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Are you considering a Roth IRA conversion? If so, your timing can significantly reduce the tax bite. A conversion involves transferring retirement funds from a retirement account, such as a traditional individual retirement account (IRA), which is funded with pretax dollars, to a Roth IRA, which is funded with after-tax dollars. This means that you’ll owe tax on the money you convert. One way to lessen the tax burden is by making the switch when your IRA’s value has dropped due to a market downturn.
Key Takeaways
- A Roth IRA conversion involves transferring funds from a retirement account such as a pretax traditional IRA into an after-tax Roth account.
- You’ll owe tax on the money you convert, but qualified withdrawals during retirement will be tax-free.
- The strategy makes sense if you think you’ll be in a higher tax bracket during retirement—you’ll save money by paying taxes now instead of later.
- When considering a Roth IRA conversion, be sure to weigh the up-front taxes and the consequences of boosting your adjusted gross income (AGI).
Traditional vs. Roth IRAs
The key difference between traditional and Roth IRAs is the timing of the tax advantages. You deduct contributions now and pay taxes on withdrawals later with a traditional IRA. Conversely, you don’t receive any upfront tax breaks with a Roth IRA, but qualified distributions are tax-free.
Additionally, Roth IRAs carry no required minimum distributions (RMDs), so if you don’t need the money, you can leave the account alone to grow tax-free for your heirs. This feature makes a Roth IRA an ideal wealth-transfer vehicle.
The Five-Year Rule
Another Roth IRA perk is that you can withdraw your contributions at any time, for any reason, with no tax or penalty. However, when it comes to Roth IRA conversions, you have to wait five years (the five-year rule) to withdraw converted funds to avoid a 10% penalty. The clock starts ticking on Jan. 1 of the year of the conversion, and a separate five-year period applies to each conversion.
The best time to convert from a traditional to a Roth IRA is generally when the market is down and your traditional IRA has lost value, and/or your income is unusually low, and/or your itemized deductions for the year have increased.
Why Consider a Roth IRA Conversion?
You’ll owe taxes on any converted funds the year you make a conversion, and the tax burden could be substantial. Still, there are several scenarios in which a Roth IRA conversion could be worth the effort—and the tax hit. These include if you:
- Expect to be in a higher tax bracket in retirement: In this case, it can make financial sense to get the taxes over with now, paying them at your current, lower tax bracket rate.
- Want to leave a tax-free inheritance to your heirs: Roth IRAs have no RMDs during the account owner’s lifetime, meaning you can watch your money grow tax-free for longer. While your heirs will have to take RMDs, they won’t owe federal income tax on withdrawals if the account has been open for at least five years. That’s another reason not to delay too long.
- Want better tax diversification: If most of your retirement assets are in tax-deferred accounts—such as traditional IRAs and 401(k)s—you may want some assets that can be withdrawn tax-free. This can help you better manage and personalize your tax brackets and planning every year.
- Have income that is lower than usual this year: A lower-than-usual income can help lessen the tax hit of a Roth IRA conversion. If you suffered a decrease in income or you own a business that operated at a loss, you could convert funds to a Roth IRA with less tax impact than in more profitable years.
- Have more itemized deductions: A Roth IRA conversion generates ordinary income, which you can offset with itemized deductions taken on the same tax return. If you have more itemized deductions than usual—and therefore a lower taxable income—it could be an excellent time to convert to a Roth.
If you are required to take an RMD from your traditional IRA in the year you convert, you must do so before doing the conversion. An RMD cannot be included in a rollover.
Roth IRA Conversions When Stocks Are Down
Here’s another scenario: Your traditional IRA’s value has dropped. You’ll owe tax on any funds you convert, so a stock market downturn could make a conversion more appealing, as you’ll pay tax on less money.
For example, say your traditional IRA was worth $100,000 and drops to $60,000 when the overall market declines. In this situation, you would be converting just $60,000 instead of the original $100,000—potentially shaving thousands of dollars off your tax bill.
