The world of retirement planning is full of strategies and loopholes, many of which investors can leverage. All it takes is a little know-how (and probably a licensed tax professional, as well). One of those strategies is the Roth IRA conversion, a tax-saving measure for certain retirement accounts.

Many people have heard of the strategy. However, there is often some confusion as to how it works, the tax implications, and when it makes sense to employ it.

After reading this article, you’ll have a solid understanding of what a Roth conversion is and what you should consider before doing one.

Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions. 

What Is a Roth IRA Conversion?

In simple terms, a Roth conversion is when you take funds that are considered “pre-tax” in a retirement account, such as a Traditional IRA or 401(k), and convert them into Roth funds. (Learn about the differences between a 401(k) and a Roth IRA here). Note that a backdoor Roth contribution is also a form of a Roth conversion.

The dollar amount of pre-tax funds that you convert to Roth dollars is added to your ordinary income for the year in which the conversion is made. If executed properly, the 10% early withdrawal penalty doesn’t apply to converted funds.

As a reminder, if you deduct the contributions you made into a Traditional IRA, the funds in that account are all considered pre-tax. In the case of a 401(k) and similar types of employer-sponsored plans, traditional 401(k) contributions do not count toward your ordinary income in the tax year that you made the contribution. (Note: FICA taxes may still apply to those earnings even if deferred on a pre-tax basis). 

While you get a tax benefit on the front end with traditional retirement accounts, you have to pay taxes on the back end when you withdraw funds from the account, hopefully at retirement.

Why Undergo a Roth Conversion?

Roth conversions are attractive because of the way Roth retirement accounts work. If you satisfy the requirements for a qualified withdrawal from a Roth account, you can withdraw all funds in the account completely tax-free. As everyone who dives into investing learns, tax-free can be hard to come by when it comes to the investing world. Keep in mind that the Roth account must be funded for at least 5 years and the account owner has to be at least age 59 ½ for the withdrawal to be considered qualified. 

The entire aim of a Roth conversion is to maximize the amount of tax-free withdrawals an investor may have at retirement age from their retirement accounts. 

When Does a Roth Conversion Make Sense?

While opting for an option that will provide you with potentially more tax-free income at retirement is attractive, you should carefully plan before undergoing a Roth conversion.

As with any decision related to your personal finances or investments, you want to make sure you are keeping your individual circumstances and goals in mind.

Some instances in which a Roth conversion may make sense include if you:

  • Plan on being in a lower marginal tax bracket in the current year compared to previous or future years
  • Are certain that you will be in a higher tax bracket at retirement age
  • Firmly believe that marginal tax rates will be considerably higher in the future
  • Want to have a strong mix between taxable and non-taxable sources of income at retirement

While there may be more reasons to consider a Roth conversion, those tend to be the most common. In many cases, individuals undergo Roth conversions after careful planning alongside a tax professional. 

How Do I Do a Roth Conversion?

This depends mainly on the type of retirement account that you are dealing with.

In the case of an employer-sponsored plan (like a 401k), you would have to go through the Plan Administrator. The Administrator is another name for the financial institution that is in charge of managing your company’s 401(k) plan. If you’re interested in processing a conversion, you can contact the benefits department and inquire about requirements. The financial institution would send you a Form 1099-R reporting the conversion, which you would then provide to your tax professional in order to file your taxes appropriately for that respective tax year. 

It’s important to note that not all employer-sponsored plans offer the Roth Conversion option. Check with your Plan Administrator or HR for more details related to your plan.

In the case of converting Traditional IRAs to Roth IRAs, the process depends on the financial institution with which you do business. Some firms have reliable customer service staff that can walk you through the process over the phone. Others require you to fill out paperwork to process the conversion. (The tax form that you want to be aware of in the case of IRAs is the 8606). It is crucial that you keep good records so you don’t end up being taxed twice in the future.

Can I Go Back?

Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers had the ability to “recharacterize” Roth conversions. This meant that they could undo the conversion and have the funds go back to being considered pre-tax.

Recharacterization is attractive in the case that the amounts you converted fall drastically due to market volatility. (Example: You convert $30,000 but it falls to $15,000. You’d still owe ordinary income tax on the $30,000).

The TCJA removed the ability to recharacterize conversions after 2017. Whether recharacterization of conversions will be re-allowed in the future is still up for debate. 

What Are The Potential Disadvantages?

The main thing to consider when processing a Roth conversion is the tax liability that results from it. If you’re not careful, a Roth conversion can potentially push you into a higher marginal tax bracket.

If you’re already in a high tax-bracket, or you live in a state that has higher tax-brackets than others, you may want to give the conversion some careful thought before going through with it. 

Also, as discussed earlier, you cannot undo a conversion. Once you process it, it’s done. 

If you are unsure of what makes sense, or if you have questions related to your individual tax situation, it is best that you consult with a tax professional.

A Final Word on Roth IRA Conversions

A major part of being a successful investor is having a clear strategy when it comes to income-planning. Knowing certain provisions of the tax code can give you an edge as an investor and taxpayer.

Many financial professionals agree that having a mix between taxable and non-taxable “buckets” to draw from can be advantageous. 

While the Roth conversion carries many benefits, it should be done only after careful planning. It does not make sense for everyone. 

Consider your current and future income picture before going through with the conversion. If you have questions related to the process, do not hesitate to reach out to the financial institution that administers your employer’s plan or your IRA.

Again, it is well worth consulting a tax professional if you believe your tax circumstances are complex.

Have questions about Roth IRA conversions? Let us know!

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Jose Hernandez
Jose Rafael Hernandez is known as "The Millennial Money Mentor" on social media. He and his family are immigrants to the United States from Venezuela. The unique challenges that he faced at a young age taught him the real value of money and its importance in life. Jose studied finance at Mercer University, where he also competed in Division 1 Baseball. After his athletic career, Jose began his professional career in the finance industry. He started his career as a wealth management advisor for one of the top Investment Advisory firms in the US, where he was responsible for just north of $20mm in AUM. Jose currently holds the Series 7 and 66 licenses. Jose decided to leave the firm so he could have the freedom to create his brand on social media, geared towards educating millennials in the areas of personal finance and investing. His mission is to leave a positive impact on others while building his own legacy and providing for his family.

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