In a NutshellMaking an IRA to Roth conversion can be a way to create a tax-free source of income in retirement. But a Roth conversion can have tax consequences — both intended and unintended.
This article was fact-checked by our editors and CPA candidate Janet Murphy, senior product specialist with Credit Karma.
Pay the tax bill now? Or pay it later? That’s the question you need to answer if you’re thinking about converting a traditional IRA to a Roth IRA.
Money you take out of a traditional IRA (known as “distributions”) is generally taxable in retirement. Distributions from a Roth IRA generally are not taxable. If you think you’ll be in a higher tax bracket in your retirement years, converting a traditional IRA to a Roth IRA lets you pay the tax bill now and enjoy tax-free distributions in retirement.
But is a traditional IRA conversion to a Roth IRA a good move? It depends. Also, if you don’t meet certain income requirements, a conversion may not even be possible for you.
- Roth vs. traditional IRA: What’s the difference?
- What is a Roth conversion?
- When does a Roth conversion make sense?
- Things to know about converting an IRA to a Roth
- How to report a Roth IRA conversion at tax time
Roth vs. traditional IRA: What’s the difference?
Both traditional and Roth IRAs are tax-advantaged retirement accounts that help people save for retirement. But there are key differences to understand before choosing between the two types of accounts.
What is a Roth conversion?
A Roth IRA conversion takes all or part of the balance of a traditional IRA and rolls it into a Roth IRA. There are a few reasons this might be appealing.
- Tax-free income in retirement — Withdrawals from a traditional IRA are usually taxable, which means you’ll owe taxes on the earnings and any contributions that you deducted on your taxes. With a Roth IRA, withdrawals are tax-free.
- No required minimum distributions — With a traditional IRA, you must take required minimum distributions, or RMDs, once you reach age 72 (as long as you reach age 70½ after 2019). Roth IRAs don’t have RMDs, so your money can stay in the account and continue to grow tax-free. Your account can also provide tax-free retirement income for your heirs if you don’t use the funds in your lifetime.
- Bypassing Roth income limits — If your income is too high, you typically can’t contribute to a Roth IRA. For the 2019 tax year, a single person had to have a modified adjusted gross income, or MAGI, of $137,000 or less to contribute to a Roth — and a married couple filing jointly had to have a MAGI of $203,000 or less. But a “backdoor” Roth conversion gets around these income limits by having you first make a nondeductible contribution to a traditional IRA, and then having you convert your traditional IRA to a Roth IRA. There are no income limits on who can contribute to a traditional IRA.
When does a Roth conversion make sense?
The downside to making a rollover into a Roth is that you have to pay the tax bill the year you make the conversion. You’ll have to report the conversion on your federal income tax return and pay any tax due by the tax deadline — typically April 15.
On the other hand, when you withdraw the money in retirement, you won’t have to pay federal income tax on the distribution. So a Roth IRA conversion might make sense if you believe your tax rate is lower now than it will be when you start taking withdrawals in retirement. But it’s a bit of a guessing game, as no one really knows what the tax rates will be in the next 10, 20 or 30 years.
Still, there may be ways to manage the tax you’ll pay on a Roth conversion. Some options may include …
- Converting earlier in the year to give yourself more time to pay the tax, which will likely be due on April 15 of the following year.
- Spreading the conversion out over a few years by converting only part of your traditional IRA now. This allows you to spread the tax payments over multiple years, too.
- Making the conversion in a year in which you have losses or tax deductions that will offset the tax.
Things to know about converting a traditional IRA to a Roth
Making an IRA-to-Roth conversion can impact your retirement earnings and tax liability in several ways. Here are a few other things to know before you make the move.
You can’t undo a Roth conversion
In the past, if you made an IRA-to-Roth conversion and then decided it wasn’t the right move, you could fully or partially reverse the conversion before filing your tax return for the year.
Thanks to the Tax Cuts and Jobs Act of 2017, undoing a Roth conversion is no longer an option. So it’s a good idea to discuss the decision with a tax adviser to ensure you know how the Roth conversion will impact your taxes.What is adjusted gross income?
You should pay the tax on a Roth conversion with nonretirement funds
Before making a Roth conversion, you need to make sure you’ll have the funds available to pay the resulting tax bill, and you won’t want to use money from the Roth to pay the tax.
There are several reasons it’s a bad idea to use part of your retirement savings to pay the Roth conversion tax.
- Less tax-free growth — Any retirement funds you use to cover the tax bill won’t be available to grow tax-free.
- 10% penalty — If you’re under age 59½, you’ll likely have to pay a 10% early withdrawal penalty on any funds from your traditional IRA that aren’t converted into the Roth (unless you qualify for one of the penalty exempt exceptions). This 10% penalty is in addition to the income taxes you’ll pay on the conversion.
There’s a five-year holding period on Roth IRA withdrawals
IRS rules say that in most cases you have to wait five years before withdrawing money converted to a Roth IRA to avoid the early penalty. The penalty is 10%, if you do withdraw funds from your Roth within five years.
How to report a Roth IRA conversion at tax time
Sometime in January or February in the year after you make the Roth conversion, you should receive Form 1099-R from the financial institution that held your IRA account. The 1099-R will show the amount converted in Box 1 and 2. In Box 7, there will be a distribution code to let the IRS know how your conversion should be taxed.
- Code 2 means you haven’t yet reached age 59½ and you may have to pay the 10% early withdrawal penalty on any portion of the distribution that isn’t converted into the Roth.
- Code 7 means you are age 59½ or older and you won’t have to pay the early withdrawal penalty, even if you don’t convert the entire amount distributed into the Roth.
You’ll use the information found on Form 1099-R to complete Form 8606. One of the form’s purposes is to report Roth conversions, so you’ll need to file this form along with your 1040 tax return for every year that you make a conversion.
Converting your traditional IRA to a Roth can potentially reduce your tax bill in retirement, but it can come with drawbacks. It’s probably a good idea to check with a tax professional on how such strategies can fit into your retirement plans. But now that Roth IRAs are not reversible, running the numbers and avoiding unintended consequences is more important than ever.
A senior product specialist with Credit Karma, Janet Murphy is a CPA candidate with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute.You can find her on LinkedIn.