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Roth Conversions — Who, Why, and How?

Converting your tax-deferred account to a Roth IRA can have some substantial tax benefits. Learn if a Roth conversion is right for you.

Posted on November 21, 2023

Roth Conversions

When setting up a retirement account, there are many decisions you need to make. Do you want to set up a tax-deferred Traditional IRA or a Roth IRA with tax-free withdrawals or both? Do you want to set up your retirement plan with a traditional custodian and invest in mutual funds or other publicly held assets, or with a custodian that allows you the flexibility to invest in alternative assets like real estate, promissory notes, and private placements?

Down the road, you may discover that a different account will better meet your needs. For instance, if you are predicting a high return on your real estate investment in your Traditional IRA, you might want to consider a Roth conversion and pay taxes on the money now before it grows. Below are some considerations to evaluate if a Roth conversion is right for you.

What is a Roth Conversion and Who Qualifies?

A Roth conversion is basically the movement of funds or assets from a traditional IRA or other pre-tax account to a Roth IRA, an after-tax account. While there is an income limit on the ability to contribute to a Roth IRA, there is no income cap on Roth conversions, so anyone, even high-income earners can convert their assets into a Roth. However, just because there are no limitations to who can do a Roth conversion, doesn't mean that it makes sense for everyone.

Why Convert?

Tax Free Growth – With a traditional IRA, you may benefit from tax deductible contributions now, but you will have to pay income tax on all distributions later on. You will also be required to take a yearly distribution once you reach age 73. With a Roth IRA, you have to pay income tax on your contributions now, but aren't subject to a tax on withdrawals once you reach age 59½. While you aren't required to take a yearly distribution for a Roth IRA, you still have to leave your funds in your account for at least five years before taking any distributions to avoid penalty, even if you've reached the 59½ mark. Depending on your income level now and what you expect your income level at retirement to be, a Roth conversion could make sense for you.

Because you will be taxed on any converted funds coming out of your traditional IRA and won't be taxed later on distributions from a Roth, it generally makes more sense to convert if you are in a lower income tax bracket now than what you expect to be at retirement. If you are in your peak earning years, the taxes you pay on your conversion will be higher than the taxes you would owe at retirement when you start your traditional IRA distributions. If you think you'll be in the same tax bracket at retirement as you are now but think congress will raise the income tax by the time you reach retirement, it also may make sense to convert to a Roth now. It's important to discuss these scenarios with a qualified tax advisor before making a decision.

Backdoor Roth – If you want to contribute to a Roth, but are ineligible because of income limits, you can contribute to your traditional IRA and then convert it to your Roth IRA. This strategy allows high earners to still fund their Roth IRA even when they can no longer make regular contributions to it.

Estate Planning – Another reason why someone would want to convert is if they were planning on entrusting the IRA to children or grandchildren upon death. This way, the inheritors wouldn't owe income taxes on the funds and could withdraw any time as long as the account met the five-year requirement.

How Does a Roth Conversion Work?

The process to convert your funds from a tax deferred account to a Roth is pretty straightforward. Just contact the custodian where the funds are held, and they can walk you through the process. At Quest since we work with self-directed IRAs, the conversion usually requires moving assets such as real estate. Clients would complete a Roth Conversion Form and provide supporting documentation depending on what type of asset is being converted.

With a Roth Conversion, you will be responsible for taxes on any money from your traditional IRA that hasn't been taxed. The converted amount will be added to your taxable income for the tax year the conversion occurs, so it may bump you into a higher tax bracket resulting in paying a higher tax rate.

There are no restrictions on how much you can convert or how many times you can convert, but you do want to consider the tax consequences. If you are going to be in a lower tax bracket for a few years, you can make a conversion each year that doesn't bump you up to the next tax bracket and save even more on taxes with this method. Deciding whether it’s appropriate to convert to a Roth from your traditional IRA should be evaluated every year. For example, if your income varies significantly from year to year, then you may want to target a relatively low-income year as one in which a conversion may be appropriate.

What to Consider Before You Convert?

  • The deadline for converting your traditional IRA to a Roth IRA is December 31st. Don't confuse this with the deadline to contribute to a Roth IRA, April 15th.
  • If you need to take a required minimum distribution the year you convert, you must take the distribution before you move any funds.
  • If you are younger than 59½ and use IRA funds to pay for the conversion tax, you will be subject to a 10% tax penalty. It is suggested that you use another source to pay for the tax to avoid unnecessary penalties.
  • Beware of the five-year rule: converted funds cannot be withdrawn until they have been in the account for five years, or you will incur a 10% early withdrawal penalty.
  • Even though you may qualify for a Roth conversion, there are still income restrictions on direct contributions to the account.
  • Any post-tax funds in your IRA aren't eligible for conversion.
When retirement planning, it's important to weigh the potential benefits and drawbacks when choosing what type of account should hold your investments. Converting IRA funds to a Roth IRA may be beneficial to you in the long run, but it is recommended that you talk with a financial advisor regarding your individual situation before making any final decisions. If you are interested in learning more about self-directed Roth IRAs and alternative investments, you can schedule a 1 on 1 with an IRA Specialist.


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