Roth IRA Conversions: How They Work and Tax Implications

InvestingIRAs

Oct 7

The Basics of a Roth IRA Conversion Vision Retirement financial planning investment management CFP RIA fiduciary Ridgewood NJ Poughkeepsie NY

A Roth IRA conversion is the process of taking a portion (or all) of your balances from either an existing traditional IRA, SEP, or SIMPLE IRA and moving them into a Roth IRA.

This post covers many related topics including why you would (or wouldn’t) consider a Roth IRA conversion and how to convert your balances while also answering many commonly asked questions about this strategy.

Roth IRA conversion benefits

One of the biggest advantages of a Roth IRA conversion is the ability to enjoy tax-free withdrawals in retirement. Unlike with a traditional IRA—which dictates you pay taxes on any tax-deductible contributions and investment gains made—Roth IRA withdrawals are tax-free, provided you meet specific requirements (which we’ll touch on shortly).

This specific tax benefit is precisely why Roth IRAs are appealing to so many investors, especially those with tax-deferred investments such as traditional IRAs and 401(k)s. Because it’s extremely difficult to predict what your tax rate will look like during retirement (especially if this is several years away), having a mix of investments—some tax-deferred, some not—is often a sound strategy.

Another benefit of conducting a Roth IRA conversion is avoiding required minimum distributions (RMDs): the amount of money (specified by the IRS) you must withdraw from your account, typically starting at age 73 (75, beginning in 2033). Unlike its IRA counterpart, a Roth IRA isn’t subject to any RMD rules—meaning you aren’t required to make withdrawals at any point during your lifetime. As a result, the money in a Roth IRA can remain in the account and continue to grow tax-free.

Finally, Roth IRAs also have fewer restrictions than traditional IRAs with respect to asset inheritance. For example, Roth IRA beneficiaries are spared the pain of paying taxes—provided the account was open for at least five years.

When to consider a Roth IRA conversion

Ideally, a Roth IRA conversion makes the most sense when you can pay tax on the converted amount at the lowest possible tax rate. Therefore, for many investors, this option is most compelling if your income drops significantly (perhaps due to a job loss, an irregular income year, or you’ve retired but haven’t started collecting Social Security or RMDs), if the value of your investments sharply declines, or if tax laws change (for the worse) as they may in 2026.

How to convert assets into a Roth IRA

You can roll over your IRA assets into a Roth IRA via two primary means: either through a direct or indirect rollover.

A direct rollover is the simplest and oft-recommended way to move retirement money, wherein the existing plan’s administrator sends funds directly to your new Roth IRA account without you ever touching the money. Employing this strategy means no taxes are withheld from the transfer amount.

An indirect rollover—also known as a 60-day rollover—gives you actual custody of the funds since a check is provided for you to deposit. In this scenario, you don’t need to make a deposit right away and can instead use the money for any purpose for 60 days; though you must eventually redeposit the funds into a new IRA by the end of this period to avoid paying income tax and a 10% early withdrawal penalty (assuming you’re under the age of 59½).

It’s also important to know that if you choose an indirect rollover, your plan administrator is required to withhold 20% of the amount for taxes before writing you a check. You’re responsible for redepositing the full amount within the 60-day window, however, and a failure to do so means the entire rollover amount (rather than the net amount) is subject to taxes and an early withdrawal penalty—which is why indirect rollovers are typically only recommended if you need a short-term loan and can execute this transaction within a 60-day window in the absence of risk. One such example? Relocating for a new job and using the funds as a short-term loan while awaiting reimbursement from your employer.

Finally, know the IRS only permits one indirect rollover within a 12-month period and that the transfer must be executed between only two accounts.

How Roth IRA conversions are taxed

It’s important to know that you can only roll over post-tax dollars into a Roth IRA; consequently, you’ll need to pay taxes on the amount converted. Assuming all accounts you’re converting from contained only pre-tax contributions, the total amount converted is taxed per your normal income rate.

However, if the account you’re converting from contains both pre-tax and after-tax contributions, you’ll need to follow the Pro-Rata Rule to determine your taxes: meaning the IRS will examine all of your IRA accounts, combined (not just the one you may have used for the conversion), and tax you proportionality.

