Broker Check

Key Tips on How to Convert a Roth IRA

April 11, 2024

Key Things to Know When Converting an IRA to a Roth IRA

The IRS provides all investors with the opportunity to convert a Traditional IRA, which will be taxable upon distributions in retirement, to a Roth IRA, which will be tax-free income during retirement.  This rule has been around since 1998 when Roth accounts were created and this allowed investors the ability to do so, however there was an income limit.  The good news today there is no longer an income limit to convert Roth IRA's.

Here are the two most common reasons people convert to a Roth IRA:

1. They are doing "Back-Door Conversions"

2. They wish to pay the tax now for future tax-free income

Let's take a look into key considerations for both.  And if you're considering Roth conversions, this is a helpful topic of how to proceed as well as what to be aware of.

Here are some shared commonalities depending how you're converting IRA's and things to be aware.

  • The 5 Year Rule - be aware that in order to enjoy tax-free income distributions, you have to wait at least 5 calendar years from the first year you do a conversion.  This also includes rollover of Roth 401k balances into a newly established Roth IRA.
  • You will receive a Form 5498 which shows contributions and year-end fair market values for both the Traditional IRA and Roth IRA.  You will also receive a Form 1099 from the Traditional IRA showing the distribution.   These are important files you will need to file for your income taxes.
  • Roth conversions must be completed prior to December 31st to count for that tax year, you cannot do this up to the IRS filing date of April 15th. 

Back-Door Conversions:   This is usually used when investors exceed the income to contribute to a Roth IRA directly, which in 2024 are incomes over $161,000 of AGI for Individual filers and $240,000 of AGI for Married Filing Jointly.

  • Generally the investor contributes to a Traditional IRA up to the annual limit ($7,000 for under 50 and $8,000 for over 50) and then converts the account to a Roth IRA.  This is important to be a non-deductible contribution, meaning you do not get a tax deduction for your contribution to the Traditional IRA and will not be counted as income in the conversion.
  • Be aware of the "Step Doctrine" - generally you will want to have this money in the IRA for a period of time prior to converting.  For example, don't max the Traditional IRA on December 19th and convert on December 20th.  Some investors contribute monthly or once per year.  Essentially it shows that the investor "Thought about" the conversion prior to doing so.
  • If you have other IRA's with pre-tax balance, those balances will be aggregated together with any after-tax contributions.  This is known as the Attribution Rule and requires diligence when filing taxes to correctly account for any taxable income.
  • Some investors do invest their Traditional IRA during the year, in the case of any gains (profit) that are converted - these will be counted as income in the year you convert.  If your investments have loses, you can use those losses to offset other passive gains.

Converting existing IRA balances:  If you wish to pay taxes now to reduce taxable income in the future you can convert taxable IRA accounts.  Do be aware that 100% of the amount converted will be counted as income in the year you convert.

  • It is best to have cash (in savings or money market) to pay for any additional taxes due, versus having taxes withheld from your IRA and the conversion amount.  This ensures the full conversion amount can grow tax-free into the future.
  • This is a way to limit Required Minimum Distributions from taxable IRA's.  For some people, the RMDs may be too much income in retirement, whereas Roth IRA's have no RMD age, which for most will be age 73 or 75 (under current laws).

The longer you can grow your Roth IRA, generally the better outcomes.  Predicting your life expectancy is impossible however this may be more valuable for those a few years from retirement, versus those who are currently in retirement.

Roth conversions can be confusing, and it helps to get guidance.  If you would like to see if a Roth conversion makes sense in your financial plan, please do not hesitate to reach out.  While there are many variables to consider we can determine the risks and tradeoffs as well as help you meet your goals.