Why consider a Roth conversion now?

Taxes could rise for a variety of reasons, making a Roth conversion a timely strategy to consider.

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Key takeaways

  • Rising deficits may increase the odds of higher taxes in the future.
  • If you convert traditional 401(K) or IRA assets to a Roth, you'll owe taxes on the converted amount. But you won't owe any taxes on qualified withdrawals in retirement.
  • With Roth IRAs, there are no required minimum distributions (RMDs) during the original owner's lifetime, making them valuable estate planning vehicles.

Converting money in a traditional 401(k) or IRA to a Roth 401(k) or Roth IRA has many potential advantages. Of course, you need to pay taxes on the converted amount. But once the money is in a Roth IRA, you don't pay taxes on qualified withdrawals, giving you more flexibility to manage your taxes in retirement and boost after-tax income.1 Plus, there are no required minimum distributions (RMDs) on Roth IRAs during the lifetime of the original owner, making them valuable vehicles for estate planning. Note: RMDs are required for Roth 401(k)s in employer-sponsored retirement programs.

There is another reason to consider a Roth conversion this year: the prospect of higher tax rates in the future, as many of the individual tax cuts of 2017 are set to expire in 2025.

Intrigued? Here are answers to common Roth conversion questions. Always consult a tax advisor about your specific circumstances.

Can I convert money from a traditional 401(k) to a Roth IRA?

Yes, you can if your plan includes an in-plan conversion facility, or if you're able to take withdrawals from your 401(k). Of course, taxes still apply. Read the section Converting a 401(k) to a Roth IRA in Viewpoints: Do you earn too much for a Roth IRA?

Can I convert to a Roth IRA even if I earn too much to contribute?

Yes, there are no income limits on conversion. Also, if you and/or your spouse have high income levels and are not eligible to contribute directly to a Roth IRA, and you do not already have a traditional IRA, you may want to consider opening a traditional IRA and making a nondeductible contribution, then converting it to a Roth IRA. This strategy is sometimes called a back-door Roth contribution.

Tip: For more detail, see Converting your traditional IRA to a Roth IRA, which includes a Roth conversion tool and a checklist.

How can I estimate my tax liability on an IRA conversion?

Remember, all of the traditional IRAs you own (with the exception of inherited traditional IRAs) are considered one traditional IRA for tax purposes, not matter how many accounts you have. Your tax liability is based on 2 things: the taxable income generated by the conversion and your applicable tax rate.

To figure out how much of a conversion from a traditional IRA to a Roth IRA may be taxable, you'll need to know the types of contributions you made to any one of your traditional IRAs (not just the one that's being converted). There are 2 types of contributions.

  1. Deductible contributions. These are contributions that are deducted from your taxable income for the tax year in which the contributions were made.
  2. Nondeductible contributions. Any contribution for which you do not take a tax deduction is known as a nondeductible contribution. Such contributions create what is sometimes called "basis" in your traditional IRA.

Estimating the taxable income from a conversion is straightforward if you've never made nondeductible contributions to any traditional IRA. If that is the case, whatever amount you convert will all be taxable income.

Note that earnings are always taxable when converted, whether they come from deductible or nondeductible contributions, so for purposes of figuring out taxes on a conversion, you can think of your balances as falling into just 2 categories: (1) nondeductible contributions, and (2) everything else. According to IRS rules, you cannot cherry-pick and convert just nondeductible contributions, leaving deductible contributions and earnings in the account, in order to avoid taxes. Instead, you must figure out the proportion of your total traditional IRA balances that is composed of nondeductible contributions, then use that percentage to find out how much of your conversion will not be taxable. Note that inherited IRAs are excluded in this calculation.

Keep state taxes in mind too. A Roth IRA conversion is a taxable event. If your state has an income tax, the conversion will generally be treated as taxable income by your state as well as by the federal government.

Tip: If your spouse has IRAs with mostly nondeductible contributions and you have IRAs with mostly deductible contributions, you might consider converting your spouse's IRAs before yours to reduce the potential tax impact of conversion.

How can I manage taxes on a Roth conversion?

Tax deductions can also help offset the tax cost of a Roth IRA conversion. For example, you may be able to take a tax deduction for donations to qualified charities. In general, by making charitable contributions, you can deduct up to 60% of your adjusted gross income (AGI).3 The deduction is usually limited to 30% of AGI for donations to some private foundations and some other organizations, as well as for contributions of non-cash assets. Note, however, that if your itemized deductions—which include charitable contributions—do not exceed the standard deduction, there wouldn't be any tax benefit from those charitable contributions. So be sure to consult with your tax advisor to plan your charitable strategy—there are techniques that can help ensure you enjoy the potential tax benefits of your charitable giving.

Learn more at FidelityCharitable.org

Does time of year matter?

Converting earlier in the year generally gives you more time to pay taxes. Taxes aren't due until the tax deadline of the following year, so you may have more than 15 months to pay the taxes on your converted balances. (Note: If you pay estimated taxes, you may need to make some payments sooner.)

But there are also some advantages to converting later in the year:

  • You can start the clock on the 5-year rule. This IRS rule requires a waiting period of 5 years before withdrawing converted balances or you may pay a 10% penalty. But the clock starts on January 1 of the year you do the conversion—no matter when during the year it actually happened. (Withdrawals of earnings are subject to a different 5-year rule. It must have been 5 years since your first Roth contribution or conversion, plus you must be age 59½ or otherwise eligible to make penalty-free withdrawals.)
  • You'll have more information about your income for the year. Since the amount you convert is considered taxable income, you may want to consider converting only the amount that would bring you to the top of your current tax bracket.

A conversion must be completed by December 31 to be included in that year's taxable income. Managing the tax impact of a Roth IRA conversion requires careful analysis. A review with a financial or tax advisor is always a good idea.

If I want to keep a specific stock or asset in my IRA in my portfolio for the long-term, can I keep that asset and convert it to a Roth IRA?

Yes. If you are holding investments in a traditional IRA—ones you want to keep for a number of years— and you think you may be in a lower tax bracket this year than you might be in the future, then a "focused conversion" may be a strategy to consider. With this strategy you move specific assets from a traditional IRA to a Roth IRA, rather than selling the assets first and then moving the resulting cash. In terms of the taxes, there is no difference between the two techniques.

Tip: To learn more, read Viewpoints on Fidelity.com: Focused conversion: A strategy for IRAs

Next steps to consider

Create a source of tax-free retirement income.

See how to convert to a Roth IRA from a traditional IRA or 401(k).

Get even more answers about converting to a Roth IRA.

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