We’ll help you understand:

  • Traditional vs. Roth IRAs.
  • Tax implications of Roth IRA conversion.
  • Other factors to consider before converting.

You may wonder if converting your traditional IRA to a Roth IRA makes sense. A Roth conversion happens when you move all or a portion of an existing traditional IRA and into a Roth IRA. Sounds simple, right? There’s nothing simple about it. It’s an irreversible taxable transaction, so you want to make sure it’s the right move before you take action.
So why would you do a Roth conversion? Aren’t all IRAs created equal? The answer is no. They’re 2 different savings vehicles with different rules and tax benefits.

Breaking down the differences between traditional and Roth

IRAs are a great, tax-advantaged way to save for retirement. There are 2 types of IRAs—traditional and Roth—and each has different rules and tax benefits.

Both IRAs have contribution limits in common: If you’re under the age of 50, you can contribute up to $6,000 per tax year toward either a traditional or a Roth IRA. (If you’re 50 and older, you may be eligible to contribute an additional $1,000 per year, meaning a total of $7,000.)

But how are they different? Let’s dive in.

Traditional IRA

With a traditional IRA, you may be eligible for a tax deduction on your contributions. If you make deductible contributions, your money will grow tax-free, but you’ll have to pay taxes when you take the money out in retirement. In addition:

  • Earnings grow tax-deferred.
  • Everyone’s eligible—you’re not limited by your income.

Roth IRA

When you invest in a Roth IRA, your contributions are after taxes and earnings are tax-free.* In addition:

  • There’s no required RMD (required minimum distribution) as long as you live.
  • If your income exceeds IRS limits, you may not be eligible for a full contribution.

But what does this mean for you? Instead of being taxed when you make deductible contributions to a traditional IRA, you’re taxed once you start taking money out—be it for retirement income, leisure, or satisfying your RMD once you turn 72.** When you contribute or convert to a Roth IRA, taxes are due for the calendar year in which those funds are applied. Once you’re ready to start withdrawing from your Roth IRA later on, distributions are tax-free.***

Ultimately, it boils down to “taxes today, or taxes tomorrow?” While many people may be likely to be in a lower tax bracket once they retire, this isn’t always the case. By the time you’re of retirement age and ready to withdraw, it’s possible your tax liability may be higher. This could be due to changes in tax policy, or if you withdraw a substantial amount (since traditional IRA distributions are taxed as ordinary income). If that’s the case, a Roth conversion may be an optimal means to provide a tax-exempt source to withdraw from once you’re older, to offset a rise in potential tax burden. However, if you don’t anticipate your tax burden will be impacted substantially in the future, a conversion now may not be suitable.

Possible tax implications of a Roth IRA conversion

Converting to a Roth IRA means you’ll pay tax on the pre-tax amount you convert now instead of during retirement. And that amount could be substantial, so you’ll want to weigh the pros and cons.

First, a Roth conversion is an irrevocable taxable event. In other words, once you convert a specific dollar amount to your Roth IRA, it can’t be undone. It used to be possible to undo a Roth conversion through a process known as recharacterization. However, this option is no longer allowable as of 2018.

When you convert funds to a Roth IRA, this transaction is applicable for the calendar year in which you made the conversion. Unlike IRA contributions, which can generally be made up until the tax filing deadline (usually April 15 of the following year), Roth conversions for a tax year can only be made within the calendar year (meaning you have until market close of the last business day of the year to apply your conversion for a specific tax year).

To touch briefly on traditional IRAs again, these accounts are generally composed of pre-tax assets, but there are situations in which you can make after-tax contributions (or non-deductible contributions) to a traditional IRA. For example, depending on how high your income is, you may not be eligible to contribute directly to a Roth IRA. In situations like this, it’s possible to contribute an after-tax amount to a traditional IRA before converting these funds into a Roth IRA. You may hear this referred to as a “backdoor Roth conversion,” or a “backdoor conversion.” However, there are some technicalities and considerations to bear in mind.

Suppose you decide to make an after-tax contribution of $6,000 to a new traditional IRA. If this is the only traditional IRA you own, and you convert the assets to a Roth IRA immediately, you wouldn’t be taxed a second time. However, any earnings that accumulate within a traditional IRA haven’t been taxed. Consequently, if your $6,000 contribution grew by $500 and you decided to convert, your conversion would be prorated, based on the ratio between pre-tax and post-tax assets.

The same would hold true if you had additional pre-tax IRAs in your name, regardless of institution. Suppose you make a nondeductible IRA contribution of $6,000 to a new IRA with Vanguard, but you also hold a traditional IRA with another institution valued at $12,000 in pre-tax contributions. If you were to convert to a Roth IRA with Vanguard, your other traditional IRA would be factored into how much you would owe in taxes, even though it’s being held somewhere else. IRA aggregation rules dictate that every pre-tax IRA you own would be considered part of the same bucket when you convert to a Roth IRA, and you may owe a proportionate amount of taxes. In other words, you wouldn’t be able to choose the amount on which you want to pay taxes. Think of it less like oil and water and more like coffee and cream: Once you blend them together in the same mug, you can’t separate them again.

If you have more than one traditional IRA, you may not want to convert them all at once because the total pre-tax amount converted in a calendar year is added to your taxable income for that year.

Other considerations

Still considering whether you should convert? Here are a few more things to consider.

  1. Start with your goals. Beyond tax management in retirement, do you have other goals, such as estate planning or transferring money to future generations?
  2. Think about tax diversification. A Roth conversion could be an opportunity to diversify your income streams early in retirement while aiming to reduce your future RMD burdens.
  3. Consider other income. What’s your current taxable income situation? Are you employed? Do you expect to have similar employment income going forward, and for how long?
  4. Start budgeting for spending or withdrawal needs. Consider your withdrawal strategy as you approach retirement. Will your spending vary over time? Will you spend more at the start of your retirement or later on?

Still not sure?

You also have the option to contribute toward your IRAs. Contributions add money toward your goals, so they act as a means for you to build wealth. Conversions are a means to optimize wealth through tax efficiency. Depending on your situation, a Roth conversion could be right for you. Whether you decide to convert now or wait until later, making an informed decision you feel comfortable with is key.

For further guidance on how to best optimize your retirement assets through conversion, you may wish to consult a qualified tax professional. In addition, the experienced advisors at Vanguard Personal Advisor Services® can help you navigate complex retirement scenarios as your plan for your future.

*Withdrawals from a Roth IRA are tax-free if you’re over age 59½ and have held the account for at least 5 years; withdrawals taken prior to age 59½ or 5 years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate 5-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).

**Although you can still complete Roth IRA conversions after you reach RMD age, please note that you must satisfy your RMD requirement prior to requesting a Roth IRA conversion each year. Your RMD must be withdrawn and you can’t contribute that amount to a Roth IRA.

***A separate 5-year holding period applies to each conversion to determine if a 10% early distribution penalty applies to withdrawals of converted assets. (The 10% penalty doesn’t apply if you’re over the age of 59½ or meet an exception.)


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Notes:

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