Should You Do a Roth Conversion?

Eligibility, Tax, and Investment Considerations

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A Roth conversion is an optional decision to change part or all of an existing tax-deferred retirement plan, such as a 401(k) or a traditional IRA, to a Roth IRA. Converting makes sense if you believe that the benefit from your money growing tax-free will be greater than the immediate cost of paying the taxes due at the time of the conversion. 

A Roth conversion of an existing retirement account is a major decision, particularly in a year like 2021 when your income might be at least marginally off-track due to circumstances beyond your control. 

Making the right decision for your circumstances can be easier when you understand the logistics and the tax implications of such a move.

Roth Accounts vs. Tax-Deferred Accounts

Understanding a Roth conversion begins with knowing the difference between a Roth retirement account and a tax-deferred account, such as a traditional IRA.

Contributions into a traditional IRA are made with pre-tax dollars. You can claim a tax deduction for the amount you invest, up to $6,000 in 2021, or $7,000 if you’re age 50 or older (the figures were the same for 2020). You might have had $50,000 in taxable income, but if you contribute $6,000 of that to an IRA, you’re taxed on only $44,000 of your income, assuming you claim no other tax deductions. But that $6,000 becomes taxable income when you withdraw it from the account in retirement. 

You can’t claim a tax deduction for amounts you contribute to a Roth IRA. Your contributions will not subtract from your taxable income in the year you make them, but they won’t be taxed when you withdraw the money from a Roth, either. 

Withdrawals from a Roth account aren’t taxable because you’ve already paid taxes on the money in the year you contributed it to your account.

Growth and earnings on a tax-deferred account are also taxable in the year they’re withdrawn, but Roth earnings can be withdrawn tax-free if they’re “qualified.” This means you’ve held the account for at least five years, you’re age 59½ or older, or the distribution is being taken because you’ve become disabled, you’ve died, or you’re taking the money for a first-time home purchase. 

What Is a Roth Conversion?

A Roth conversion involves taking money from a tax-deferred account and moving it into a Roth account, where it will grow tax-free. Taxes will come due on the amount you move into a Roth in that tax year, just as they would if you took the funds out in retirement. 

The IRS doesn’t care whether you’re reinvesting the tax-deferred account distribution or you’re spending it on your retirement pleasures, when it’s withdrawn from your traditional IRA. That money wasn’t taxed at the time you made contributions, so it’s taxable now.

The tax is due for the tax year in which the distribution is taken. For example, you would report the income on your 2021 tax return filed in 2022 if you take the conversion withdrawal any time from Jan. 1 through Dec. 31, 2021.

What If You Made Nondeductible Contributions?

Part of the amount you convert to a Roth IRA won’t be subject to tax if you made nondeductible contributions to your traditional IRA or your 401(k)—you didn’t claim a tax deduction for that money in the year you made them. Unfortunately, you can’t take just the non-taxable portion from your traditional IRA for 401(k) and call it even. 

The government requires that every dollar you convert be split between non-taxable and taxable contributions, based on the ratio that the nondeductible contributions represent in the value of your retirement accounts. 

Using nondeductible IRAs to get money into a Roth IRA is sometimes referred to as a "backdoor Roth IRA" strategy.

For example, let’s say you made nondeductible contributions to your IRA of $8,000 and the value of your entire traditional IRA is $80,000. If you decide to convert $10,000, then 10% (derived from the $8,000 contribution being 10% of the total balance) of your IRA, or $1,000 ($10,000 x 10% = $1,000), is not taxed. You would pay tax on the remaining $9,000 conversion.

Am I Eligible to Make a Roth Conversion?

First, income limits can prevent you from making Roth IRA contributions. You might be able to make a partial contribution, or you might not be able to contribute directly to a Roth IRA at all, based on these limits: 

  • Contributions become limited at incomes of $125,000 for single filers in 2021, and phase out completely at income of $140,000.
  • The gradual phaseout starts at $198,000, then goes to $208,000 for married couples filing jointly.
  • The limit is $10,000 in 2021 if you’re married but file a separate tax return. You can’t contribute at all if you earn more than $10,000 in this case. 

