When to convert IRA to Roth?

If you want to enjoy tax-free distributions in retirement, you may consider doing a Roth IRA conversion. This type of conversion involves transferring your tax-deferred retirement savings from an IRA to a Roth IRA and paying taxes at ordinary income taxes. However, would converting an IRA to a Roth IRA be a smart move?

Converting an IRA to a Roth IRA might make sense when taxes are low or you have a reduced income. If you do the Roth IRA conversion when you are in an unusually low tax bracket now, you can avoid paying higher taxes when you take a distribution in retirement. A Roth IRA conversion might also be a good option if you want to leave tax-free income to your beneficiaries so that they won’t pay taxes again when they take a distribution.

When Converting IRA to Roth IRA Makes Sense

The following are some of the situations when it makes sense to convert an IRA to a Roth IRA.

Taxes are low

If you are in a low tax bracket now, it can be advantageous to convert an IRA to a Roth IRA to avoid paying higher taxes in retirement. Some potential reasons why you could be in a higher tax bracket in the future include earning more as you move up job ranks or if you expect to move to a state with high taxes.

When you convert an IRA to a Roth IRA, you will pay taxes upfront on the rollover. Once the funds go into a Roth IRA, you won't pay taxes again on the money when you make a withdrawal in the future as long as you meet the requirements of a qualified distribution. You can decide to convert part of or all of your IRA retirement money, whichever option is convenient for you.

Reduced income

If your income is unusually low due to job loss, furloughs, or pay cuts, it makes sense to do a Roth IRA conversion. Since you will pay taxes on the Roth IRA conversion at your current tax bracket, a lower income can put you in a lower tax bracket. Hence, you will pay less tax on the conversion than the taxes you would have paid in retirement.

For example, if you are single and your income declined from $70,000 to $40,000, it means that you have dropped from the 22% tax bracket to the 12% tax bracket. Hence, if you do a $20,000 Roth IRA conversion, your income will be subject to the 12% tax bracket because your income declined by $30,000 to the 12% tax bracket.

Leave a tax-free inheritance to your beneficiaries

A Roth IRA conversion may a good option if you want to leave tax-free income to your beneficiaries. Where the Roth IRA is part of your estate that will be shared among your heirs, you can opt to convert an IRA to a Roth IRA so that your beneficiaries won’t have to worry about taxes.

If you want to leave the retirement savings to your children, the IRS requires these beneficiaries to take the full distribution within 10 years and pay the required taxes. While the 10-year rule would still apply to Roth IRA distributions, the beneficiaries won’t pay taxes again when they take a distribution.

Your income is too high

If you earn too much money to be eligible to open a Roth IRA, you could consider doing a Roth IRA conversion. Roth IRAs have income limits that determine who can contribute to the account.

If you are not eligible to make direct contributions to a Roth IRA, you can opt to use a backdoor Roth IRA. This is a two-step process that involves contributing to a non-deductible IRA then converting it into a Roth IRA.

How to Convert an IRA to a Roth IRA

Here are the basic steps involved when converting your IRA to a Roth IRA:

Open a Roth IRA

The first step is to open a Roth IRA with a brokerage or financial institution of your choice. You can also use an existing Roth IRA account to hold the funds converted from a traditional IRA to a Roth IRA.

Contact plan administrators

Once you have the Roth IRA account details, you should contact the plan administrators of the traditional IRA and Roth IRA to initiate the conversion. You can ask the Roth IRA plan administrator to provide the account details so that the traditional IRA plan administrator can make a direct rollover to the new account.

Submit paperwork

Once you have communicated with the plan administrators, you may be required to provide certain documentation to complete the transfer. If you are converting part of the IRA funds, you must state the amount of funds that you want to convert to an IRA. The Roth IRA conversion can be completed in a few days to a couple of weeks.

Taxes

Once you complete the Roth IRA conversion, you must notify the IRS about the conversion when filing taxes for the year. You will be required to file tax Form 8606 while filing your income taxes.

When Not to Convert an IRA to a Roth IRA

While converting to a Roth has many benefits, there are situations when a Roth IRA conversion may be a bad idea.

One of these situations is when you are nearing retirement. When you convert to a Roth IRA, you must wait at least five years to take qualified distributions. If you take a distribution before you have completed the five years, the withdrawal will be considered a non-qualified distribution, and you will owe income taxes, and a penalty tax if you are not yet 59 ½.  

Also, if you don't have a separate source of funds to pay taxes for the conversion, it may be a bad idea to convert the IRA to a Roth IRA. Retirement experts recommend paying the taxes from a different account like a savings account such as a certificate of deposit or savings account. Paying the taxes from your IRA fund could eat into your retirement savings.