IRA Conversion Fact Sheet

Note: This article is part of Morningstar’s 2018 Guide to IRAs. A version of this article appeared on Feb. 15, 2011.

The opportunity to take tax-free withdrawals on IRA investments and avoid required minimum distributions certainly holds appeal, but converting traditional IRA assets to Roth isn't for everyone. Investors should check with a tax specialist to ensure that they've considered the ramifications--including the potential tax liability--before converting.

Here are some common questions related to IRA conversions, along with the answers.

What are the benefits of converting? There are two key benefits. First, Roths offer tax-free withdrawals in retirement, whereas withdrawals from traditional IRAs are taxed as ordinary income. Second, Roths don't require you to take distributions during retirement, so if you don't need the money you can let the assets accumulate for your heirs.

Who is a good candidate for conversion? The key factor to consider is your tax rate at time of conversion relative to your expected tax rate at time of withdrawal from the IRA. If you expect your tax rate will be higher at the time of withdrawal, you're better off paying the tax on the conversion today. Very generally speaking, younger people are better candidates for conversion than are older investors who are close to retirement or already retired; with a longer time horizon, younger folks can better take advantage of the tax-free compounding afforded by the Roth. But conversions can also make sense for some older adults, especially those who don't expect to need their IRA assets during their lifetimes and expect to pass their IRA assets for the next generation. Those who have the cash on hand to pay the taxes associated with the conversion are also much better candidates for conversion than those who will need to tap the IRA assets to pay the tax. Investors who have a lot of assets in traditional 401(k)s and IRAs may also benefit from a conversion because it will diversify the tax treatment of their in-retirement withdrawals.

Who should think twice about converting? As a very general rule of thumb, a conversion will tend to be less attractive for older investors who are well into retirement and actively tapping their IRAs for living expenses. Conversions are usually a bad idea if tapping the IRA assets is the only way to pay conversion-related taxes. Finally, conversions won't generally make sense for those who haven't saved much for retirement and will therefore be in a lower tax bracket in retirement than they are now.

Have the income limits for starting a Roth from scratch gone away? The income limits to open a Roth IRA are still in place, as outlined in this overview. In 2018, individuals with incomes of more than $135,000 can't make a direct contribution to a Roth; the threshold goes up to $199,000 for married couples filing jointly. However, individuals whose incomes are over those limits can take a backdoor way into a Roth, opening a traditional nondeductible IRA, then converting soon thereafter. They'd owe taxes on any investment earnings at the time of the conversion. This strategy doesn't make sense, however, for those with substantial traditional deductible IRA assets because the taxes associated with the conversion will be based on the breakdown between deductible and nondeductible contributions in the IRA.

Can I roll over a regular 401(k) into a Roth IRA directly? Yes, assuming you no longer work for the company where you amassed the 401(k). In this case, the rollover functions almost exactly like a conversion; you'll owe taxes on your deductible contributions and investment earnings at the time you convert. This article discusses the key steps to consider when undertaking a rollover.

Will I owe taxes because of the conversion? It depends. In the unlikely event you've made only nondeductible contributions and you don't have any investment earnings in the account, you won't owe taxes upon conversion. If, however, your IRA consists of deductible contributions, rollover assets from a traditional 401(k), and investment earnings--or some combination thereof--you'll owe taxes when you convert.

Should I worry about what the conversion will do to my reportable income (namely, pushing me into a higher tax bracket)? Yes, and that's one of many reasons to check with a tax advisor before embarking on a conversion. The risk is that in bumping up your income level, you could disqualify yourself for tax credits and deductions that would otherwise be available. You could also reduce your child's eligibility for financial aid for college if the conversion pumps up your income, even for a single year. However, it's also possible to convert just enough to avoid pushing yourself into a higher tax bracket; a tax advisor can coach you on undertaking a series of partial conversions.

Is there a limit to how much I can convert? No. But once you're looking at converting large sums, it's especially important to consider the tax implications, both the effect on your tax bracket and whether you have money on hand to pay the conversion-related taxes.

Is the conversion permanent (or can I convert back)? Prior to 2018, you could convert back through what's called a recharacterization. A recharacterization enabled you to change the character of a Roth IRA to a traditional IRA, and vice versa. However, for IRA assets converted in 2018 and thereafter, recharacterizations are no longer allowable.

Do I have to convert all of my accounts, or is a partial conversion possible? A partial conversion is possible and advisable if converting in a single year creates an extreme tax burden or pushes you into a higher tax bracket.

If I do a partial conversion, can I convert only nondeductible traditional IRA contributions? That would be nice, wouldn't it? Regardless of which IRA assets you convert, the assets will all receive the same tax treatment upon conversion, based on the proportion of nondeductible contributions and deductible contributions/investment earnings.

After I convert, can I contribute to the new Roth account this year or in the future? Yes, but only if your income is under the limits for new contributions ($135,000 for individual filers and $199,000 for married couples filing jointly). If your income is above these levels, you’ll need to open a traditional, nondeductible IRA and then convert it.