Should I do a Roth Conversion?

August 03, 2021 by Carolyn Richardson, EA, MBA
Roth and Traditional IRS Plus and Minuses

Whether to convert your tax-deferred retirement account to a Roth IRA or Roth 401(k) is a conversation that taxpayers frequently have with their financial advisors, accountants, tax preparers, and sometimes their barber or bartender. It seems like a simple idea: convert that account to a Roth and you can withdraw the money tax-free in future years. But is it a good idea for you? Many people are under the mistaken impression that a Roth conversion has no downside where taxes are concerned, but whether that is true depends on various factors in your own financial circumstances now, and what you expect them to be in the future.

A Roth conversion is where you move your retirement savings, currently in a tax-deferred retirement account such as a traditional IRA or 401(k), 403(b), annuity, or 457 plan, into a Roth account. This can be done either by receiving a check from your traditional retirement plan and depositing it into a designated Roth IRA within 60 days (called an indirect conversion), or by asking your trustee of the traditional account to transfer it to a Roth, either with another trustee or in a new account with the same trustee (called a direct or trustee-to-trustee conversion). But these types of transfers do have tax consequences, as the amount that you transfer is taxable income for the tax year. On the other hand, there is no income limitation on making a conversion, so all taxpayers are eligible to make a conversion. However, you cannot make a conversion of your required minimum distributions (RMD) or of an inherited IRA.

Is a Roth conversion a smart money move for you?

As I said earlier, that will depend on different factors based on your own personal finances. Many financial planners advocate for making a Roth conversion because the money can then be withdrawn tax-free if it has been in the Roth account for at least 5 years. But many financial consultants do not take into account the taxpayer’s current tax situation and whether they can afford to pay the taxes that will come due if the taxpayer makes a Roth conversion.

Let’s look at a simplified example. Jim is a taxpayer who normally earns about $75,000 a year, and he has diligently saved 10% of his salary into his regular 401(k) account with his current employer, whom he has worked for since 2001. Jim recently quit his job and left the 401(k) sitting with his employer for now, but he’s thinking about rolling it into an IRA, either as a rollover IRA or a Roth IRA. Jim is a single taxpayer and claims a standard deduction every year when he files his return. Jim’s tax rate is 20%, so his tax savings on his annual contribution to the 401(k) is $1,500. Because Jim had invested his 401(k) contributions wisely, in 2021 his balance in the 401(k) is now worth $250,000 due to earnings. Should Jim do a Roth conversion from his regular 401(k), rather than the traditional IRA?

If Jim does a rollover to a traditional IRA, there will be no tax consequences as the money is still in a deferred retirement account, assuming Jim does a correct indirect rollover or a direct rollover. If Jim converts the entire amount of his current 401(k) balance to a Roth IRA, though, this will push Jim’s gross income from $75,000 to $325,000 for 2021. That will put him into the 24% tax bracket, which means he might wind up paying as much as $60,000 in additional taxes on his 2021 return. That is nearly as much as Jim’s entire salary for the year, so paying those taxes would be painful.

Can Jim have tax withholding done on the conversion so he doesn’t have to pay so much when he files? Withholding is not typically done on a trustee-to-trustee transfer. If Jim does an indirect conversion, then withholding is an option but the maximum amount the trustee can withhold is 20%. This means the trustee will withhold $50,000, leaving Jim with a $10,000 shortfall when he files. Worse, if Jim is under 59½ years of age when he does the conversion, the amount withheld is considered to be an early distribution from the 401(k) and would not only be subject to his regular income taxes but also a 10% penalty tax for an early distribution, costing him another $5,000 in taxes.

So out of Jim’s $250,000 account balance, he has now lost up to $65,000 in taxes. Even with a direct conversion he will lose $60,000 in taxes, as tax must be paid on the amount transferred regardless of how it was transferred. And this doesn’t even consider any state taxes that may be due on the conversion. Jim will need to invest his new Roth account very wisely to make up for the net effect the taxes on the conversion cost him.

In such a scenario, it would probably not make financial sense for Jim to do a Roth conversion of his entire balance, but it might make financial sense to do a smaller conversion, such as $25,000 or $50,000 instead of $250,000. There is no requirement that you move the entire account into a Roth when doing a conversion and doing it in smaller pieces over a number of years would spread out the tax liability. It may also reduce the overall taxes, since a smaller conversion may not result in a higher marginal tax rate. The only consideration in this situation is the 5-year holding period to then withdraw the funds from the IRA tax-free, as each conversion has its own holding period. So, if Jim converted $50,000 on 1/1/21, he could then withdraw funds from this account tax-free on 1/1/2027. If he converts another $50,000 in on 1/1/22, he would have to wait until 1/1/2028 to make tax-free withdrawals from this account. The taxpayer needs to keep track of what funds are converted and what are withdrawn in case the IRS questions a withdrawal from a Roth conversion.

While Roth conversions make sense for many taxpayers, if you are thinking of doing one, you should check with your tax preparer or run the numbers yourself in your tax software to get an estimate of the costs. Do this before you do the conversion, so you don’t regret it come tax time!



Carolyn Richardson, EA, MBA
Learning Content Managing Editor


Carolyn has been in the tax field since 1984, when she went to work at the IRS as a Revenue Agent. Carolyn taught many classes at the IRS on both tax law changes and new hire training. In 1990, she left the IRS for a position at CCH, where she was a developer on both the service bureau software and on the Prosystevm fx tax preparation software for nearly 17 years. After leaving CCH she worked at several Los Angeles-based CPA firms before starting at TaxAudit as an Audit Representative in 2009. Carolyn became the manager of the Education and Research Department in 2011, developing course materials for the company and overseeing the research requests. Currently, she is the Learning Content Managing Editor. 


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