Should You Do a Roth Conversion?

Eligibility, Tax, and Investment Considerations

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A Roth conversion of an existing retirement account is a major decision. Among other factors, consider your current income tax rate, your expected future income tax rate, and the anticipated rate of return on your investments. As when making any retirement planning decision, it helps to get all your information together in one place.

What Is a Roth Conversion?

A Roth conversion is an optional decision to change an existing qualified retirement plan, such as a 401(k) or a traditional IRA, to a Roth IRA. By doing so, you take money that is currently treated as tax-deferred and convert it into an account that grows tax-free. In order to make such a conversion, however, you must pay taxes on the amount you convert.

Who May Convert to a Roth?

There are income limits that impact the ability to make Roth IRA contributions. Depending on your income, you may be able to make a partial contribution or you may not be able to contribute directly to a Roth IRA at all.

In 2020, contributions are limited at $124,000 in income for single filers, phasing out completely at $139,000. For married couples filing jointly, the phase-out starts at $196,000 and goes to $206,000. In 2021, these limits are slightly higher. Single filers are limited at $125,000 and unable to contribute at $140,000. Married couples filing jointly have a phase-out that starts at $198,000 and goes to $208,000. No limit has existed for Roth conversions since tax laws changed in 2010, however. People who earn too much to qualify directly for a Roth IRA can still get one by converting.

Making the Decision About a Roth Conversion

Converting makes sense if you believe the benefit from your money growing tax-free will be greater than the cost of paying the taxes due at the time of the conversion and you have the money available to pay those taxes.

These may not be easy determinations to make. Fortunately, there are many calculators to assist you.

Like any analysis, a calculator’s results are only as accurate as the assumptions you provide it. Keep in mind the following when making your decision about converting to a Roth:

  • If you expect your tax rate to be higher in retirement than it is right now, a conversion is more likely to be the right move.
  • The greater the expected rate of return on your investments, the more likely a Roth conversion is a good idea.
  • The longer you have until retirement (and, therefore, until you will need to take your money out of the Roth IRA in order to support yourself), the better the Roth conversion will appear.

Having to take money out of your retirement account to pay the taxes due on a conversion is a strong indication that a Roth conversion might not be appropriate for you.

How Previous Nondeductible Contributions Factor In

If you previously made nondeductible contributions to your IRA or 401(k), then part of the amount you convert to a Roth IRA will not be subject to tax. Using nondeductible IRAs to get money into a Roth IRA is sometimes referred to as a "backdoor Roth IRA" strategy.

Unfortunately, you can’t just take out the non-taxable portion. Instead, the government requires that every dollar you convert be split between non-taxable and taxable based on the ratio the nondeductible contributions represent in the value of your retirement accounts.

For example, if you previously made nondeductible contributions to your IRA of $8,000, the value of all of your traditional IRAs is $80,000, and you decide to convert $10,000, then 10% ($8,000 out of $80,000) of your conversion, or $1,000 ($10,000 x 10% = $1,000) is not taxed. You would pay tax on the remaining $9,000 conversion.

Accounts You May Convert to a Roth IRA

You can convert a traditional IRA or a 401(k) to a Roth IRA. Note, however, that you typically cannot convert a 401(k) to a Roth IRA while you are still working for the employer where your 401(k) is held. However, when you terminate employment, you may convert and roll over your IRA at the same time.

Converting to a Roth IRA Over Time

Many people cannot afford to pay the taxes due on a potential Roth IRA conversion, even if they believe conversion is their best long-term financial strategy. If that sounds like you, 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, yet gradually converting your retirement accounts to tax-free status.