IRA Roth conversion

What is a Roth conversion?

A Roth conversion is a process where you move funds from a pre-tax retirement account, like a traditional IRA, 401(k), or similar account, into a Roth IRA. This involves paying taxes on the converted amount in the year of the conversion, but once the funds are in the Roth IRA, they can grow tax-free and be withdrawn tax-free in retirement. This strategy can be particularly beneficial if you expect your tax rate to be higher in the future. However, it's important to consider your current and future financial situation, as well as the potential tax implications, before making a decision.

Who is able to convert to a Roth IRA?

Anyone with a traditional IRA, regardless of their income, can perform a traditional IRA to Roth IRA conversion. Additionally, people who have a 401(k), 403(b), SEP, or SIMPLE IRA may also convert these funds to a Roth IRA, assuming they meet specific criteria.

Common retirement account conversions

Several types of retirement accounts can be converted to a Roth IRA, each with its own set of rules and considerations. Here's a breakdown:

• Traditional IRA to Roth IRA conversion: This is the most common type of conversion and typically requires that you pay taxes on the converted amount.
• 401(k) to Roth IRA conversion: Funds from a 401(k) can be rolled over into a Roth IRA, but you generally need to have left your job or be of retirement age. Taxes will usually apply on the converted amount.
• 403(b) to Roth IRA conversion: Similar to a 401(k), funds from a 403(b) can be converted to a Roth IRA, with the same general rules and tax implications.
• SEP IRA to Roth IRA conversion: SEP IRAs can be converted to Roth IRAs, but you'll typically owe taxes on the converted amount.
• SIMPLE IRA to Roth IRA conversion: SIMPLE IRAs can be converted, but there's a 2-year waiting period from the date you first participated in the SIMPLE IRA plan. After that, normal conversion rules and taxes apply.
• 529 to Roth IRA conversion (rollover): A direct conversion from a 529 plan to a Roth IRA, commonly known as a rollover, isn't typically allowed. However, up to $35,000 of unused 529 plan assets can be moved to a Roth IRA if certain conditions are met. The 529 plan must have been in existence for 15 years, the funds must have been in the 529 for at least 5 years before they (and associated earnings) can be moved, and the transfer must be to an IRA for the same beneficiary. The 529 to Roth IRA conversion limit is equal to and counts toward the annual Roth IRA contribution limit, and there’s a lifetime cap of $35,000 per beneficiary.

Roth IRA conversion rules and tax considerations

When exploring the possibility of converting to a Roth IRA, it's important to be aware of the specific guidelines, or Roth IRA conversion rules, that govern this process. And remember, the conversion will be permanent—you can't revert the money back to a traditional IRA. Deciding whether to convert to a Roth IRA also hinges on issues like your tax rate now versus later, the tax bill you'll have to pay to convert, and your future plans for your estate.

Will you need the money in 5 years or less?

There's a 5-year holding period on withdrawals of money that were part of a Roth conversion. So if you think you'll need the money within that time, you should reconsider. You could end up owing the taxes you were hoping to minimize with a conversion.

Will you end up in a higher tax bracket?

All or a portion of the money you convert could be considered "reportable income" by the IRS. If you're on the cusp of the next tax bracket, there's a chance you'll get bumped up in the year you convert.

To avoid this, consider converting a portion of your traditional IRA. This could help you:

• Stay out of that higher tax bracket.
• Spread the taxes related to the conversion over a few years instead of getting hit with the entire bill in 1 year.

Will your tax bracket be higher now or later?

No one really knows how tax rates could change over the next 5, 15, or 25 years.

If you believe your tax rate is lower now than it will be when you start taking withdrawals, a conversion may look promising because you'll pay conversion taxes while you're in a lower tax bracket and enjoy tax-free Roth IRA withdrawals later (when the higher tax bracket won't matter).

But if you believe your tax rate is higher now than it will be when you start taking withdrawals, a conversion could cost you more in taxes now than you'd save with tax-free withdrawals later.

So what do you do? It may help to "diversify" your taxes—in other words, pay some of the taxes now (when you're still building your retirement savings) and save some for later (when you need that money to cover expenses in retirement).

