to the Roth option. Unlike with a Roth IRA, there are no income caps on your ability to contribute, although there are contribution limits.

If your employer allows it, you can also contribute up to $46,000 on an after-tax basis to the retirement plan and then either convert this money to a Roth 401(k) as an in-plan conversion, roll it over to a Roth IRA as an in-service distribution, or roll it over to a Roth IRA after leaving your employer. Only the earnings that have accrued from these contributions at the time of the conversion would be taxed. This $46,000 for 2024 is on top of the $23,000 or $30,500 (for those who are 50 or over) regular 401(k) contribution limits. Note this amount may be reduced for employer matching contributions.³

Conclusion

The mechanics of a Roth IRA conversion are pretty simple. The work for investors comes from understanding the tax implications and the potential benefits of doing the conversion. A knowledgeable financial advisor can help you do the math and think through your individual situation.