What is an IRA conversion and how does it work?

What is an IRA conversion?

Learn about the benefits of IRA conversions and Roth conversions with M1 Finance. Get started now or call 312-600-2883 to learn more.

While moving investments around may appear to be burdensome, it may be an important effort in order to gain tax benefits. A Roth IRA conversion is when you move the assets in your traditional, SIMPLE, or SEP IRA into a Roth IRA. It is a taxable and reportable event because you move assets from tax-deferred accounts into a tax-free account.

A Roth conversion is beneficial for people who have large balances in their IRA accounts and anticipate that their tax rates will either remain the same after they retire or will go up. This is because people pay taxes on their IRA distributions in retirement, but Roth IRA distributions are not taxed.

IRA conversion and rollover types

There are a couple of reasons why people convert other types of IRAs to Roth IRAs. Those who believe that their ordinary income tax rates will be higher after they retire than they are now can benefit by paying income taxes now on their money instead of later when they take distributions.

A Roth IRA conversion also allows people to benefit from tax-free growth of their contributions. When they withdraw their contributions and earnings in the future, they will not have to pay taxes. Roth IRAs also allow people to continue contributing after they reach age 70 ½ as long as they continue to earn income.

Many people convert 401(k) accounts to IRAs and then convert the IRAs to Roth IRAs. They do this for more flexibility in their investments and to benefit from tax-free growth. Some people have multiple 401(k) accounts at different former employers. Rolling the funds over to IRAs and completing Roth IRA conversions in one place can allow you to manage your investments more effectively and to track them more easily.

Find out more about the benefits of IRA conversions and Roth conversions with M1 Finance.

Size of IRA markets

According to the IRS, when tax provisions changed and made Roth IRA conversions available to people at all levels of income, IRA conversions increased by 800 percent in a single year to reach $64.8 billion. During that year, Roth IRA conversions exceeded regular contributions for the first time.

According to the Investment Company Institute, 58 percent of people who have traditional IRAs report that their IRAs contain rollover funds from their former 401(k) plans. Some of these investors then converted their traditional IRAs to Roth IRAs to take advantage of the Roth plan benefits.

Rules for IRA conversions

It is important for you to understand the rules for IRA conversions if you are interested in an IRA to Roth conversion. While there are Roth IRA income limits for making the regular annual contributions, there are no limits for conversions. This means that even if your income exceeds the maximum income for your tax-filing status, you can still complete an IRA to Roth conversion to benefit from tax diversification in your retirement savings.

Under the IRA rollover rules, the IRS allows you to complete only one rollover per year. A rollover is when you roll funds over from your 401(k) to a traditional IRA or from a SEP or SIMPLE IRA to a traditional IRA. However, conversions from traditional to Roth IRAs are not similarly limited.

It is important to note that once you complete an IRA to Roth conversion, it cannot be undone. You are not allowed to recharacterize a Roth IRA conversion later back to a traditional IRA.

Taxes on conversions

When you complete an IRA conversion, the funds that come out of your traditional IRA will be taxed at your ordinary income tax rate in the year that the Roth IRA conversion occurs. Nondeductible contributions that you made to your traditional IRA will avoid taxes because they were not tax-deferred.

If you complete the IRA conversion in the right way, you will not be assessed an IRS early withdrawal penalty of 10 percent even if you are under the age of 59 ½. People who opt to take substantially equal periodic payments from IRAs are able to convert those amounts to their Roth accounts as the payments are received. The payments will be taxable, but the 10 percent early withdrawal penalty will not be assessed.

If you have started to take required minimum distributions from your traditional IRA because you are older than age 70 ½, you are not allowed to convert those distributions to a Roth IRA. Under the Roth conversion rules, the tax-exempt parts of your contributions from a rollover can only equal a pro-rata share of the total amount that you are rolling over.

Discover more about the benefits of IRA conversions and Roth conversions with M1 Finance. Get started now or call 312-600-2883 to learn more.

