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Tax Advantages of Roth IRA Conversions

By April 18, 2022May 16th, 2022No Comments

No one likes paying more taxes than necessary. When it comes to retirement investment accounts, one way to potentially pay less over the long run is to convert a pre-tax vehicle, such as a traditional IRA, to a Roth IRA. Roth IRA conversions can make sense not only in the years leading up to your retirement, but, as you’ll learn, during your retirement as well.

How Roth IRAs Work

Traditional IRAs, 401(k)s and other retirement savings accounts are funded with pre-tax dollars—meaning that contributions are excluded from your taxable income in the year they’re made. Contributions and earnings are taxed when distributions are taken in retirement.

Roth IRA contributions, on the other hand, don’t lower your taxable income—but contributions can be withdrawn tax free, and earnings can be withdrawn tax free after at least five years since you first contributed to the account.

Roth IRAs are attractive to investors who believe that their tax bracket in retirement will be lower than their current one. Only those below a certain income level are eligible to contribute directly to Roth IRAs. In 2022, for married couples filing jointly, if your modified adjusted gross income is equal to or greater than $214,000, you can’t contribute to a Roth IRA.1

Taxes Aren’t the Only Selling Point

Another advantage of Roth IRAs is that account holders can withdraw contributions at any time, for any reason, penalty free. You have to wait until age 59½ to withdraw earnings with no penalty, provided that your Roth IRA has been open for at least five tax years.

Of course, withdrawing funds before they’ve had ample time to grow defeats the purpose of tax-advantaged investing; even small withdrawals can sap your savings’ compounding power over time. For wealthy investors, Roth IRAs often serve as a valuable estate planning tool. That’s because, unlike traditional IRAs, they do not have required minimum distributions (RMDs). If you don’t need the money in your account to live on, you can leave it there to grow and ultimately to be passed on to heirs. For that reason, many people do Roth conversions even if they’re already retired. Bear in mind that converting a traditional IRA to a Roth does not reduce RMDs for the year the transaction takes place. That’s because the required distribution is based on your IRA balance at the end of the previous year. 

Converting to a Roth

Roth IRAs have been permitted by law since 1998, but they took time to catch on. Today, 21% of U.S. households have a Roth IRA, compared with 28.2% that have a traditional IRA.2

Roth IRA conversions account for a significant part of that growth. In a Roth IRA conversion, funds can be moved from a traditional IRA, simplified employee pension (SEP) IRA, or savings incentive match for employees (SIMPLE) IRA into a Roth. Roth conversions gained even more popularity in 2010, when the federal government started allowing conversions regardless of account holders’ income. Because the conversion strategy allows wealthy investors to sidestep Roth IRA’s income limitations, it’s often referred to as a Backdoor Roth IRA.

Be Ready for a Tax Bill

Roth conversions generate a tax liability that is due for the tax year in which the transaction occurs. Depending on the amount of assets being converted, the levy may be substantial and may even push you into a higher tax bracket. Calculating your tax bill can be tricky, particularly if you own other retirement accounts that are funded with pre-tax dollars, so it’s important to seek advice from your wealth team.

Before completing a conversion, make sure you have adequate funds to pay those taxes. Resist the temptation to use a portion of the funds you’re converting. Doing so will leave you with less to potentially grow tax free in the Roth and, if you’re under 59½, the amount removed for taxes will be subject to a 10% early-withdrawal penalty. Since there is no limit to the number of Roth conversions an individual can do, many people stagger the conversion process across multiple years to manage the tax impact.


1“Roth IRA Contributions for 2022”

2“The Role of IRAs in US Households Saving for Retirement, 2021”

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Roth IRA Conversions are complex and treatment depends on the type of IRA that is being converted to a Roth IRA. The views expressed regarding Roth Conversions are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be a solicitation to buy or sell or engage in a particular investment strategy. Before initiating a Roth IRA Conversion, please consult with a financial or tax professional and ensure you consider all your available options, including applicable taxes, fees and features.

If you convert a Traditional IRA to a Roth IRA, the amount of the conversion will be treated as a distribution for income tax purposes and is includible in your gross income (excluding any nondeductible contributions). Although the conversion amount generally is included in income, the 10% early distribution penalty tax will not apply to these conversions, regardless of whether you qualify for any exceptions to the 10% early distribution penalty tax. If you are required to take a required minimum distribution (RMD) for the year, you must remove your RMD before converting to a Roth IRA.

A distribution from a Roth IRA is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, qualified first-time home purchase or death.