Personal Finance

How to Convert to a Roth IRA — And Why You Might Want To

Running through the pros and cons of various retirement savings options can be a bit overwhelming for anyone — let alone those who are young and perhaps considering such tools for the first time. While most workers are likely to just sign up for their employer’s 401(k)s, others may eventually decide to add an IRA to the mix. However, even then, they may end up selecting a Traditional IRA when a Roth IRA may have technically been more beneficial to them overall. Luckily, there is a way to effectively “correct” this: a Roth IRA conversion (sometimes referred to as “Backdoor Roth IRAS”). Just as it sounds, via this method, taxpayers can turn their current Traditional IRA into a Roth after the fact.

So how do Roth IRA conversions work and why might they be a good option for some workers? Let’s take a look at a few important things to know about the process.

Traditional IRAs versus Roth IRAs — Why a Conversion Can Be Beneficial

What’s the difference between a Traditional and Roth IRA?

So what makes an IRA “Traditional” or “Roth”? It all comes down to taxes. As you may know, when making contributions to a Traditional IRA, you’re typically able to deduct those contributed funds from your taxable income. However, when you retire, you’ll then pay taxes on any withdrawals you make.

On the other hand, Roth IRAs basically work in reverse of this. While you’ll still pay taxes on funds you contribute along the way — assessed at your income tax level at the time of your contributions — when you retire, you’ll be able to make withdrawals on your funds tax-free. This includes any gains the account has made thanks to investments.

Beyond taxes, there are a few other differences between the two accounts. For one, since you’ve already paid taxes on Roth contributions, you’re able to withdraw principle funds (but not gains) from your account with tax or penalty. However, taking early distributions from your Traditional IRA will result in you paying income tax on the funds as well as a 10% penalty. Lastly, although Traditional IRAs require accountholders to take annual Required Minimum Distributions (RMDs) when they turn 72, Roth IRAs do not have RMDs to worry about.

Who might want to convert to a Roth IRA?

Based on the differences between the account types, you can probably guess that, when it comes to the decision of whether or not to convert to a Roth IRA, a key component is taxes. Since Roth accounts allow you to pay taxes on your contributions but make untaxed withdrawals (at retirement age), those who are currently in a lower tax bracket than they expect to be upon retiring may consider this option. Broadly speaking, this is often advantageous for younger workers who may be earlier in their careers and who might have yet to reach their full wage-earning potential.

Can anybody do a Roth IRA conversion?

Something important to know about Roth IRAs is that there are typically limits on who can contribute to them. Specifically, for tax year 2022, individuals with modified adjusted gross incomes (MAGIs) of $144,000 or more are not able to contribute to a Roth. This limit raises to $214,000 for married couples filing jointly. However, despite these income limits existing for contributions, they do not apply to conversions.

How do taxes impact Roth conversions?

Although you will need to pay income tax on the funds being moved from your traditional IRA to a Roth IRA, you will not have to pay the 10% penalty that is typically assessed on early withdrawals — as long as you properly convert your account instead of taking a distribution.

Can I access Roth funds after converting?

If there’s any “catch” to Roth IRA conversions it’s that converted funds cannot be withdrawn for five years. After this timeframe, funds can be withdrawn in accordance with regular Roth rules. Should you need to withdraw these funds before this five-year timespan has elapsed, akin to an early withdrawal from a Traditional IRA, you’ll be assessed a 10% penalty.

Should I convert my entire IRA amount to Roth?

Although there is not currently a limit on how much you can convert to a Roth IRA, keep in mind that you will need to pay taxes on any funds you convert. Therefore, it likely makes more sense to do your conversions in stages. Additionally, as mentioned, converted funds cannot be accessed for five years, so it may be wise to create what’s known as a “Roth conversion ladder” where you make conversions annually so that your funds become accessible in stages as well. Incidentally, this strategy can also be useful if you’re pursuing early retirement and want to be able to make withdrawals.

Is a Roth IRA conversion best for me?

Ultimately, it’s up to you to consider all of the factors presented and determine if a Roth conversion is the best move for your situation. However, if you’re having trouble deciding, you can also try a Roth conversion calculator like the one offered by Charles Schwab. This tool will talk you through some of the factors and, based on that, give you a theoretical look at the difference. Obviously such calculators can’t predict the future but they can still be useful for helping you choose the best mathematical path based on what’s known.

How to Convert to the Roth IRA

Now that you’ve decided you’d like to convert to a Roth IRA… how exactly do you do that?

Converting to a Roth IRA

First, if you have an IRA with a financial institution that also offers Roth IRAs, they may provide guidance on how to perform a conversion and can handle a lot of the steps on their end. This can obviously make your life a lot easier as they’ll do the heavy lifting. Of course, if you don’t find such info available or you plan on keeping your new Roth IRA elsewhere, you may need to do some of the work on your own.

Typically, the first step to converting to a Roth IRA is to open a Roth IRA. Then, once this is done, you can instruct your current IRA custodian to transfer your funds to your new account. You’ll need to complete the paperwork in order to authorize this transfer.

Keep in mind, that you may not want to convert all of your funds at once. Thus, you’ll want to be careful when filling out your paperwork in order to ensure that you’re only moving the amount of funds you plan for at that time.

Preparing your taxes after a conversion

As detailed earlier, converting to a Roth IRA will have some tax implications. Once you’ve completed a conversion, your account custodian should send you a Form 1099-R with the details of your converted funds. Like other tax forms, this should arrive by the end of January in the year following your conversion. The information on this form will then be used to fill out Form 8606 as well as Form 1040 as part of your annual tax filing. Of course, if you have further questions, be sure to speak to a tax professional.

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To be clear, a Roth conversion or “backdoor Roth IRA” may not make sense for every future retiree. Instead, the decision will come down to a few important factors involving taxes, your time horizon (when you’ll need the funds), and more. Furthermore, for those who can benefit from a conversion, it may make sense to create a “conversion ladder” to prevent having to pay a massive tax bill in a single year. With these disclaimers out of the way, it may very well be worth looking to your IRA’s custodian to explore your conversion process options.