You can shift money from a tax-deferred individual retirement account (IRA) into an after-tax account—but how much tax do you pay on that Roth IRA conversion? And does it always make financial sense to do so?
The biggest difference between Roth IRAs and tax-deferred retirement accounts like traditional IRAs and 401(k)s is when you pay the tax:
Traditional IRA and 401(k) contributions are tax deductible for the year when you make them, and you pay income tax on withdrawals in retirement. The money you pay in and the money it earns are both taxable.
Roth IRA contributions don’t offer an up-front tax break, but withdrawals in retirement are tax free.
Why Do a Roth IRA Conversion?
There are a couple of reasons to consider a Roth IRA conversion (also called a rollover). If you would like to contribute to a Roth directly but make too much money to qualify, you can legally get around the income limits by doing a Roth IRA conversion. This strategy is often called a backdoor Roth.
Another good reason to make the switch: You expect to be in a higher tax bracket in retirement than you’re in now. Remember, Roth IRA withdrawals are tax free in retirement—even when you take out earnings. You can pay taxes now while you’re in a lower tax bracket and enjoy tax-free withdrawals later.
How to Do a Roth IRA Conversion
If you decide that a Roth IRA conversion makes sense for you, here’s what you need to do to make it happen:
Put money into a traditional IRA (or another retirement account). You’ll have to open and fund a new account if you don’t have one already.Pay taxes on your IRA contributions and earnings. If you deducted your traditional IRA contributions (which you did if you met income limits), you have to give back that tax deduction now.Convert the account to a Roth IRA. If you don’t yet have a Roth IRA, you’ll open one during the conversion.
There are a few ways to do the conversion:
Indirect rollover. You get a distribution from your traditional IRA and put it in your Roth IRA within 60 days.Trustee-to-trustee rollover. Ask your traditional IRA provider to transfer the funds directly to your Roth IRA provider.Same trustee transfer. If the same provider maintains both of your IRAs, you can ask that provider to make the transfer.
How Much Tax Will You Owe on a Roth IRA Conversion?
When you convert from a traditional IRA to a Roth IRA, the amount that you convert is added to your gross income for that tax year. It increases your income, and you pay your ordinary tax rate on the conversion.
Say you’re in the 22% tax bracket and convert $20,000. Your income for the tax year will increase by $20,000. Assuming that this doesn’t push you into a higher tax bracket, you’ll owe $4,400 in taxes on the conversion.
Be careful here. It’s never a good idea to use your retirement account to cover the tax that you owe on the conversion. Doing so would lower your retirement balance, which could cost you thousands of dollars in growth over the long term. Instead, save up enough cash in a savings account to cover your conversion taxes.
Converting from a 401(k)
If you want to shift money from your 401(k) to a Roth IRA, make sure the money is transferred directly to your Roth IRA provider. If not, your company will withhold 20% of the amount for tax purposes.
If your company does issue a check to you (instead of transferring it to your Roth IRA provider), here’s what happens: You have only 60 days to deposit all the money into a new Roth—including the 20% that you didn’t receive. If you don’t meet this deadline—and if you’re younger than age 59½—then you’ll owe a 10% early withdrawal penalty on any money that hasn’t made its way into the Roth.
Either way, you’re still on the hook for income taxes on the entire amount that you convert.
Don’t Wait All Year to Pay
Most people pay their income tax to the government with every paycheck. It’s automatically withheld, based on the withholdings that you claim on Form W-4. As the year goes on, your taxes are withheld for you. You don’t have to write a separate check to the government until you file your taxes. And that’s only if you didn’t have enough money taken out and you still owe.
But small business owners and corporations make estimated quarterly tax payments. These entities must estimate how much tax they’ll owe based on their income and expenses. And then, each quarter—typically on the 15th of April, June, and September of that year and January of the following year—they fill out a form and send in their payments.
Why is this important to note? If you convert a substantial traditional IRA to a Roth IRA early in the year, then your quarterly income—and therefore, your quarterly taxes—will increase.
Say you convert during the first quarter of the year. You would need to pay the tax triggered by the conversion when your quarterlies are due. In this example, that would be by April 15.
If you wait until the end of the year or when you file your taxes, you could owe penalties and interest.
Safe Harbor Rules
If you’re used to paying estimated taxes, you may be wondering about safe harbor rules. Safe harbor rules mean that if you pay at least 100% (or 110%, depending on the situation) of your previous year’s taxes in estimated taxes this year, then you won’t pay any fees or interest by underpaying.
This is to protect individuals and businesses whose income may skyrocket—thanks to a great year—following a poor year. Provided that you’ve paid at least as much as you did last year, you’re pulled into the “safe harbor.” And you won’t have to worry about penalties and interest.
Still, this is where things can get sticky, and it’s a good idea to speak with a tax advisor. Of course, if you pay your estimated taxes, you won’t have anything to worry about. If you end up paying too much into the tax system, you’ll get a refund when you file your taxes at the end of the year.
Should I Do a Roth IRA Conversion?
A Roth IRA offers huge benefits—tax-free withdrawals during retirement and no required minimum distributions (RMDs), to name just two. Still, a conversion isn’t always a good idea.
In general, you should consider a conversion only if:
You can pay the taxes out of your savings account without tapping the IRA funds.You’re confident that you’ll be in a higher tax bracket in retirement.
Keep in mind that you could be in a higher tax bracket later in life even if you don’t earn more money at work. Your income might be higher due to any combination of:
Rents and royalties
Social Security benefits
Pensions and annuities
Be sure to consider these other income sources when you estimate your future tax bracket.
When should I consider a Roth individual retirement account (IRA) conversion?
A Roth individual retirement account (IRA) conversion may be wise if you think that you’ll be in a higher tax bracket in retirement than you’re in now. Since you have to pay taxes on traditional IRAs when you convert them, think about your current tax rate and the value of the account that you have now. If the market is down, there is less to tax than in a time when your funds are doing well.
How can I tell if I will be in a higher tax bracket later?
There’s no real way to know what the tax code will look like when you retire—unfortunately, it changes often. What you can determine is how many sources of funding you’ll have in your retirement. If you have a pension, annuity, rental properties, or other passive income streams, you may earn just as much or more in retirement as you do now. In 2022, we are in a historically low tax period, so plan accordingly.
How much can I be penalized for underpaying my taxes?
If you’re not having taxes withheld from a paycheck, then you are expected to pay either 100% of last year’s tax bill or 90% of this year’s bill. The penalty for underpayment is typically 0.5% of the unpaid tax for each month or partial month that it goes unpaid. In addition to the penalty, underpayments are subject to 3% interest for individuals.
The Bottom Line
If you’re interested in doing a Roth IRA conversion, be sure to consider the current and future tax consequences before making any decisions. If you can cover the taxes and think you’ll be in a higher tax bracket later on, it can make great financial sense. If not, you may be better off leaving your money in a traditional IRA.
It’s helpful to consult a financial planner or advisor who can help you decide if—and when—a conversion might benefit you.