What it means
A traditional IRA is funded with money that was often deducted from income, so the tax is paid when the money is taken out. A Roth IRA works the other way: contributions come from after-tax money, but qualified withdrawals, including the growth, are tax-free.
A conversion lets you switch the tax treatment of money already in a traditional account. The cost of a conversion is the income tax due in the year you do it.
The pre-tax amount converted is added to your taxable income, and it can push you into a higher tax bracket. Many people therefore convert in stages across several years, or during a year when their income is unusually low.
The benefits can be significant. Roth IRAs do not require withdrawals during the owner's lifetime, so the money can keep growing tax-free and can be passed on to heirs.
Future tax-free income can also protect against higher tax rates, and it helps in retirement planning by diversifying the types of tax treatment available. Several rules matter.
If you hold both pre-tax and after-tax money across your traditional IRAs, the pro-rata rule treats the conversion as a proportional mix of the two, so you cannot choose to convert only the after-tax part. Ideally the tax is paid from money outside the IRA, because paying it from the converted funds reduces the amount that grows tax-free, and there can be a penalty if you are under the age of 59 and a half.
Tax law changes over time, including the rules on whether a conversion can be reversed, so check the current rules or consult a tax professional. A conversion is a tax decision, not a market call, and it works best when you have cash available to pay the bill and a long time before you need the money.
In practice
Real-world examples.
Example
A consultant takes a year off between jobs and her taxable income falls to $40,000. She converts $30,000 from her traditional IRA that year, paying tax at a low bracket, and plans to keep the rest in the traditional account.
Example
A business owner expects his tax rate to be higher in retirement because of larger pension income. He converts $20,000 each year over five years, spreading the tax bill so that he does not move into a higher bracket.
Example
A retired couple with no need for their IRA money wants to leave an inheritance. They convert part of the account to a Roth IRA, pay tax now at their own rate, and their children will receive tax-free income later.
Formula
Calculation
Tax cost of conversion = pre-tax amount converted x marginal tax rate
After-conversion tax-free balance = amount converted (tax paid from outside funds)
A saver converts $50,000 from a traditional IRA to a Roth IRA in a year when her marginal tax rate is 24%. The tax due is 50,000 x 0.24 = $12,000, which she pays from her savings account. The full $50,000 now grows tax-free. If it doubles to $100,000 over time, she can withdraw the whole $100,000 without further income tax, compared with a tax bill of 100,000 x 0.24 = $24,000 if the money had stayed in the traditional account and her rate was the same.Case study
Seen in the real world.
Daltrey Family Office is an illustrative, fictional advisory firm that helped a client with a $400,000 traditional IRA. The client expected to face higher tax rates in retirement and had $60,000 in savings.
The adviser proposed converting $100,000 per year over four years instead of all at once. The tax on each $100,000 at a 24% marginal rate was $24,000, which the client paid from savings and a part-time salary, and each year's income stayed within the 24% bracket.
The illustrative lesson is that splitting the conversion kept the bracket under control. A single conversion of $400,000 could have pushed part of the income into a much higher rate and left no cash to pay the bill.
Watch out
Common mistakes.
- Converting without setting aside cash to pay the tax, so the bill is paid from the IRA and the benefit shrinks.
- Ignoring the effect on the tax bracket and on income-linked costs, when a large conversion can raise the tax rate and other charges that depend on income.
- Forgetting the pro-rata rule, when the tax-free portion of a mixed account cannot be converted on its own.
Questions
People also ask.
Is a conversion the same as a rollover?
No, a rollover moves retirement money between accounts of the same kind without changing its tax treatment, while a conversion changes a traditional account into a Roth.
Is there a limit on how much I can convert?
There is generally no income or dollar limit on conversions, although the amount is added to your taxable income.
Should I convert if I expect a lower tax rate in retirement?
Often not, because paying tax now at a higher rate to avoid a lower rate later would usually cost you.
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