What Is a Roth Conversion? And How Does It Work?

Whenever you consider investing for retirement, the word Roth (and the tax advantages it represents) should always grab your attention. Tax-free growth and tax-free withdrawals in retirement? Sign us up for that every time!

Market chaos, inflation, your future—work with a pro to navigate this stuff.

But maybe, for whatever reason, your retirement savings are in a traditional account. Can you still take advantage of a Roth? Yep! It’s called a Roth conversion.

A Roth conversion is simply the process of moving funds from a traditional retirement account—like a traditional 401(k) or IRA—into a Roth IRA. If you’re:

• Saving for retirement
• Have plenty of cash in the bank
• Still have a long way to go before retirement

Then a Roth conversion might save you a lot of money in the long run.

Listen. A Roth conversion is like a lot of things in life (it comes with trade-offs). Let's break this down so you can decide if a Roth conversion makes sense for you.

How Does a Roth Conversion Work?

A Roth conversion is a pretty simple process as long as you follow the steps (we’ll show you those in a moment). In a nutshell, here’s how a Roth conversion works:

• You make the decision to move money from a traditional account—like a traditional 401(k) or traditional IRA—into a Roth IRA.
• Once that money is moved, it gets added to your taxable income for the year and you’ll owe ordinary income tax on it once tax season rolls around.
• From that point on, all the money you moved into your Roth IRA will grow tax-free—and you’ll be able to withdraw that money in retirement without owing any more taxes on it.

The main reason to consider a Roth conversion is for its impact on your taxes. Basically, you’re choosing to pay some tax now so you won’t have to pay more tax later. And there’s no penalty for converting. The only thing you’ll be on the hook for is the tax bill.

Roth vs. Traditional Accounts (Quick Comparison)

Feature	Traditional IRA/401(k)	Roth IRA
Contributions	Pre-tax	After-tax
Growth	Tax-deferred	Tax-free
Taxes on withdrawals	Yes	No (for qualified withdrawals)
Required minimum distributions	Yes	No
Tax implications	Lower taxes now	Lower taxes later in retirement

If you want, you can always take a deeper dive into how traditional and Roth accounts stack up. But stick with us here for all you need to know on the Roth conversion.

What Are the Benefits of a Roth Conversion?

The big draw of a Roth conversion is getting the tax advantages of a Roth IRA (those come int the long term, and you’ll have to pay taxes at conversion to get them). Under the right circumstances, a Roth conversion could give your retirement savings a major boost.  

Here are three main benefits that come with a Roth conversion:

Tax-Free Growth on Your Retirement Savings

After a Roth conversion, all your investment growth will be shielded from taxes inside the Roth account. That means you won’t have to pay a single cent in taxes on that money in retirement.

This is a huge deal! If you let your investments grow over several decades, it could lead to tens of thousands of dollars in growth that Uncle Sam can’t touch.

No Taxes on Your Withdrawals in Retirement

When you invest for retirement with a traditional retirement account, you’re investing with pretax dollars. Translation? You don’t pay taxes on the money when you put it in.

In other words, you get a tax break now (in the form of a tax deduction), but you’ll pay taxes on the growth and withdrawals in retirement later. That’s what people mean when they say tax-deferred.

If that doesn’t sound great to you, fear not because a Roth conversion solves that problem. Once you convert your traditional, tax-deferred retirement savings to a Roth account and pay your taxes on it, you’ll enjoy tax-free withdrawals in retirement.

More Control Over Your Retirement Withdrawals

At some point, Uncle Sam will take his cut. That’s where required minimum distributions (RMDs) come in.

If you have a traditional IRA or 401(k), you’ll be forced to start taking money out of your account once you reach age 73.¹ Ready or not, you’ll have to start paying taxes once those RMDs kick in.

But Roth plans don’t have RMDs—which means you get to decide how and when you take money out of your account in retirement.

Should I Convert My Retirement To Roth?

When Does a Roth Conversion Make Sense?

If you have the cash on hand to pay your taxes up front on a Roth conversion, think of it as one of those opportunities to pay a little now can save you a bundle later.

But Roth conversions aren’t for everyone. How can you know? Well, here are three situations where it does make sense:

You’re more than five years away from retirement.

The IRS requires the money you convert to stay in the account for five years.² If you withdraw it sooner, you may owe fees on top of a 10% additional tax.

Plus, the longer your money can grow tax-free after the conversion, the better. It doesn’t make sense to do a Roth conversion if you’re just going to take the money out a few months later.

You can pay the taxes on a Roth conversion with cash.

Let’s do things the Ramsey way: You should only do a Roth conversion if you have the cash to pay taxes on the money you’re transferring. Never take money from your retirement savings to cover the taxes on a Roth conversion. You’re only robbing your future self.

Also, don’t feel like you have to convert all your traditional retirement funds at once. You could convert some this year—whatever amount fits your budget—and convert the rest later.

You’re completely out of debt (including your mortgage).

If you don’t have any debt whatsoever—no credit cards, no student loans and no mortgage—congrats! That means you’re on Baby Step 7, and you’re probably in a position to make progress on your retirement goals—including a Roth conversion.    

When you're not sending hundreds or even thousands of dollars to a bank or mortgage lender every month, you have more room in your budget. That makes it easier to cash flow or set aside the money you need to cover a potentially large tax bill after a Roth conversion.

No matter where you stand financially, a Roth conversion is a financial move that could have a serious impact on your tax situation and investing strategy. You might want to talk to a financial advisor before you get started.

