What is a Roth conversion?
A Roth conversion is the moving of assets from a tax-deductible traditional individual retirement account, or IRA, to a non-deductible Roth IRA. Participants in Roth IRAs don’t pay income tax when they withdraw those funds in retirement because money deposited into a Roth is from after-tax income.
The most important distinction between a traditional IRA and a Roth IRA is that traditional IRAs are grown with pretax income and taxed when the funds are withdrawn, while Roth IRAs are contributed to with after-tax income and are tax-free at withdrawal. That makes Roth IRAs a better option for people who think they’ll be in a higher tax bracket when they’re older.
However, because Roth IRAs limit contributions from people who earn a higher income, many high earners put their money in traditional IRAs, which don’t have income limits. If these wealthy people want to invest in a Roth IRA, they’ll have to convert their traditional IRAs in a Roth conversion. Roth conversions themselves used to have income limits, but these have since been removed.
Another term for a Roth conversion is a “backdoor” Roth IRA contribution. The conversion is carried out through an asset rollover between the trustees of the traditional IRA and the Roth IRA. Because contributions to a Roth IRA are made after tax, it follows that converting a traditional IRA to a Roth IRA would incur a tax penalty. In fact, the account holder will pay taxes on the entire amount she converts unless the funds from the traditional IRA were not tax-deductible, in which case she has already paid taxes on them.
Roth conversions require the customer to wait five years before withdrawing the money to avoid a tax penalty, and with a Roth IRA earnings can’t be withdrawn without a tax penalty at all until the account holder turns 59 ½. It’s also possible to undo a Roth conversion and recoup the tax dollars spent, but only within a specified time frame.
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Roth conversion example
A tax-savvy investor with a large simple IRA account wants to see his money grow tax-free. He consults his financial planner and decides to convert his conventional IRA into a Roth IRA. The conversion, however, doesn’t get him out of paying taxes. The traditional IRA is from pre-tax income, so he will owe federal income tax on that money. After the Roth conversion, though, his money grows tax-free and he can withdraw it without paying more taxes when he retires.