To illustrate, let’s assume you have a total of $50,000 in two traditional IRAs, $20,000 of which consists of post-tax contributions (meaning you already paid taxes on that money). As a result, your percentage of after-tax dollars is 40% ($20,000/$50,000). Furthermore, let’s assume you want to convert $30,000 into a Roth IRA. In this scenario, you wouldn’t get taxed on $12,000 (40% x $30,000) of the conversion. However, the remining portion ($18,000) would be taxed at your ordinary income rate.

When taxes are due on a Roth IRA conversion

The amount you convert is added to your gross income for the tax year, and your tax liability is due upon filing your tax return for the year in question. Therefore, if you complete a Roth IRA conversion in 2024, your taxes are due on April 15, 2025 (taxes are generally due quarterly, in equal payments, for those paying estimated taxes).

Note you can choose to withhold taxes from the amount you’re converting, but this means less money in your Roth account will grow tax-free. What’s more, if you’re under age 59½ at the time of conversion, any amount that doesn’t go toward the Roth will be considered an early withdrawal and therefore likely subject to an extra 10% penalty.

The five-year rule on Roth IRA conversions

Knowing when you’ll need to withdraw your converted funds is also important in your decision-making process because the investment earnings portion of Roth IRA conversions are subject to a five-year waiting period. If you tap any funds from the amount converted, therefore, you’ll need to pay taxes and a 10% penalty on the investment earnings portion of the same.

Also keep in mind that the five-year waiting period begins on January 1 of the year in which you convert your IRA. For example, if you complete the conversion in December 2024, your window will have actually begun on New Year’s Day of that same year.

Furthermore, each conversion made has its own five-year period. If you make one Roth IRA conversion in 2024 and another in 2025, for example, the five-year period would begin on January 1, 2024 for your 2024 conversion, and the window for your 2025 conversion would start on January 1, 2025.

Exceptions to the five-year rule

Specific situations can help you skirt the early withdrawal penalty on the five-year rule for a Roth IRA, such as making a $10,000 withdrawal to fund a first-time home purchase, withdrawing up to $5,000 in the year following the birth or adoption of a child, withdrawing to pay for qualified higher education expenses (books, tuition, fees, and/or room and board) for you or an immediate family member, or taking out funds to cover unreimbursed medical expenses (those exceeding 10% of your adjusted gross income).

In addition, if you happen to lose your job and thus your health insurance, you can use Roth IRA funds to pay for insurance premiums while you’re unemployed.

Potential impact on Medicare, Social Security, and capital gains

The amount you decide to convert to a Roth IRA is taxed as ordinary income and can therefore push you into a higher federal income tax bracket. Consequently, the additional income can adversely impact those nearing Medicare eligibility, claiming Social Security benefits, and/or perhaps subject to long-term capital gains taxes.

For example, IRMAA—income-related monthly adjustment amount—is the additional amount you might need to pay in addition to your Medicare premiums, given Medicare surcharges on higher-income beneficiaries.

The surcharge is calculated based on tax returns reported from two years prior, meaning your 2024 income determines your IRMAA in 2026, your 2025 income determines your IRMAA in 2027, and so on. Surcharges can amount to several hundred dollars a month, depending on your income.

A higher income can also take a chunk out of your Social Security check, as your least-favorite uncle—Uncle Sam—can in fact tax Social Security benefits depending on the earnings listed on your income tax return.

Currently, if your total income exceeds $25,000 for an individual or $32,000 for a married couple filing jointly, you must pay federal taxes on your Social Security income (while your benefit amount subject to taxation varies based on income).

A third consideration is a tax on capital gains. If your income is low enough—below $47,025 in 2024 (or $94,050 for married couples filing jointly)—you can avoid taxes on capital gains, which is sometimes extremely beneficial for retirees, especially those living on a fixed income.

In sum: what to know about Roth IRA conversions

While adding a Roth IRA to your investment portfolio is often recommended, whether or not you should convert to one is an entirely different story. You’ll need to consider many tax-related implications when pondering this option, as discussed in this article, but a CFP® professional can thankfully help you evaluate whether a conversion makes sense for you given your own unique situation.

Want to know if a Roth IRA conversion is right for you? Schedule a FREE Discovery call with one of our CFP® professionals.

FAQs

The deadline for converting funds to a Roth IRA is December 31 each year.
As age limits on conversions don’t exist, you can convert any amount of pre-tax IRA funds into a Roth IRA whenever you want and no matter your age.
The most obvious drawbacks are the tax hit you’ll take on the amount of your conversion and the fact that you can’t touch the converted money for at least five years without facing a penalty.