How to convert an IRA

To complete an IRA conversion, you can follow these steps:

  • Deposit money in a traditional IRA account
  • Pay taxes on your contributions and earnings
  • Convert to a Roth IRA

There are three ways to to do the conversion. You can either open a new traditional IRA account and fund it or simply work with your existing IRA. You will then need to pay the taxes on your earnings and contributions because only post-tax contributions are able to be transferred into a Roth IRA.

If you deducted your traditional IRA contributions, you will have to give back the deduction. The contributions and gains will be added to your taxable income when you file your tax return for the year. If your tax rate is lower now than you anticipate it will be in the future, it makes sense to complete an IRA conversion now instead of waiting until the tax rates increase.

Finally, you can convert to a Roth in one of the following three ways:

  • Complete a 60-day rollover
  • Complete a trustee-to-trustee transfer
  • Complete a same trustee transfer

If you choose to complete a Roth conversion under the 60-day rollover rule, you can take the money directly from your traditional IRA. The trustee will issue a check that is payable to you. Under the Roth IRA rules, you must deposit the money into a new Roth IRA account within 60 days. If you do not, you may face an IRA withdrawal penalty of 10 percent on top of your taxes.

An easy way to complete an IRA conversion is through a trustee-to-trustee transfer. Under this method, you contact the traditional IRA trustee at your existing plan and direct him or her to transfer the money to the trustee of your Roth IRA account. Choosing this method may help you to avoid making costly mistakes.

With a same trustee transfer, your money stays with the same institution where your traditional IRA is located. You can set up a Roth IRA account with the traditional IRA trustee and instruct him or her to move the money from your traditional IRA to your Roth account to complete the Roth conversion.

When to convert

Knowing when to convert your IRA to a Roth IRA is important because of the taxes. You should choose a year in which your tax rate is lower than normal. For example, you might choose to complete your Roth conversion during a year in which you are unemployed, change jobs, or have a lower salary.

Similarly, a good time to complete a Roth conversion is when the balance in your traditional IRA account is down because the market has declined. This will give you a smaller amount on which you will have to pay taxes.

Choosing to convert early in the tax year is a good idea. This is because you will not have to pay the taxes until April of the following year. Converting early in the calendar year allows you more time to pay the taxes on your IRA conversion. It might also be a good idea to spread out the conversion. If you complete it in stages, it might be easier for you to afford the taxes.

Get more benefits of IRA conversions and Roth conversions with M1 Finance. Get started now or call 312-600-2883 to learn more.

Reasons you should convert

There are several reasons why you should consider converting a rollover IRA to a Roth IRA, including the following:

  • The earnings on your investments will grow tax-free
  • You will have the ability to lower your taxable income in retirement
  • Your tax rate in retirement may be higher than it currently is
  • Roth IRAs do not have required minimum distributions after you retire, which are mandated by the IRS beginning after age 70 ½ for traditional IRAs
  • Tax-free withdrawals in retirement
  • No Roth IRA income limits when you are converting to a Roth IRA

Who should not convert?

If your adjusted gross income will be high enough to move you into a higher marginal tax bracket during the year of the conversion, you should hold off on converting to a Roth IRA. You also should not complete a conversion if you will be unable to pay the taxes. You may have to pay taxes now on converted amounts that you previously deducted from your income. You can use a Roth conversion calculator to help see how it might impact your taxes and income.

The converted amount will be added to your adjusted gross income for the year. An increase in your gross income that is caused by a conversion could move you into a higher tax bracket. Some people pay the tax bill with part of the converted balance but doing that sacrifices some of the tax-free investment growth that you might otherwise enjoy. If you are under age 59 ½, you might also be assessed a 10 percent IRA withdrawal penalty on money that you take out to pay the taxes.

You should also avoid converting to a Roth if you will need the money in the next five years. If you take distributions of rolled-over funds and earnings within five years of when you open your Roth, you run the risk of the amounts being taxed. You may also have to pay a 10 percent Roth IRA withdrawal penalty for removing money before the five-year period is up. This penalty may be assessed when you withdraw funds from your Roth before five years have elapsed from the time that you open the account.

