Thinking of converting to a Roth IRA?

From contribution restrictions to tax implications, here's what you need to know.

Key points

  • Partial conversions enable you to spread out your tax payments over multiple years
  • There are no income restrictions on Roth IRA conversions — anyone can make the switch
  • Roth IRAs generally provide federal (and possibly state and local) tax-free income in retirement and greater flexibility when it comes to distributions
  • Be sure to consult a tax advisor before making your decision
While there are many factors to consider, including how changes might affect your tax planning, converting your traditional IRA or employer-sponsored retirement account to a Roth IRA may offer you more flexibility and control over your nest egg in retirement. Before making a decision, consult with a tax and/or legal advisor to get help determining whether converting to a Roth IRA might be right for you. When deciding what to do with your 401(k), review all of your choices.

Anyone can convert

As long as taxes are paid on the conversion (i.e., pre-tax) amount, anyone can convert a traditional IRA, or other eligible retirement plan asset,Footnote 1 to a Roth IRA. Doing so presents an opportunity for investors who wish to potentially lessen their tax burden in retirement. Converting also offers greater flexibility as no required minimum distributions (RMDs) are required to be made to the original Roth IRA account holder. Of course, every financial situation is unique, so consult with a tax and/or legal advisor before taking any action.

But not everyone can contribute

There can be restrictions to your ability to contribute to a Roth IRA based on your modified adjusted gross income (MAGI). Your MAGI is generally the adjusted gross income of your household plus certain tax-exempt income you may have. To learn more, view the most current 401(k) and IRA contribution limits and refer to the annual limits guide (PDF).

It's not an all-or-nothing proposition — consider a partial conversion

Pre-tax assets that are converted from a traditional IRA or other eligible retirement plan to a Roth IRA are treated as a taxable distribution and are subject to ordinary income tax rates in the year of the conversion. You can do a partial conversion — that is, convert a portion of your assets over two years or more, thereby spreading out your tax payments. You don't have to convert the entire account at once.
Converting to a Roth IRA may be worth considering if you:
  • Have assets invested in traditional IRAs or employer-sponsored retirement plans
  • Think you'll be in a higher tax bracket in retirement, or if you're temporarily in a lower tax bracket now
  • Can afford to take the tax hit now without dipping into your retirement account to pay taxes on the income generated by the conversion
  • Have unused tax deductions (such as charitable contributions or medical expenses) that can help offset the taxable income generated by the conversion
  • Wish to reduce the taxable value of your estate or potentially leave income tax-free assets to your heirs
Note that if you have multiple non-Roth IRAs, any conversion will be deemed to be made from all of the IRAs on a proportionate basis. Also, if you have both deductible and non-deductible contributions held in your non-Roth IRAs, any conversion will be deemed to be taken pro rata from each contribution type.

Understanding Roth IRAs

There are a variety of factors to consider before you determine whether to convert your traditional IRA or other eligible retirement plan to a Roth IRA. Again, you should consult with a tax professional to assess the potential impact on your long-term financial goals before making any decisions.

How do they work?

Earnings on your assets will have the potential to grow tax-deferred and can be distributed income tax-free (on a federal and possibly state level) in a qualified distribution after five years from the first day of the year in which you make your first Roth IRA contribution or five years from the year in which you make the applicable Roth conversionFootnote 2 if one of the following applies:
  1. You are age 59½ or older at the time of the distribution
  2. You qualify for a special purpose distribution for the purchase of a first home (lifetime limit of $10,000)
  3. You die or become permanently disabled
If you make a withdrawal that does not meet these or certain other exceptions, you will generally owe ordinary income tax (at the federal and possibly state and local level) on any distribution of earnings and, potentially, a 10% additional federal tax (in addition to possible state and local additional taxes) for taxable withdrawals prior to age 59½.Footnote 3
When you make a conversion, keep in mind that if you have both pre-tax funds and after-tax funds in one or more non-Roth IRAs, you cannot choose to convert only the after-tax funds first. Instead, any conversion will be deemed to be made proportionately from all your funds across all your non-Roth IRAs.
In addition, there are a number of exceptions to the 10% additional tax on distributions before age 59½. For example, one such exception is for a qualified birth or adoption distribution. However, a qualified birth or adoption distribution attributable to earnings is generally includable in taxable income. Qualified birth and adoption distributions are limited to $5,000 (not indexed for inflation) per birth or adoption. The $5,000 limit applies to individuals, so spouses could each receive a distribution of up to $5,000 per qualifying birth or adoption. Other exceptions to the 10% additional tax include withdrawals made by someone who is terminally ill and those taken to pay for costs related to a federally declared disaster. Beginning in 2024, people experiencing domestic abuse and those who withdraw up to $1,000 per year for emergency personal or family expenses may be exempt from the 10% additional tax, as well. Consult Go to third-party website IRS Publication 590-B popup and your tax advisor for more information.

