Roth Conversion

Roth IRA Conversions

Roth Conversion

For younger investors who expect to be in a higher tax bracket in their retirement years, a Roth IRA can be a very attractive proposition for their retirement savings because the growth is not just tax-deferred but tax-free. In a recent article, we examined the differences between a traditional 401(k) and a Roth 401(k), and the same considerations apply to IRAs.

When a traditional IRA is converted to a Roth IRA, there is an immediate tax liability. An often overlooked problem with conversions is that the money paid in taxes is no longer available to compound in your accounts. This Roth IRA Conversion Analyzer illustrates the value of leaving that tax payment in your account: Roth IRA Conversion. In our experience, most of the time this calculator concludes that it is not a good idea to convert a Traditional IRA to a Roth IRA. 

In our opinion, taxes should be deferred until they are necessary to be paid, unless you have a very good reason. If you do decide to convert, it only makes sense to pay the taxes when the taxes can be paid without having to use the IRA funds. Currently, there are no income restrictions for doing a Roth conversion.

Generally, converted assets in the Roth IRA must remain there for at least five years to avoid penalties and taxes. Once the five-year requirement has been met, distributions from a Roth IRA are tax-free and penalty-free if at least one of the following conditions exists:

  • You reach age 591/2
  • You pass away (Roth IRAs can be especially valuable for your heirs)
  • You become disabled
  • You make a qualified first-time home purchase

Unlike a traditional IRA, a Roth IRA does not have required minimum distributions (RMDs) during the lifetime of the original owner. Thus, it can take full advantage of the power of compounding over a long period of time.

For people who have too high of an income to directly contribute to a Roth IRA, there is a way to obtain one that many people are unaware of (a backdoor Roth IRA). It involves establishing a traditional (but nondeductible) IRA and immediately converting that IRA to a Roth. Even though it may sound shady, it is completely legal, at least for now.

Normally, you would think that since you already paid taxes on the money that went into the nondeductible IRA, you would not have to pay them again when converting it to a Roth. You would be wrong, however, because when you convert one of your IRAs, Uncle Sam treats it as though you converted a portion of all of your IRAs. This is called the “pro rata” rule, and here is an example of how it works. Suppose that you have $15,000 in a traditional (deductible) IRA and you establish a $5,000 nondeductible IRA that you immediately convert. The portion of the conversion that is tax-exempt is calculated as $5,000 / ($5,000 $15,000) = 25%, meaning that the $5,000 (which was already taxed once) will be taxed again at 75% of your marginal tax rate. Suddenly, the backdoor Roth IRA option does not look so attractive after all. One way around the pro rata rule is to roll the traditional IRA into your 401(k) plan, assuming your employer allows it. Of course, you are then stuck with the investment options and expenses of the 401(k), which could be incredibly costly to you over a long period of time.

Before engaging in any of the transactions described in this article, IFA strongly advises investors (including our clients) to consult a professional (e.g., a CPA or estate planning attorney) who is well-versed in these regulations (which are highly fluid) and is very familiar with their situation. The calculator section of has several tools to assist you in evaluating whether a Roth is right for you. If you would like to speak to an IFA wealth advisor, please call us at 888-643-3133.