If you have accumulated a large balance in a traditional IRA, now may be an ideal time to convert some or all of it to a Roth IRA. The recently enacted Tax Cuts and Jobs Act (TCJA) reduces individual income tax rates through 2025, lowering the cost of conversion. When you do a Roth conversion, you are subject to tax on some or all of the amount you convert, so it could be cheaper to do it now, while tax rates are more favorable.
But, why choose a Roth in the first place?
Roth IRAs are advantageous if you expect your tax rate to go up in the future — or at least not go down. That’s because Roth IRA contributions get no deduction up front, while qualified withdrawals of contributions and earnings are tax-free. Given the TCJA’s temporary reduction of tax rates, your tax rate may go up in 2026 (assuming your income remains about the same and Congress does not take action).
Contributions to traditional IRAs, on the other hand, are taxed later: They are deductible (up to an annual limit) if you are eligible, but withdrawals of deductible contributions, plus earnings, are taxable. If you expect your tax rate to be lower when you withdraw the funds, such as in retirement, you may be better off deferring taxes with a traditional IRA.
Second, regardless of your expected tax rate, you may benefit from a Roth IRA conversion if your other assets are sufficient to meet your living expenses in retirement. With a traditional IRA, you must begin taking required minimum distributions (RMDs) — and pay taxes on those distributions — every year once you reach age 70-1/2. But, a Roth IRA imposes no such requirement, so you can allow the funds to continue growing tax-free as long as you wish. Also, if you hold a Roth IRA for life, you can leave it to your spouse, children or other loved ones free of income taxes. In contrast, an inherited traditional IRA can come with a substantial income tax bill.
Making the switch
If you decide to convert your traditional IRA to a Roth IRA, be sure you understand the tax implications. You will be subject to federal income taxes on the amount you convert, if the funds are attributable to deductible contributions and earnings. Amounts attributable to nondeductible contributions are not taxable, since they were made with after-tax dollars. Unfortunately, you cannot reduce or eliminate taxes on a Roth IRA conversion by converting only nondeductible amounts. (See “Watch out for the pro-rata rule.”)
Keep in mind that a Roth IRA conversion can potentially push you into higher tax brackets, depending on your income level and the amount you are converting. To avoid this result, consider doing the conversion gradually between now and 2025. This allows you to spread the tax liability over several years and avoid a bracket-busting increase to your taxable income in a single tax year.
If you believe a Roth IRA conversion is right for you, thoroughly review the relative costs and benefits. Careful planning is particularly important now that the TCJA has eliminated a tax code provision that had allowed taxpayers to undo a Roth IRA conversion up until the extended tax return due date for the year in which the conversion is made. (However, if you did a conversion in 2017, you have until October 15, 2018, to undo it.)
Starting in 2018 Roth IRA conversions are irrevocable. Talk with your financial advisor before you pull the trigger.
Sidebar: Watch out for the pro-rata rule
Nondeductible contributions to a traditional IRA are not taxable when those amounts are converted to a Roth IRA. However, that does not mean you can choose to convert only those amounts in an attempt to avoid taxes. The pro-rata rule treats all of your traditional IRA funds as a single account and allocates the converted amount among deductible contributions, nondeductible contributions and earnings on a pro-rata basis.
Suppose, for example, that you have two traditional IRAs: One has $60,000 in deductible contributions and earnings and the other has $30,000 in nondeductible contributions, but no earnings. You might think you can convert the $30,000 nondeductible IRA into a Roth IRA and avoid taxes. But, under the pro-rata rule, the $30,000 is treated as if it had come from one big $90,000 IRA comprising two-thirds deductible contributions and earnings and one-third nondeductible contributions. As a result, two-thirds of the conversion amount, or $20,000, is taxable, and only the remaining $10,000 is nontaxable.