Moreover, suppose your traditional IRA has lost value and your income is lower than usual, or you have more itemized deductions (or both). In that case, it can signal a particularly opportune time for a Roth IRA conversion. You’ll pay tax on a smaller converted amount, and your reduced taxable income and/or increased deductions could move you into a lower tax bracket, saving you even more money.
Roth IRA Conversion Consequences
Of course, if you’re considering a Roth IRA conversion, weigh the upfront taxes and the consequences of boosting your adjusted gross income (AGI) before making any decisions. Be sure you have the cash on hand to cover the tax bill—any IRA funds used to pay taxes will miss out on tax-free growth for retirement, undermining the very reason for doing the conversion.
Also, be aware that an increase in taxable income could bump you into a higher tax bracket. It could also lead to higher Medicare costs, higher Social Security taxes, and the loss of certain write-offs, such as the student loan interest deduction or the child tax credit. Crunch the numbers first to ensure that the potential consequences don’t outweigh the benefits of the conversion.
How to Do a Roth IRA Conversion
If you decide a Roth IRA conversion is right for you, there are several ways to accomplish the switch.
- Direct rollover: You can ask your plan administrator to make the payment directly to your Roth IRA. Ask your administrator for instructions. The payment may be made by check.
- Trustee-to-trustee transfer: Ask the financial institution holding your IRA to make the payment directly to your Roth IRA. If the same financial institution holds both accounts, this is called a same trustee transfer.
- 60-day rollover (indirect rollover): You receive a distribution from your traditional IRA custodian, and then you deposit the funds into your Roth IRA within 60 days yourself. This is the least secure choice and can subject you to tax penalties if not done correctly.
No matter which method you use, the Internal Revenue Service (IRS) will collect the federal tax you owe when you file your tax return for the year of the conversion. Your IRA custodian will report the conversion as a distribution on Form 1099-R and the Roth contribution on Form 5498.
Frequently Asked Questions (FAQs)
How Do I Avoid Taxes on a Roth IRA Conversion?
You probably can’t avoid paying taxes on a Roth IRA conversion, but there may be ways to lower the tax bill, such as spreading out the conversion over multiple years, making the tax hit easier to manage.
Another option is to max out your tax bracket. For example, using 2024 tax rates, let’s say you’re single and earn $75,000 a year, putting you in the 22% tax bracket. The next tax bracket kicks in when your income exceeds $100,525. You could convert up to $25,525 ($100,525 – $75,000) without bumping up to a higher tax bracket.
What Is a Roth IRA Conversion Ladder?
A Roth conversion ladder is a multiyear strategy in which you shift money from a tax-deferred retirement account—such as a traditional IRA or 401(k)—into a Roth IRA. However, instead of doing it just once, as you would with a standard Roth IRA conversion, you do a series of conversions over several years. If done correctly, you can withdraw the converted funds with no tax or penalty before reaching age 59½—the age at which you can usually tap into your funds without taxes or penalties.
How Much Can You Convert from a Traditional to a Roth IRA?
In 2024, the most you can contribute to all of your IRAs is $7,000 per year ($8,000 if you’re 50 or older). However, there is no limit on the amount you can convert from a tax-deferred account, such as a traditional IRA, into your Roth IRA in a single year. Of course, you will owe tax on the converted amount, so it’s essential to weigh the pros and cons before converting any funds.
The Bottom Line
Bad news is hardly ever good news. But Roth conversions are one situation in which it can be. Whether the stock market is bad or your income is down this year, there could be a silver lining.
And here’s one more reason to consider a Roth IRA conversion: low tax rates and looming tax rate hikes. The current federal income tax rates, ranging from 10% to 37%, are set to expire at the end of 2025 if lawmakers don’t extend them, which would reinstate the higher 2017 rates. This means a Roth IRA conversion could save you even more if you will be in a substantially higher income tax bracket during retirement.