What are the benefits?

Since there are no income restrictions on Roth IRA conversions, many investors are taking a hard look at the potential benefits — primarily federally tax-free withdrawals and no mandatory distribution schedule — to determine whether a conversion makes sense.
  • Take future taxation into account — While Roth IRA contributions are not tax-deductible, qualified distributions are federal (and possibly state) income tax-free. This is a great perk if you anticipate being in a higher tax bracket when you withdraw your money — typically in retirement. Many investors hold a significant portion of their retirement savings in a tax-deferred plan — such as a 401(k) or other employer-sponsored retirement plan. However, that money is taxed as income upon distribution. Converting some of your savings to a Roth IRA (accomplished through a partial or complete conversion) allows you to diversify your retirement assets from a tax perspective.
  • Enjoy greater flexibility — Unlike a traditional IRA, Roth IRAs are not subject to RMDs while the original account holder is still alive, so you are not required to begin taking distributions at or shortly after age 73 (although distributions still will be required after your death).Footnote 4 You also can continue to contribute to your Roth IRA for as long as you earn income at any age, provided your MAGI is within the eligibility limits for Roth IRA contributions.
Next steps

Footnote 1 The following account types are eligible for conversion to a Roth IRA: traditional IRA, rollover IRA, SEP IRA, and SIMPLE IRA (after being held for two years), as well as assets in tax-qualified retirement plans such as 401(k), 403(b), 457(b), profit sharing and money purchase plans. Note, however, that qualified plan assets are only available for conversion to a Roth IRA if they are otherwise permitted to be distributed from the plan under the plan terms.

Footnote 2 This five-year period begins on January 1 of the tax year for which the first contribution to a Roth IRA was made, or January 1 of the tax year in which the applicable conversion to a Roth IRA was made.

Footnote 3 In addition, a special provision applies for converted assets. If a non-qualified withdrawal is made within five years following the beginning of the conversion tax year the entire withdrawal may be subject to the 10% additional federal taxes for pre-59½ withdrawals unless an exception applies.

Footnote 4 Effective January 1, 2023, the required beginning date for RMDs is April 1 of the year after you turn age 73. You are required to take an RMD by December 31 each year after that. If you delay your first RMD until April 1 in the year after you turn 73, you will be required to take two RMDs in that year. You may be subject to additional taxes if RMDs are missed. Please see your tax advisor regarding your specific situation.

Investing involves risk. There is always the potential of losing money when you invest in securities.

Diversification does not ensure a profit or protect against loss in declining markets.

A special five-year period applies to assets held in a Roth IRA that were previously converted from a traditional IRA or employer-sponsored retirement plan. If you take a distribution from your Roth IRA during the five-year period that begins on January 1 of the year of the Roth conversion, the portion of the distribution that is attributable to converted amounts may be subject to a 10% additional federal tax if you are younger than age 59½ at the time of the distribution, unless an exception applies. A separate five-year period applies to each conversion, and special ordering rules determine the order in which converted amounts are treated as being withdrawn from the account.

Generally, for a distribution from a Roth IRA to be federal (and possibly state and local) income tax-free, it must be a qualified distribution. A qualified distribution from your Roth IRA may be made after a five-year period has been satisfied (this period begins January 1 of the tax year of the first contribution or the year of conversion to any Roth IRA) and you (i) are age 59½ or older, (ii) are disabled, (iii) or qualify for a special purpose distribution such as the purchase of a first home (lifetime limit of $10,000). In situations where the original account owner is deceased and the five-year period has been satisfied, distributions to the beneficiary are also considered a qualified distribution. If you receive a non-qualified distribution from your Roth IRA, the earnings portion of such distribution generally will be subject to ordinary income tax, plus a 10% early withdrawal additional tax if received before age 59½ unless an exception applies. A 10% early withdrawal additional tax may also be owed on converted Roth IRA principal withdrawn before the end of the five-year period. Although RMDs are not required for the original account owner, RMDs would generally apply to the inherited Roth IRA account.

The 10% additional federal tax generally applies to withdrawals from a Roth IRA before age 59½, but certain exceptions apply, such as, but not limited to, death, disability, birth or adoption of a child, and first-time home purchase (lifetime limit of $10,000). If you leave your employer in the year you reach age 55 or later, distributions from your employer-sponsored qualified retirement plan will be exempt from the 10% additional tax. A tax advisor can help you determine whether the additional tax applies to your situation.

Footnote 
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
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