Roth IRA conversion

🇺🇸

s are permitted by US tax regulations. If you have a Traditional IRA, you can convert part or all of the account to a Roth IRA. You pay taxes as if you withdrew the entire amount converted, but without any penalty for early withdrawal; in return, the money will grow tax-free in the Roth IRA, and you will not pay any tax on that withdrawal if you meet the Roth IRA distribution rules. The gain or benefit depends on your current marginal tax rate, your expected marginal tax rate in future years, and how you would otherwise invest the funds that you use to pay the taxes.

How to convert
With most brokerages, to convert, you buy shares (or open a new account) in your Roth IRA, and fund it by "selling" shares in your traditional IRA. If you convert shares in the same fund, you have not actually sold anything, so the brokerage will not charge a purchase fee or redemption fee on the conversion. The specific process for selecting the conversion amount may vary, so check with your brokerage.

All Roth IRA conversions are reported in Part II of IRS Form 8606.

Whether to convert
If you expect to be in a lower tax bracket in future years, wait until then to convert. Likewise, if converting the whole amount from a traditional IRA would push your marginal tax rate for this year higher than you desire, convert only the amount that will keep this year's marginal tax rate at or below your target, and convert the remainder in future years.

If your traditional IRA contains substantial non-deductible contributions, it's often best to convert as soon as possible - but see the [Converting with non-deductible contributions] section below if you also have substantial pre-tax amounts in any non-Roth IRA.

Otherwise, compare your current marginal tax rate and your expected marginal tax rate in the future, and consider where you will invest the money for the tax payment if you choose not to convert. Conversion is less attractive if your retirement marginal tax rate is lower than your current marginal tax rate, and more attractive if the tax payment would have to be invested in an inferior investment.

If your current marginal rate is lower than your expected future tax rate, you should convert in preference to any investment except a matched contribution to a retirement plan, or an HSA. If the rates are equal, max out your Roth contribution in preference to converting, but convert in preference to maxing out your 401(k) or taxable investing. If your current rate is slightly higher, max out a decent 401(k) or Roth in preference to converting, but convert in preference to investing in a taxable account. If your current rate is much higher, do not convert.

For calculations which illustrate these principles, see Traditional versus Roth - Calculations. The difference between paying the conversion from converted funds, vs. paying the conversion tax from cash on hand, is discussed there.

If you don’t expect to spend money from your traditional and Roth accounts, e.g., if your pension and Social Security cover your needs, then consider your heirs’ expected marginal tax rates when deciding whether to convert. Someone leaving everything to tax-exempt charities should be less willing to convert than someone leaving everything to children who may be in their own peak earning years.

Another consideration when expecting not to spend RMDs is how the tax drag on the taxably-invested RMDs affects the situation. See situation (c) in “Traditional plus taxable” vs. Roth for details.

The underlying math formulas for deciding the appropriateness of a Roth IRA conversion are described here.

Other considerations
A good time to do Roth conversions could be in years when your income is lower:
 * 1) when unemployed or working fewer hours
 * 2) when going back to school full-time instead of working
 * 3) when taking time off to care for a family member
 * 4) in early retirement before Social Security is collected

Two conflicting considerations: when you expect
 * 1) high medical itemized deductions lowering your taxable income
 * 2) one spouse to outlive the other by many years and be taxed at single rates

In all cases, ultimately the marginal rate comparisons discussed above are what matter.

If you might retire before taking Social Security, you are likely to be in a very low tax bracket before Social Security starts. To see if Roth conversions would benefit you during this time, estimate your taxes and marginal tax bracket during the early retirement period as well as for the years you are taking Social Security (if eligible) and then Required Minimum Distributions (RMDs) from tax-deferred accounts.

If your post-Social Security tax bracket is higher, it may be advantageous to you to convert during the early retirement period, while delaying Social Security. It can be an advantage for converting to a Roth early, as traditional IRA withdrawals are counted as income for determining how much Social Security is taxable, while Roth withdrawals, which are based on already-taxed money, are not taxed again (assuming the withdrawals occur when you are over age 59.5 and the Roth has been open 5 years).

