Is a Roth IRA conversion right for you?

Before you convert your existing IRA or employer-qualified plan to a Roth IRA, make sure this option is right for you.

How a Roth IRA conversion works

Converting to a Roth IRA involves moving assets from an IRA or an employer-qualified plan to a Roth IRA. If the assets you convert are pre-tax contributions, they’ll be subject to ordinary income tax the year you convert. The benefit is that qualified distributions from a Roth IRA are tax free. Individuals are eligible to convert regardless of their age or level of income.

You are not required to have withholding as you convert to a Roth IRA. If you do, the withholding is considered as part of the distritubution, and if you are not yet the required age of 59½, the withholding amount is considered an early distribution subject to penalty. 

When a Roth IRA conversion makes sense

While there’s no “one size fits all” answer, a Roth IRA conversion may make sense if:

  • You won’t need to access the money in the account within the first five years after you establish the Roth IRA. Keep in mind that although five years is the minimum required for tax-free withdrawals, a longer timeframe is usually necessary for an IRA conversion to be most effective.
  • You can pay the tax due on the conversion without having to draw money out of the original IRA or employer-qualified plan to make the payment.
  • You’re in a lower tax bracket than the one you expect to be in when you retire.
  • You want to build an estate for your heirs and help reduce the overall tax burden for your family.

Are you a good candidate for a conversion to a Roth IRA?

It depends on a number of factors, but here are just a few of the individuals who could benefit from a Roth IRA conversion:

  • Women who are married and nearing or in retirement. In general, women live an average of three years longer than men. But if you outlive your husband, yet continue receiving the same amount of income (e.g., from a joint life pension plan), you could end up in a higher tax bracket when your filing status changes to single. With a traditional IRA account, a higher tax bracket would result in higher taxes on your withdrawals. But with a Roth IRA, your withdrawals are tax-free once the five-year holding period is met and you reach age 59½. So a tax-bracket change would have no impact on the account.
  • Individuals who are concerned about rising tax rates. Many people are concerned that income tax rates may be rising significantly in the future. A rising tax environment makes tax free Roth IRA withdrawals even more valuable. Roth IRAs can help manage the risk that rising tax rates will eat into your retirement income, leaving you less money than you anticipated.
  • Anyone who wants to leave a financial legacy. There are a number of benefits to using a Roth IRA to build an estate to pass on to your heirs:
    • Reduce the taxable portion of your estate. When you convert an existing IRA or qualified plan to a Roth IRA, you’ll potentially reduce the taxable portion of your estate when you pay the taxes up front.
    • Share your legacy with your loved ones, tax and penalty free. Your beneficiaries will receive the total value of your account without having to pay any income taxes or penalties. In fact, the only income taxes they would potentially need to pay would be on any distributions of earnings they receive prior to the five-year holding period (from the date you originally established the account or made the conversion).
  • Anyone who wants to take advantage of these additional benefits. A Roth IRA offers a few benefits that are not available with a traditional IRA or employer-qualified plan. These include:
    • Tax-free growth. Once the Roth IRA is established and the up-front taxes have been paid, your money in the account grows tax-free.
    • No RMDs. Roth IRAs have no required minimum distributions (RMDs) during the owner's life, so all your money can remain in the account and continue growing. Over time, this could result in more significant retirement savings for you or an increased inheritance for your beneficiaries. In contrast, a traditional IRA requires annual distributions once you reach age 70½. And failing to take these distributions on time and in full results in an IRS penalty — 50% of the amount that should have been taken.
    • Option to contribute as long as you like. With a traditional IRA, you can no longer contribute to your retirement account once you reach age 70½ — even if you’re still earning income. But with a Roth IRA — even one that was converted — you can continue making contributions regardless of your age, as long as you or your spouse have earned income from a job and meet the other qualifications. Certain restrictions apply so ask your advisor for details.
    • Tax-free withdrawals. While you grow the account for your heirs, you can also access it when you want to without paying taxes on withdrawals, as long as you’ve kept the assets in the account for at least five years and you’ve reached age 59½. (Note that contributions made to a Roth IRA can be withdrawn tax-free at any time.) On the flip side, withdrawals from traditional IRAs and employer-qualified accounts are typically taxed as income. You can also draw money from the account tax-free if you reach a different qualifying event such as a disability, or if you, your children or grandchildren meet the requirements for a first home purchase.

A Roth IRA conversion can benefit many types of investors. And combining this type of account with other retirement savings plans, such as traditional IRAs and 401(k)s, can help ensure you have a well-rounded portfolio for retirement. Here are some additional considerations to help you make a decision.

Tax-free conversion opportunity

Converting a qualified plan to a Roth IRA may present special advantages if you have after-tax money in a 401(k) plan. This is because after-tax assets can be converted to a Roth IRA tax-free. Related earnings that are converted will be subject to tax, however, so be sure to consult your plan administrator and tax advisor before adopting this strategy.

What if you change your mind after the conversion?

You can reverse (recharacterize) an IRA conversion for any reason, until Oct. 15 of the year following the conversion. You may want to do this if the value of your Roth IRA account dropped or you’re unable to pay the tax. This removes any tax consequences you would have incurred with the Roth IRA conversion.1 However, if you intend to reconvert, you may not do so until the latter of Jan. 1 of the year following the year in which the original conversion took place or 30 days after the recharacterization.

What about Roth IRA contributions?

If you qualify, you can also grow your retirement savings through Roth IRA contributions. But keep in mind that even though there are no restrictions on who can convert to a Roth IRA, there are restrictions on who can contribute to one. Specifically, to make a full contribution, you must have a modified adjusted gross income (MAGI) of less than $118,000 if you’re single, or less than $186,000 if you’re married and filing a joint return. Also, if you’re married and filing separately, you can’t contribute to a Roth IRA unless your MAGI is less than $10,0002. You or your spouse also must have earned income of at least the amount of the contribution. This is why a Roth IRA conversion, which has none of these restrictions, is so appealing.

If your income is too high to make a Roth IRA contribution and you’re not eligible for a deductible IRA, you can opt to fund a non-deductible traditional IRA and convert to a Roth IRA later. The after-tax contributions are not taxable when you do a conversion. But be careful with this strategy if you have other pre-tax IRA assets because special tax rules apply. Consult your tax advisor.

With its tax-advantaged savings and distributions, a Roth IRA is an excellent addition to any retirement plan. Talk to your financial advisor to learn more about the Roth IRA and determine if a conversion is the right choice for you.