Taxes on Roth Conversions: What You Need To Know

Mar 03, 2024 |

Converting from a traditional IRA to a Roth IRA can be a smart financial decision, yet it comes with potential tax ramifications. Overlooking the taxes on Roth conversions has implications for your retirement savings.

As companies increasingly trim or eliminate pension benefits, many individuals are reevaluating their personal retirement savings strategies to bridge the gap.

Part of this reassessment involves contemplating transitioning from a traditional IRA to a Roth IRA. While the traditional IRA has historically been a popular element of retirement planning, the tax benefits of the Roth IRA are compelling.

Before proceeding with a conversion from a traditional IRA to a Roth IRA, it’s crucial to comprehend the tax regulations governing Roth conversions.

Traditional IRA vs. Roth IRA

Traditional and Roth IRAs are the two main types of individual retirement accounts. Both are accounts specifically for retirement savings. In 2024, you can contribute up to $7,000 annually ($8,000 for those aged 50 years and older). The main difference is that you contribute pre-tax money to the traditional IRA, whereas your funds for a Roth IRA have already been taxed.

Remember that you will still be required to pay taxes on the money you contribute to the traditional IRA, but this expense is deferred until retirement. You will then pay taxes on the money as you withdraw it.

Comparing the benefits of traditional and Roth IRAs

Traditional IRAs may hold a tax advantage over Roth IRAs. If you possess a deductible IRA (as opposed to the non-deductible alternative), you can deduct some or all of your contributions from your yearly tax return. This tax deduction feature often makes the traditional IRA an appealing choice for many individuals.

Conversely, Roth IRAs are generally perceived as more versatile than traditional IRAs in various respects. Firstly, contributions to a Roth IRA can be made at any age. Upon reaching 59½, you can withdraw funds from your Roth IRA anytime, even for non-retirement purposes. (However, withdrawing investment earnings before this age threshold may incur a 10 percent penalty unless it qualifies as a distribution.) Furthermore, funds in a Roth IRA can remain in the account indefinitely.

One notable exception regarding Roth IRA withdrawals: a five-year rule stipulates that withdrawals are deemed qualified distributions only if it has been at least five years since the account was initially opened and contributions were made, irrespective of your age.

In contrast, traditional IRAs mandate minimum annual withdrawals once you reach 70 ½. Additionally, after reaching this age, you are prohibited from contributing further funds to your traditional IRA without incurring taxes on excess contributions.

Income limitations

Traditional and Roth IRAs each have income-related restrictions. For traditional IRAs, you must be 70 ½ years or younger to contribute money without paying an additional tax. Your total income will determine if your contribution is tax deductible. Your tax deduction will also depend on whether you or your spouse has a retirement plan through work, like a 401(k).

Roth IRAs don’t impose any age restrictions. However, you must have an adjusted gross income of less than $135,000 ($199,000 for married couples filing jointly).

IRA to Roth conversion: Is it right for me?

There is no right answer when considering sticking with a traditional IRA or switching to a Roth IRA. However, understand that a traditional IRA to Roth conversion is taxable. It may take a while before you recoup this expense and start benefiting from your decision to switch.

Taxes on Roth conversions: The rules

You can convert some or all of your traditional IRA funds to a Roth IRA. You will only be taxed on the amount you convert, which is taxed at the same rate as your regular income.

In other words, the amount you’re transferring to a Roth IRA will count as additional income, which could push you into the next tax bracket.

The amount of your Roth IRA contribution that will be subject to tax depends on whether that amount was deductible. If so, your contributions and their gains will be taxed in full. If you had nondeductible traditional IRA contributions, this amount would not be subject to tax.

Also, remember that while your contributions to a Roth IRA are taxed, the earnings you gain from them are not. When you withdraw earnings, you will not be expected to pay taxes on that amount.

What are the taxes on Roth conversions?

You can pay the tax on your traditional to Roth IRA conversion in several ways.

The most common way is to include it with your regular income tax payment to the IRS. This is because the additional “income” from the conversion will usually offset any deductions or losses on your tax return.

Some people make the mistake of using the IRA funds that are being converted to pay the tax, but doing so means you will have less to contribute to your Roth IRA account. This ultimately limits the tax-free growth of your gains. You will also have to pay the 10 percent penalty on the money you don’t convert to the Roth IRA if you are under the age of 59 ½.

When you convert to a Roth IRA, you can withdraw tax-free the amount you converted without paying a penalty within the first five years, but you are subject to the five-year rule on earnings.

This is a major factor to consider if you are less than five years from retiring. It’s important that if you convert to a Roth IRA, you do so in plenty of time for retirement.

When does a traditional IRA to Roth conversion make sense?

Despite paying taxes on pre-taxed funds to convert to a Roth IRA, several scenarios may warrant the conversion. Do any of these apply to you?

  • You anticipate being in a higher income tax bracket when you retire than you currently are.
  • You don’t plan to take any distributions when you turn 70 ½.
  • You are relocating to a state with higher income taxes.
  • Your other losses or deductions will offset the amount you’d pay for your conversion.
  • The total value of your IRA investment might be hitting a low point.

These are the most common circumstances when people switch to a Roth IRA, but it is not meant to be an exhaustive list.

Another scenario when conversion might be useful is if you’re starting to save for retirement at an early age. Are you nervous or unsure about stashing away money for so long and being unable to get to it? A Roth IRA gives you peace of mind, knowing you can access your funds in the event of financial need.

Both traditional and Roth IRAs have plenty of positive aspects. A diversified portfolio of assets can help you maximize your gains, especially if the future is unclear.

Our advisors can work with you to determine the long-term financial impact of converting to a Roth IRA (including the taxes on Roth conversions) and see if it makes the most sense for your situation. Contact our team today to see how you can maximize your retirement savings for the future you envision.

Let’s talk

Whether you have a specific question, or you’re interested in learning more about how our approach can be tailored to your situation, we’d love to hear from you.