How to find out if a Roth conversion is right for you—and how to do one

A Roth conversion is just as it sounds: a way to convert funds from a traditional IRA (individual retirement account) into a Roth IRA. A Roth IRA is a powerful retirement savings tool, since your money grows tax-free, and it might make sense for you to shift your funds into one.

To help you figure out if it's a good money move for your situation, CNBC Make It spoke to Fred Egler, a certified financial planner at Betterment, about the difference between the two types of IRAs, the pros and cons of doing a Roth conversion and exactly how to execute one.

How does a traditional IRA work?

With a traditional IRA, you contribute pre-tax dollars and let that money grow tax-deferred over time.

You'll pay taxes on your contributions and any investment gains only when you withdraw the money, which you can do starting at 59½. If you withdraw before then, you may have to pay a 10% fee for early withdrawals, unless you qualify for an exception.

With this type of IRA, there are required minimum distributions, meaning you have to start taking money out by April 1 following the year you turn 72 and by December 31 of later years.

For 2020, you can contribute up to $6,000 in this account, or $7,000 if you're 50 or older.

How does a Roth IRA work?

With a Roth IRA, contributions are taxed when they're made, so you can withdraw the contributions and earnings tax-free once you reach 59½.

There's an income cap on the Roth IRA, which the IRS sets each year based on modified adjusted gross income (MAGI): For 2020, a single person earning $139,000 or more and a married couple making $206,000 or more cannot directly contribute to a Roth.

Like a traditional IRA, there's also a contribution limit: For 2020, it's $6,000 a year, or $7,000 for people age 50 or older. If you are contributing to both accounts, keep in mind that your total contributions to all of your traditional and Roth IRAs cannot be more than $6,000 a year, or $7,000 if you're over 50.

What is a Roth conversion?

A Roth conversion turns a traditional IRA into a Roth IRA. If you have money in a traditional account, but like the idea of making future withdrawals tax-free, converting to a Roth would allow you to do so.

Anyone is eligible to do a Roth conversion, regardless of their income.

"They are a great way for high income individuals to get money into a Roth IRA without contributing directly to one because of the income cap," says Egler. You may have heard of this process of sidestepping the cap referred to as a "backdoor Roth IRA."

What are the pros of doing a conversion?

The biggest benefit is that you'll be able to keep money in a Roth IRA, where it will grow tax-free and qualified withdrawals in retirement won't be taxed.

If you think your tax rate is going to be lower now than it will be when you start withdrawing money, converting to a Roth is especially appealing because you'll pay taxes on the money while you're in a lower tax bracket.

It's also a way to avoid required minimum distributions, which is the minimum amount you have to withdraw from your account each year. With a traditional IRA, you have to start taking withdrawals at 72. Roth IRAs don't require withdrawals at a certain age, so your money can continue growing there until you're ready to take it out.

What are the cons of doing a conversion?

There are tax consequences that come with moving money from a traditional to a Roth, explains Egler: "In most cases, when you convert funds, it's considered a taxable event, which means that you owe taxes on some or all of the amount that you convert to a Roth. Basically, that money will be added to your income for that tax year."

If you're converting a ton of money, the tax consequences are going to be high and the process might be more of a burden than an advantage. "Let's say someone had $500,000 in their traditional IRA," says Egler. "It probably wouldn't make sense to convert that to a Roth because you'd be adding $500,000 to your taxable income for the year."

Additionally, if you think your tax rate is higher now than it will be when you start taking withdrawals, a conversion could cost you more in taxes now than you'd save with tax-free withdrawals later, Egler says. You can use a Roth conversion calculator to estimate how this might play out for you, but it's hard to predict future tax rates, especially if you won't be taking funds out for 10 to 30 years.

While everyone's situation is different, it might not make sense to do a conversion if you're close to retirement. "The shorter the time period, the less advantageous the Roth conversion can be, because the tax-free growth has less time to compound and grow," Egler says.

Plus, there's a "five year rule" that says you have to wait five years from the conversion to take full advantage of tax-free distributions from the Roth IRA. "For people who plan to use that money in retirement sooner rather than later, it probably doesn't make sense," Egler says.

"Once you do a Roth conversion, it's irreversible," Egler adds. "If you're going to do one, you should certainly make sure it's for you."

How do you do a Roth conversion?

If you've considered the tax consequences and decide that a conversion makes sense for you, the first step is to put money in a traditional IRA account if you don't already have one. Next, you'll open a Roth account if you haven't already.

"You pay taxes on a Roth conversion when you file your taxes, which is generally in April," says Egler. "Your investment custodian will provide you with a tax form in relation to the Roth conversion." It's smart to plan ahead and make sure you have money set aside to pay the tax out of pocket when you file, rather than use the money from your IRA withdrawal. "Those funds should stay in retirement accounts and grow over time," says Egler.

There's no limit on how much you can convert. Here are the three ways to get your money from a traditional account to a Roth:

1. Indirect rollover. You'll receive a distribution check from your traditional IRA and then contribute it to your Roth IRA within 60 days.
2. Trustee-to-trustee transfer. You tell the financial institution holding your traditional IRA funds to transfer an amount directly to your Roth IRA at a different institution.
3. Same trustee transfer. If your IRAs are held at the same institution, you tell the trustee to transfer an amount from your traditional to your Roth.

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