Roth individual retirement accounts (IRAs) are a popular retirement savings tool. Funds in the account can grow tax-free and eligible investors do not pay any taxes on the principal or profits when they withdraw money from the account, provided they satisfy certain requirements. In some cases, people with a traditional IRA or 401(k) may want to convert their account to a Roth IRA.
Converting an entire traditional IRA to a Roth IRA is possible. But it isn’t only an all-or-nothing undertaking. You can convert just a portion of your balance to a Roth IRA if you want to. Find out more about what you need to know about partial conversions.
Key Takeaways
- Roth IRAs are tax-advantaged accounts for retirement savings.
- Tax is paid as normal on contributions in the year they are made, then the money grows and can be withdrawn tax-free.
- Conversions from a traditional IRA are permitted.
- You can convert just a portion of your IRA balance, if you want.
Roth Conversions Aren’t All-or-Nothing
There are no rules stating that converting a traditional IRA to a Roth IRA is an all-or-nothing prospect. You are permitted to convert only a portion of your traditional IRA balance if you want, although you can also convert the full balance, if desired.
That gives you more flexibility when it comes to managing your money. You can convert very precise amounts if you want, giving you the chance to avoid moving into a higher tax bracket.
How to Roll Over Funds to a Roth IRA
Converting your traditional IRA to a Roth IRA isn’t overly difficult, but it’s important to follow the steps of the process carefully. If you don’t follow the proper procedures or take too long to complete the conversion, you may owe penalties.
The IRS recommends three methods for completing the conversion.
Rollover
With the rollover method, you request a distribution from a traditional IRA, then contribute the money to a Roth IRA. There is a time limit of 60 days from the date of the distribution to make the contribution. Otherwise, it is treated as an early distribution and incurs tax penalties.
This is the most difficult method, in that it requires careful attention to finishing the process within the required time limit.
Trustee-to-Trustee Transfer
If you want to move funds in an IRA at one brokerage to a Roth IRA at a different brokerage, you can work with both institutions to coordinate the transfer. Your brokers will organize the exchange and conversion for you.
Same-Trustee Transfer
If you have a traditional IRA with a brokerage firm and want to convert all or part of it to a Roth IRA at the same company, your brokerage should be able to handle that easily. All they have to do is move money between the two accounts.
How to Pay the Tax on a Roth Conversion
One thing to watch out for when making a Roth IRA conversion is taxes.
You can deduct money contributed to a traditional IRA from your income. However, money added to a Roth IRA gets taxed as normal.
Note
When you convert a traditional IRA to a Roth, you pay income taxes on any amount converted.
While it can be tempting to use some of the money being converted to pay the taxes, this is a bad idea. If you use those funds, the IRS treats it as an early distribution and assesses a tax penalty equal to 10% of the funds used. Doing this also reduces the amount you have saved for retirement.
Instead, you should use money from other sources to pay the taxes. Keep in mind that if you convert a large amount, you might have to make estimated tax payments on it throughout the year. You’ll have to report the conversion when you file your taxes.
To get a rough idea of your tax liability from converting a traditional IRA to a Roth IRA, multiply the amount you convert by your expected tax bracket. So, if you expect to have a taxable income of $50,000 as a single filer, your tax bracket is 22%, for example. If you convert $10,000, you’ll owe roughly $10,000 * 22% = $2,200 on the conversion.
Should You Do a Partial Roth Conversion?
Whether you should do a partial Roth conversion depends on your goals, your current income, and your expected income in retirement.
Current and Future Tax Brackets
Traditional IRAs reduce your tax bill today but make you pay taxes in the future. Roth IRAs tax you now, but let you avoid taxes on the money in retirement.
To get the most out of these accounts, you have to determine your current tax rate and your expected tax rate in retirement. If you’re in a higher tax bracket now than you will be in retirement, traditional IRAs tend to be better. If you expect to be in a higher tax bracket during retirement, a Roth IRA provides a greater benefit.
Note
If you’re in a low income-tax bracket for one year, you can take advantage of the opportunity to pay a low tax rate on a conversion to avoid a higher tax rate later on.
In an email to The Balance, Paresh Shah, managing partner at PareShah Partners, a Hicksville, New York-based financial planning firm, recommended that you also consider state taxes when converting. “Are you moving to (or from) a state with lower state taxes? Maybe you want to wait or rush, depending on where you are moving to.”
Fine-Tune Your Income
Because you’re free to convert just a portion of your IRA balance to a Roth IRA, you can use the conversion process to fine-tune your income and avoid moving to a higher tax bracket.
For example, in 2022, all income between $10,275 and $41,775 is taxed at 12% for single filers.
If you have a taxable income of $35,000, you might want to take the opportunity to make a conversion to take advantage of that low tax rate. If you choose to convert $6,775, your taxable income will rise to exactly $41,775 and you’ll still pay just 12% on the amount converted.
After the conversion, you never have to pay taxes on the money in the account, including profits, locking in the low 12% tax rate on that money.
Consider Other Programs Determined by Income
One important caveat to converting money from a traditional IRA to a Roth IRA is that the extra taxable income could affect your eligibility for other programs.
“There are some caveats that could reduce the strategy’s effectiveness,” Matt Stephens, a certified financial planner (CFP) from Wilmington, North Carolina, said. “A big one (that’s easy to miss) is with the Affordable Care Act limits. The Roth conversion could be taxed at a low rate, but if the extra income causes someone to lose the ACA premium subsidy, it might not be worth it,” he told The Balance in an email.
Frequently Asked Questions (FAQs)
What are the distribution rules after a Roth conversion?
While you can withdraw contributions to a Roth IRA without paying taxes or a penalty at any time, even before you turn 59½ if you qualify, there are some rules to keep in mind. You must have the account open for at least five years before making withdrawals to avoid paying taxes on earnings. There is also a separate five-year waiting period for withdrawing converted funds, even if your Roth IRA has been open for at least five years.
What is a backdoor Roth conversion?
The IRS places income limits on who can contribute to a Roth IRA. A backdoor Roth IRA is a strategy that relies on an IRA conversion to get around these limits. You make a backdoor Roth IRA contribution by first putting money in a traditional IRA and then converting that IRA to a Roth.
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