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3 Things You Need to Know Before Converting to a Roth IRA

If you have a traditional IRA, you can convert your account to a Roth IRA in order to take advantages of the benefits that account type offers. You can even do a Roth conversion if you make too much to contribute directly to a Roth. Before you submit the conversion paperwork, however, there are a few things you need to know.

You may end up with a hefty tax bill

A traditional IRA is a tax-deferred account, meaning that you don't pay income taxes on your contributions or investment earnings until you withdraw the money.

On the other hand, contributions to a Roth IRA are made on an after-tax basis, meaning that you pay income tax on the money you contribute, but will owe no taxes upon withdrawal, no matter how much money your investments earn.

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Because of this, when you convert your traditional IRA to a Roth, you typically need to pay ordinary income tax on the entire amount of the conversion. The only exception is if any of your traditional IRA contributions were non-deductible or haven't been deducted yet. For example, if you put money in a traditional IRA and convert the account to a Roth IRA before you deduct the contributions on your taxes, you won't owe anything.

If you have a long-established traditional IRA, this can result in a massive tax bill. If you convert a traditional IRA worth $50,000 to a Roth IRA and you're in the 25% tax bracket, you can expect at least $12,500 added to your tax bill -- more if the conversion amount pushes you into a higher bracket.

If you pay the tax with money in your traditional IRA, you could also face a penalty

You don't necessarily have to pay the taxes due on a Roth conversion out of pocket. If you'd like, you can use money from your traditional IRA to cover the taxes. In the previous example, instead of converting the entire $50,000, you could convert $40,000 and use the other $10,000 to cover the taxes.

The problem with doing this is that if you're under 59 1/2 years old, you may have to pay the IRS' 10% early-withdrawal penalty on the amount used to pay taxes, since any money not rolled into a qualifying retirement account technically counts as a withdrawal. Continuing our example, the $40,000 you convert into a Roth IRA wouldn't trigger the penalty. However, the $10,000 you use to pay the tax bill could result in a $1,000 penalty, plus your state may charge additional penalties of its own.

The "five-year rule" starts at the time of your conversion

One provision of a Roth IRA says that in order to withdraw any earnings tax-free, your account must be open for five years. You can withdraw your original contributions whenever you'd like, but not any profits your contributions have generated.

Keep in mind that when you convert a Roth IRA that the five-year clock starts from the time of the conversion, not when you opened the original traditional IRA. This is especially important to keep in mind if you're approaching retirement age, or plan to use the account to fund college expenses or a first-time home purchase within the next several years.

The bottom line: Who should convert to a Roth IRA?

A Roth IRA conversion can be an especially smart move if you're in a low tax bracket now, and want to avoid taxable income in retirement. Or, if some of the other Roth benefits apply to you, such as no required minimum distributions, paying the tax on a Roth conversion could be worthwhile.

Finally, if you earn too much to contribute directly to a Roth IRA, a conversion can be a smart way to get around the Roth IRA income limits.

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