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What Is a Roth Conversion?

You've heard me talk about how much I love the tax advantages of a good ol’ Roth retirement account. And if your money gets to grow from the start in a Roth account, all the better. But Hogan, you may say, my retirement savings started out in a regular 401(k), 403(b) or IRA—can I still take advantage of a Roth? Well, my friend, you need to hear about the Roth conversion.

What Is a Roth Conversion?

Basically, a Roth conversion is just the process of transferring funds from a traditional retirement account, like a 401(k), into a Roth account. Now, just writing the word Roth gives me goosebumps. It’s no secret that I’m a big fan of the Roth investment vehicle to grow your money tax-free. Sounds pretty good, right? Let’s take a closer look at the details.

How Does a Roth Conversion Work?

A Roth conversion can happen in one of three ways. The first can be done when you move your money from a traditional employer-sponsored plan—think 401(k) or 403(b)—to a Roth employer-sponsored plan. In this scenario, the money stays in the employer-sponsored plan, but converts from a traditional option to the Roth. This can happen when your employer adds a Roth option to the workplace retirement plan. If they do that, you should seriously consider a conversion, if you can afford to pay the taxes—more on that in a minute.

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The second type happens when you convert the funds from a traditional employer-sponsored plan to a Roth IRA. You’re moving your money out of the employer-sponsored plan to a personal Roth where you decide where to invest the money—with the help of an investment pro.

Because not all employers offer the Roth option, the traditional 401(k) to Roth IRA conversion is the most common.

The third option is moving money from a traditional IRA to a Roth IRA. Now, while you can't contribute to a Roth IRA if your income exceeds the limits set by the IRS, which are $196,000 for couples and $124,000 for singles in 2020, you can get around these limits by converting a traditional IRA into a Roth IRA in stages.1 This process is known as a "backdoor Roth”—and don’t worry, it’s completely legal.

But there’s one catch. Remember, when you put money into your traditional employer-sponsored plan or a traditional IRA, you used pre-tax dollars. That means you haven’t paid taxes on that money yet. So, when you transfer that pre-tax money into a Roth employer-based plan or IRA, which is funded with after-tax dollars, you’ll have to go ahead and pay taxes on that money now.

So why would that be a good idea?

When Does a Roth Conversion Make Sense?

Well, given today’s reduced individual tax rates, you may wind up in a higher tax bracket in retirement. So paying the taxes up front for a Roth conversion—if you can afford it—and getting the money out tax-free in retirement, is one of those times when paying a little now can save you a bundle later.

After a Roth conversion, your money grows tax-free in the Roth IRA and you won’t pay any taxes on that money when you’re ready to withdraw from the account in retirement. Because of the 2017 Tax Cuts and Jobs Act, the current tax rates are relatively low. So now might be a good time for a conversion rather than risking rates rising down the road.

Those are the two main tax considerations that can help you decide if the Roth conversion would work for you: tax rates and if you have the cash on hand to pay those taxes on the conversion.

Let’s talk about tax rates first. Because the conversion amount is added to your taxable income, it could potentially bump up your tax bracket. I’m going to throw some numbers your way, so stay with me here.

So, for example, a married couple filing jointly in 2020 with a taxable income of $100,000 pays 22% in taxes and can convert up to $71,050 without hitting the next tax bracket, which begins at $171,051 and is taxed at 24%.2 Now, paying the taxes on this conversion would break down like this: Let’s say you have $100,000 in a traditional 401(k), and you want to convert it to a Roth IRA. You’ll pay 22% on the first $71,050 ($15,631 in taxes), and 24% on the remaining $28,950 ($6,948 in taxes) for a total tax hit of $22,579 on the conversion.

And you want to seriously consider doing a Roth conversion only if you can afford to pay the tax bill with cash. No exceptions, people! A conversion could add thousands of dollars to your tax bill. If you have a large amount to convert and it’s going to cost you north of $10,000 in taxes, doing a traditional IRA rollover is probably a better option. But if you have a smaller conversion amount and have the cash on hand, get the money into the Roth sooner rather than later.

If the thought of adding thousands of dollars to your tax bill this year sounds like way too much to handle, there is another option! You don't have to convert those retirement funds all at once. In fact, you could plan to spread the conversion over several years instead of doing it all in one lump sum, breaking down your tax obligation into manageable bite-sized chunks in the process.

When it comes to Roth conversions, it could be the right call for you if:

  • Your timeline to retirement is more than five years. The money you convert into a Roth IRA must stay there for a five-year period.3 If you withdraw money before the five-year period, you may pay a 10% penalty and additional income taxes.

  • You can pay the taxes on a Roth conversion with cash on hand. Do not touch any of your other assets, especially ones you have for retirement. That’s just doing stupid! It’s so important that I’m going to say it again: You must be able to afford to pay the tax bill with cash for a conversion. If you can’t do that, don’t do the conversion.

This is a big decision, and you don’t have to make it alone! Get in touch with a tax advisor who can help you understand the tax implications of a Roth conversion and help you decide which option might work best for you.

Get With a SmartVestor Pro!

If you’re seriously considering a Roth conversion, the best way to get closer to turning your high-definition retirement dreams into reality is to talk with one of our SmartVestor Pros. They’ll know what options you have based on your timeline to retirement, tax obligations, your future tax bracket, and anything else relevant to your situation. And look, I know it can be confusing. Even I turn to a pro when it comes to this stuff. So, take a deep breath—you don’t have to do it alone!

Find your SmartVestor Pro today!

Chris Hogan

About the author

Chris Hogan

Chris Hogan is a two-time #1 national best-selling author, financial expert and host of The Chris Hogan Show. He is a frequent guest on Fox News, Fox Business, Yahoo! Finance and the Rachael Ray Show. Since 2005, Chris has served at Ramsey Solutions, where he gives practical money advice on retirement, investing and building wealth. Learn More.

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