Cautions
Recognize three cautions regarding taking conversions in these situations:
 * 1) If you are drawing Social Security, a Roth IRA conversion could result in a one-year increase in the taxable portion of your Social Security benefits. Total income for Social Security purposes is defined as half of your benefits plus any other income, including tax-exempt income. This income level determines the taxable percentage of your benefits (0%, 50%, or 85%). Keep in mind that future distributions from a Roth won't affect the taxation of your Social Security benefits, which may help you in the long run.
 * 2) Medicare premiums depend on your modified adjusted gross income (MAGI) from the previous two years (for example your 2021 MAGI determines your 2023 premiums). A Roth conversion reported in a given year will increase your MAGI for that year and therefore may increase your Medicare premiums two years hence. Most retirees pay the standard Medicare Part B premium—about 25% of the total cost—with the U.S. government paying the rest. For affluent individuals, if your MAGI exceeds certain levels (for 2021, $88,000 MAGI single; $176,000 joint) your premium will likely be higher.
 * 3) After you reach the calendar year you attain age 72 and must start Required Minimum Distributions (RMDs) from traditional IRAs, the full RMD must be completed before you make any Roth conversions.  For example, if you perform a Roth conversion in the 4th day of the new year and take the RMD on the 5th day or later, the IRS will consider the Roth conversion funds to have actually been RMD funds that have been improperly moved into the Roth account.

If you are eligible for tax credits now, find your true marginal tax rate, not your tax bracket, and use that in the decision whether to convert. If you are in a 25% tax bracket (e.g., federal plus state) but increasing your income by $1000 causes a tax credit to phase out and costs you $50 in credits, your actual marginal tax rate is 30%.

RMDs that you will reinvest, not spend
A Roth IRA is exempt from required minimum distributions while you are alive. Therefore, if the Roth conversion is close to break-even based on the above marginal rate analysis, but you might be forced to take distributions from your traditional IRA which are more than you need to live on, there is an advantage to conversion; you will keep more money growing tax-deferred for longer.

This advantage can be slight or significant. See p. 7-8 of To Roth or Not To Roth and Why Roth conversions always pay off—if you can hold on long enough for more discussions.

Using a spreadsheet
Forum member BigFoot48 has created a spreadsheet, Retiree Portfolio Model (RPM), for use by retirees, or those nearing retirement, which will estimate the financial impact on your portfolio, including income taxes and RMDs, from doing Roth conversions. Use this spreadsheet to determine if Roth IRA conversions may be worthwhile for your personal situation.

Yearly results are calculated and provided (such as income, expenses, taxes, inheritances, and asset sales over a selectable 1 to 40 year period) for both doing conversions, and not doing conversions, so an easy comparison can be made.

Another useful spreadsheet is the Personal finance toolbox

With minimal input in the appropriate green cells, including filing status and ages:

and income other than the Roth conversion amount:

it automatically generates the marginal tax rate applicable to that situation for any range of conversion amounts

The "170" in the upper right of the last picture is the x-axis increment, adjustable as needed.

Two more spreadsheets regarding the reinvested RMD situation are in the part (c) discussion of ”Traditional plus taxable” vs. Roth.

Converting with non-deductible contributions
If you have non-deductible contributions in your traditional IRA, you do not pay tax on the amount of non-deductible contributions. If you make a partial conversion, you must prorate your deductible and non-deductible contributions across all traditional IRAs (including SEP and SIMPLE IRAs) as of December 31 of the year you convert. For example, if you had a traditional IRA worth $10,000 that contained $5000 in non-deductible contributions and you converted (or withdrew) $3000 leaving $7000 in that IRA at the end of the year, then half of the $3000 is taxable. To compute the taxable amount of your conversion, use IRS Form 8606.

Since the amount of non-deductible contributions do not increase as the traditional IRA grows, there is a tax advantage to converting quickly. If you wait for your $10,000 traditional IRA with $5000 in non-deductible contributions to grow to $20,000 before converting, you pay tax on $15,000 rather than $5000, tripling the tax but only doubling the amount converted.

In particular, if you don't have any kind of a traditional IRA and are not eligible to contribute directly to a Roth, you can make a backdoor Roth contribution to a traditional IRA and then convert soon after; you will pay no tax on the conversion (except for market fluctuations in the few days between contribution and conversion), and thus you have effectively contributed to a Roth. If you already have pre-tax money in a traditional IRA which you do not want to convert, then you cannot use this technique to make a tax-free contribution to a Roth, as any partial conversion will be partly taxed.