Give this some thought and talk with your tax advisor about what might be best for you.

Where will you get the money to pay the conversion taxes?

Before you use money from your IRA to pay the tax bill, consider the following:

Short-term consequences

The money taken out of your IRA to pay conversion taxes would be considered a distribution. This could result in even higher taxes in the year you convert.

In addition, if you're younger than age 59½ and you withdraw money from your IRA to pay conversion-related taxes, you could also face a 10% federal penalty on that withdrawal.

Long-term consequences

You'll lose the chance for that money to compound, or earn on both the principal amount of your investment and the accumulated earning, and grow tax-free in your IRA—which means less money when you need it in retirement.

The benefits of a Roth conversion

A Roth conversion might benefit those who anticipate being in a higher tax bracket in the future, as it allows you to pay taxes on the converted amount now, rather than in retirement. This can lead to significant tax savings down the line. Additionally, Roth IRAs offer tax-free growth and tax-free withdrawals in retirement, making them an attractive option for those looking to minimize their future tax burden.

Another advantage is that Roth IRAs don't have required minimum distributions (RMDs) at age 72*, unlike traditional IRAs, allowing your money to continue growing tax-free for as long as you like. Furthermore, Roth IRAs can be a useful estate planning tool, as they can be passed on to beneficiaries tax-free. However, it's important to weigh these benefits against the upfront tax cost and to consider your personal financial situation and goals.

*73 if the account owner reaches age 72 in 2023 or later

Why you might convert to a Roth IRA

Tax-free withdrawals in retirement

When taking withdrawals from a traditional IRA or other pre-tax retirement account, you'd have to pay taxes on the money your investments earned—and on any contributions you originally deducted on your taxes.

With a Roth IRA, as long as you meet certain requirements, all of your withdrawals are tax-free.

Review the rules for IRA withdrawals

Watch your money grow tax-free for longer

Traditional IRAs force you to take required minimum distributions (RMDs) —the minimum amount that you must withdraw from certain types of retirement accounts, such as traditional IRAs and 401(k) plans, each year once you reach a specific age, typically 72 or 73*—regardless of whether you actually need the money. So, you lose the tax-free growth on the money you had to withdraw.

These distributions are required by the IRS to ensure that individuals don't defer taxation on these accounts indefinitely. The amount of the RMD is calculated based on the account balance and the account owner's life expectancy, as determined by IRS tables. Failure to take the RMD can result in significant penalties.

On the other hand, Roth IRAs don't have RMDs during your lifetime, so your money can stay in the account and keep growing tax-free.

*Due to changes to federal law that took effect on January 1, 2023, the age at which you must begin taking RMDs differs depending on when you were born. If you reached age 72 on or before December 31, 2022, you were already required to take your RMD and must continue satisfying that requirement. However, if you had not yet reached age 72 by December 31, 2022, you must take your first RMD from your traditional IRA by April 1 of the year after you reached age 73.

Leave a tax-free inheritance to your heirs

The people who inherit your Roth IRA will have to take RMDs, but they won't have to pay any federal income tax on their withdrawals as long as the account's been open for at least 5 years.

A conversion can get you into a Roth IRA—even if your income is too high

The conversion would be part of a 2-step process, often referred to as a "backdoor" strategy.

First, place your contribution in a traditional IRA—which has no income limits. Then, move the money into a Roth IRA using a Roth conversion.

But make sure you understand the tax consequences before using this strategy.

Review Roth IRA income limits

Is a Roth IRA conversion right for you?

Converting to a Roth IRA can be a strategic financial decision, especially if you expect to be in a higher tax bracket later in life. This conversion involves transferring funds from traditional IRAs or other retirement accounts into a Roth IRA to take advantage of tax-free growth and withdrawals. Roth IRAs also provide advantages such as no required minimum distributions and the potential to leave a tax-free inheritance to heirs. Before you convert to a Roth IRA, consider the tax implications since you'll have to pay taxes on the converted amount in the year of the conversion. If you need help deciding whether a Roth conversion is right for you, Vanguard can provide guidance on the process, help you understand the costs and benefits, and offer tools to effectively manage your retirement accounts.

Learn how to convert to a Roth IRA online