Finally, if you are 70 ½ or older, you will have to take your required minimum distribution before you will be able to convert your traditional IRA to a Roth IRA. You are not allowed to convert your RMDs to a Roth.

Backdoor Roth IRA

A backdoor Roth IRA refers to when you convert from a traditional IRA to a Roth IRA. You are required to pay taxes on the contributions in this type of conversion. The taxable amount that is converted will be added to your gross income on your taxes, and your regular income tax rate will be applied to the total.

A backdoor Roth IRA conversion is a way for high-income taxpayers to open Roth accounts. These are not subject to the income limits for regular Roth contributions. You can complete as many conversions as you would like, but you will not be able to make regular contributions to your Roth IRA if your income exceeds the limits.

To create a backdoor or mega backdoor Roth, you can make non-deductible IRA contributions and roll them over into a Roth IRA since there are no income limits on Roth conversions. If the money in your traditional IRA is post- rather than pre-tax money, do not take a deduction on your contribution amount. This might allow you to avoid taxes during the conversion. However, this subject should be discussed carefully with a financial advisor.

High-income earners are allowed to convert as long as they pay the appropriate taxes on the conversion. The 10 percent withdrawal penalty is not assessed when you convert a rollover IRA to a Roth IRA within a 60-day window. You can contribute money to an existing traditional IRA, sell your shares, and roll the money over to your Roth account. Alternatively, you can convert the entire traditional IRA account to a Roth IRA.


Investors are able to withdraw the contributions that they make to a Roth IRA at any time without paying taxes or penalties. However, under the Roth IRA rules, this does not apply to earnings or interest on your Roth investment when withdrawing from it.

It is important for you to pay attention when withdrawing from a Roth IRA early so that you do not withdraw your earnings or interest. If you do, you will be assessed penalties and may be taxed.

A Roth conversion ladder is a method that you can use to withdraw converted funds from your Roth IRA penalty-free and tax-free to fund an early retirement. To create a Roth conversion ladder, start by converting the money in your traditional IRA to a Roth IRA. You will pay taxes at the time of the conversion. You then need to wait a minimum of five years to be able to withdraw the money without being assessed the penalty. While you wait for the five years to pass, you can transfer additional money in stages so that you will have money in years six, seven, and so on.

IRA rollover

When you complete a direct rollover, your money is directly transferred from one retirement account to another. Money is not withheld for taxes in direct rollovers. The retirement account administrators send the money directly to your new account.

In some cases, the administrator might send you a check that is made out to the new plan. You will have the responsibility of mailing the check to your new IRA. As long as the money is never technically in your hands, it will not be treated as income, and taxes will not be withheld.

An indirect rollover occurs when you cash out your old 401(k) or other retirement plan and reinvest the funds in a new plan within 60 days. In this case, 10 to 20 percent of your money will be withheld for taxes. The administrator will cash out your retirement account and mail you a check called a rollover distribution, and it will not be for the full balance because of the withheld amount.

The IRS requires that you reinvest the exact amount that was in your old account, including the money that was withheld. For example, if you had a balance of $20,000 in your old 401(k) and receive a check for $18,000, you will need to pay the $2,000 difference to your new IRA. You will then get the $2,000 that was withheld back in the form of a tax credit.

Rollover distributions are considered to be taxable income. If you take a rollover distribution early before reaching age 59 ½, you will also have to pay a 10 percent early withdrawal penalty.

IRA transfers

IRA transfers occur when the money is sent directly from the administrator of one retirement account to the administrator of another. A trustee-to-trustee transfer occurs when the trustee at the institution where your traditional IRA is located sends the funds directly to the trustee of the institution where your new account is located.

A custodian-to-custodian transfer is when the custodian of one account sends the funds directly to the custodian of your new account. Both of these methods are easier than trying to complete a conversion under the 60-day rule and are less susceptible to errors.

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