Roth IRA Conversion Rules: When and How To Convert Your IRA

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A Roth IRA conversion involves moving money from a pre-tax retirement plan, such as a traditional IRA or a 401(k) plan, into a Roth IRA. This process is called a conversion because these types of accounts have very different tax consequences. Specifically, money in a traditional IRA or 401(k) plan has never been taxed, so distributions are fully taxable. But a Roth IRA is funded with after-tax money. This means that if you convert these accounts into a Roth, you’ll have to pay tax on the entire balance. Although no one wants to trigger a big tax bill, there are times when a Roth conversion can make a lot of sense. Here’s a look at when a Roth IRA conversion is appropriate and what rules and regulations you’ll have to follow.

What Are the Roth IRA Conversion Rules?

The most important thing to understand when it comes to a Roth IRA conversion is that it is a taxable event. If you are converting $100,000 from a traditional IRA to a Roth IRA all at once, for example, your income will jump by $100,000 and you will be responsible for ordinary income tax on the full amount. Depending on the size of your conversion, you may be pushed into a higher tax bracket.

On the plus side, there are no income limits on Roth conversions — they are open to anyone. As there are income limits on making regular contributions to a Roth IRA, this is a big benefit.

You can convert any pre-tax retirement plan into a Roth. This includes traditional IRAs, 401(k) plans, 403(b) plans, 457 plans, SIMPLE and SEP-IRAs. Essentially, any qualified retirement plan can be converted to a Roth IRA.

When To Consider Converting to a Roth IRA

The best time to convert to a Roth IRA is when it creates the fewest tax consequences and offers the best potential for future growth. Here are the primary considerations:

• Converted balances are fully taxable. You’ll want to convert in a low-income year to keep the most money possible.
• You could be pushed into a higher tax bracket. Don’t forget to include the full amount of your conversion in your tax planning, as it can make other income you earn subject to higher tax rates.
• It’s generally best to convert when you are younger, rather than older. This gives you the best chance for long-term, tax-free growth. You may also be in a lower tax bracket at a younger age.
• Consider your future income level. If you’re planning on living on just Social Security in retirement, it might make sense to avoid converting at all, since you won’t be paying much tax on your IRA withdrawals in retirement.

Roth IRA Conversion Limitations and Restrictions

Although there are no income limitations on Roth IRA conversions, there’s an important time limit regarding when you can withdraw the money.

• You may have to wait five years to access the money. If this is your first Roth IRA, you must leave the money in the account for at least five years to avoid taxation on any earnings you withdraw. If you’re under age 59 1/2 when you withdraw the money, you’ll also pay a 10% early withdrawal penalty. However, if you have already contributed to another Roth IRA at least five years prior to your distribution, you won’t have to worry about paying any taxes.

How Does the Roth IRA Conversion Process Work?

The actual process of converting to a Roth is actually pretty straightforward. In fact, it’s essentially the same as rolling over your IRA or other tax-advantaged account to another — except in this case, you’ll need to inform the IRS and pay your taxes. Here’s the process:

• Set up a Roth IRA. This can be a new account or an existing Roth.
• Contact the firm that holds the account you want to convert. Inform them you wish to convert your account into a Roth account. You’ll likely have to fill out some paperwork indicating whether you want to make a full or partial conversion, along with information about the receiving Roth IRA. This process can be easier if both accounts are at the same firm.
• Use Form 8606 to report your conversion. Per IRS instructions, you’ll need to use Form 8606 to report the transaction and pay the proper amount of taxes. You may want to work with a tax advisor to ensure you’re filing correctly.

Tax Implications of a Roth IRA Conversion

The biggest drawback to a Roth IRA conversion is that it’s a taxable event. In fact, in some cases, it can trigger a huge tax bill. That’s why it’s essential to make a plan to minimize the tax ramifications.

For example, you might consider waiting until you’re in a low tax bracket to make your conversion. If you were unemployed for any period of time during a given year, or received any type of pay cut, you may be in a lower tax bracket, and you can make lemons out of lemonade by using that year for your conversion.

Another option is to convert in a year in which you have larger-than-usual deductions. For example, if you’ve made sizable charitable donations in a given year, that can be a good time for a conversion.

Remember that you’ll have to add the amount of your conversion to your taxable income in any given year. This can push you up to a higher tax bracket, further complicating your tax situation.

Before you convert, consider the following factors, from a tax perspective:

• Amounts you convert will be fully taxable
• Converting in a lower-income year can save you money on a conversion
• Consider waiting to convert until you have a lot of deductions to offset the increased income
• Beware of the effects of a large conversion pushing you into a higher tax bracket

Common Mistakes To Avoid During a Roth IRA Conversion

Although a Roth IRA conversion can be beneficial, there are some pitfalls you’ll want to avoid during the process. Here are the most important:

• Converting too much at once: Remember, the entire amount that you convert is included in your taxable income. A large conversion can push you into a higher tax bracket.
• Forgetting to account for taxes: A sizable Roth IRA conversion can result in a huge tax bill. If you don’t have the funds to cover the cost, it could undermine your whole strategy.
• Not considering your long-term strategy: If you’re anticipating being in a low tax bracket after you retire, it might make sense to wait to take money out of your retirement plan instead of converting to a Roth when your overall taxes will be higher. You should also factor in your anticipated needs for retirement income, understanding the difference between tax-free and fully taxable retirement plan withdrawals.

Is a Roth IRA Conversion Right for You?

A Roth conversion may be right for you if it doesn’t upset your tax situation and if you can benefit from the long-term, tax-free growth that a Roth can provide. You might want to consult with a financial or tax advisor to help you make the computations needed to determine if a conversion makes financial sense for you. Remember that you aren’t required to convert the entire amount of your retirement plan balance to a Roth IRA all at once. If it makes sense from a tax perspective to slowly convert your balance over time, that can be a viable strategy as well.

Editor's note: This article was produced via automated technology and then fine-tuned and verified for accuracy by a member of GOBankingRates' editorial team.

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