But these limits apply to contributions, not to conversions. No limit has existed for Roth conversions since tax laws changed in 2010. Those who earn too much to contribute directly to a Roth IRA can still establish a Roth account by converting.

You typically can’t convert a 401(k) to a Roth account if you’re still working for the employer where your 401(k) is held, although a Roth 401(k) option may be offered. You can convert and roll over your 401(K) when you terminate employment, however. 

Pros and Cons of a Roth Conversion

Your current income tax rate, your expected future tax rate, and the anticipated rate of return on your investments all factor in to whether a conversion is a good, or bad, idea for you. These might not be easy determinations to make. Fortunately, there are many calculators available online to assist you.

The most critical issue might be whether you have the money available to pay the taxes that will come due. If you have to use any of the money you took out of your tax-deferred account to pay the taxes, this might be a strong indication that a Roth conversion might not be appropriate right now. You’re just giving the IRS a portion of your retirement savings before you have to. 

  • You can take the tax hit for withdrawing from a tax-deferred plan now if you anticipate that your tax rate will be higher—and result in more taxes due—if you withdraw the money when you retire.

  • Your investment will grow tax-deferred in the Roth IRA, which can result in some significant savings if you still have some time to go before retirement.

  • You’ll take a significant tax hit in the short term if you’re in a higher tax bracket now than you expect to be when you retire.

  • You’ll defeat the purpose of retirement savings if you use any of the conversion money to pay the tax bill, rather than reinvesting it in a Roth account.

What Is the Tax Rate on a Conversion?

Your conversion will be taxed at your marginal tax rate: The top tax bracket that the withdrawal puts you in when it’s added to your other income. And tax brackets aren’t carved in stone. They are adjusted periodically to accommodate inflation and legislation.  

For instance, you would have been in a high, 28% tax bracket if filing as single on income of $85,000 in 2010, including the amount of retirement savings you withdrew to make a conversion. Now fast-forward to 2021. That $85,000 would put you at a marginal tax rate of just 22% because 2018 legislation changed the percentage rates and the spans of income they applied to. You would have paid less in taxes if you had waited 11 years to take that tax-deferred distribution and convert it to a Roth account.

Add your anticipated taxable income for the year to the amount of Roth conversion withdrawal you plan to take to find out the percentage rate you’ll pay on your top earnings—that portion of your income that includes the conversion distribution you took—in 2021:

2021 Rate Single Taxpayers Married Filing Jointly 
10% Up to $9,950         Up to $19,900
12% $9,951 to $40,525  $19,901 to $81,050
22% $40,526 to $86,375  $81,051 to $172,750
24% $86,376 to $164,925    $172,751 to $329,850
32% $164,926 to $209,425 $329,851 to $418,850
35% $209,426 to $523,600  $418,851 to $628,300
37% $523,601 or more $628,301 or more
Internal Revenue Service

President Biden has expressed his intention to increase the tax rates of higher-income Americans, so the tax bite could increase for high earners in coming years. 

Does the Conversion Have to Be Done All At Once?

Many people can’t afford to pay the taxes that will come due on a Roth IRA conversion, even if they believe that conversion is their best long-term financial strategy. So you can convert only the amount of your account on which you know you can comfortably afford to pay the tax. 

You can continue to do a partial conversion year after year, never having to make that giant tax payment, while gradually shifting your retirement accounts to tax-free status over time.

Key Takeaways

  • Contributions to tax-deferred retirement accounts are made with pre-tax dollars because you can claim a tax deduction for them in the year they’re made. 
  • That money becomes taxable when it comes out of the account again, whether you plan to reinvest it in a Roth account in the near term or spend it later in retirement. 
  • The tax is immediately due for the year you take the withdrawal to make the conversion, but you can convert just a portion of your tax-deferred savings at one time.
  • You can later withdraw the money from the Roth account tax-free in retirement, and growth on that money is tax-free as well.