Roth Conversion Rules: What You Need to Know

If you decide to do a Roth conversion, guess what? You’ve got to follow the rules. (Boo.) If you don’t, you could end up getting penalized by the IRS. (Double boo.)

Direct Transfers vs. Indirect Transfers

There are basically two ways to transfer money from a traditional account to a Roth account: You can do a direct transfer or an indirect transfer. The differences are very important, so let’s take a closer look.

In a direct transfer (or trustee-to-trustee transfer), the financial institution that holds your traditional retirement account transfers the money directly to your Roth account. It’s the simplest, least risky way to do a Roth conversion (and the only way we recommend).

An indirect transfer complicates things—a lot. If you choose this method, you’ll get a check for the funds you’re transferring out of your traditional account. The idea is that you’ll deposit the money into a Roth account yourself.

But the IRS has a rule for that (because of course they do). Once that check is cut, the clock starts ticking, and you have 60 days to deposit it into your Roth account. If you don’t, you’ll pay a penalty on top of the taxes you already owe for conversion in the first place.³

What’s the lesson here? Keep things simple with a direct transfer.

Income Limits and Conversion Limits

There’s no limit on how much money you can convert from a traditional retirement account to a Roth IRA in a single year. It also doesn’t matter what your income or tax filing status is—anybody can do a Roth conversion.

And here’s more good news: There are no limits on how many Roth conversions you can do in a year. Whether you want to convert all your traditional accounts in one large transfer or break them up into multiple Roth conversions throughout the year, you’re good to go either way.  

How to Do a Roth Conversion

Now let’s walk you through how to do a Roth conversion. It’s summed up in three simple steps.

1. Do the math.

When you open a Roth IRA, the money has to stay in there for at least five years (the IRS calls this the five-year rule). Break that rule, and you could owe penalties and taxes on what you withdraw.

While we’re on the subject, we always recommend you use cash to pay the taxes on what you convert. Also—and you probably saw this coming, since it’s us—it’s best if you’re debt-free and have a fully funded emergency fund before you begin investing in the first place.

 

2. Do the paperwork.

Get in touch with your plan administrator or the financial institution that handles your traditional retirement account and let them know you want to do a Roth conversion. They’ll tell you what forms you need to fill out and even help you complete them (if you’re nice).

Just be prepared to give them all the information they need to process the conversion—including account details, the amount you want to convert, and any relevant personal information.

Once you submit your forms and give the thumbs-up, keep track of the conversion and make sure it’s completed successfully. Then get confirmation from the financial institution managing your account that the funds have been transferred to your Roth account.

3. Pay your taxes (with cash).

The last step is the most painful—giving Uncle Sam what you owe him. Never withhold taxes from the amount you’re converting to a Roth (the IRS will treat it as a withdrawal and tax the crud out of it). And never borrow from any retirement account to cover a tax bill! You can simply pay the taxes on your Roth conversion when you file your return in the spring.

Is a Roth Conversion Right for You?

Hey—how about an example?

Let’s say you’re 30 years old, you have $50,000 sitting in a traditional retirement account and you’re trying to decide whether to convert it to a Roth IRA or leave it alone.

If you're in the 24% tax bracket (and to keep things simple, converting the full amount doesn't bump you higher) you'd be looking at a $12,000 tax bill if you transfer that $50,000 to a Roth IRA all at once. That’s a pretty big hit.

The flip side to that bummer is that once you settle with Uncle Sam, your $50,000 can grow tax-free inside your Roth IRA—you won’t pay taxes on one bit of that growth when you take it out in retirement. But how much growth are we talking about?

The stock market’s historical average annual rate of return is 10–12%.⁴ If you converted now and didn’t invest a single dollar more, your $50,000 could grow to more than $1.3 million over the next 30 years—with zero taxes.

To Convert or Not To Convert?

Convert to a Roth IRA	Leave Money in a Traditional IRA
Age 30	Age 30
Roth IRA balance: $50,000	Traditional IRA balance: $50,000
Taxes owed for Roth conversion (paid in cash): $12,000	Taxes paid on contributions: $0
Age 30–60	Age 30–60
Investments grow tax-free for 30 years at 11% average annual return	Investments grow tax-deferred for 30 years at 11% average annual return
Age 60	Age 60
Roth IRA balance: $1.33M	Traditional IRA balance: $1.33M
Withdraw $50,000/year for retirement	Withdraw $50,000/year for retirement
No taxes owed on investment growth	Taxes owed on all contributions and growth
Age 60–85	Age 60–85
Total withdrawals: $1.25M	Total withdrawals: $1.25M
Total taxes owed: $0	Total taxes owed: $181,250

Now, if you choose to leave that $50,000 parked right where it is in your traditional account instead, you’d owe taxes not just on the $50,000 but also on every bit of compound interest growth when you withdraw it. What’s that look like?

Well, if you retired at age 60 and withdrew $50,000 a year for 25 years—and all that money came out of your traditional retirement account—you might end up paying around $181,250 in taxes (and that’s based on the average income tax rate of 14.5%)!⁵

In this super simple example, you get to choose between paying $12,000 now or paying $181,250 later.

And while that may seem like a decision that pretty much makes itself, you don’t want to guess your way through a Roth conversion. Think long term. Run the numbers. And if you’re unsure what you should do, sit down with a financial advisor. They can help you map it out.

 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.