Traditional IRA to Roth IRA: Tax traps and opportunities

The Individual Retirement Account (IRA) is a cornerstone of retirement planning in the United States. Among the strategic choices available to savers, there is growing interest in converting a Traditional IRA to a Roth (or Roth conversion). 

This move transforms tax-deferred retirement savings into tax-free growth assets. But beware: there are immediate tax consequences to such a decision, and it’s imperative to understand them before taking the plunge.

From Traditional IRA to Roth IRA: Understanding the basics

A Traditional IRA allows you to make tax-deductible contributions, but imposes income tax on subsequent withdrawals. Conversely, a Roth IRA works with after-tax dollars: you pay taxes at the time of contribution or conversion, but withdraw your funds tax-free at retirement, under certain conditions.

A Roth conversion involves transferring all or part of a Traditional IRA to a Roth IRA. In return, you pay tax immediately on the converted amount, as if you had withdrawn it.

Tax implications: A hefty bill to be anticipated

When you make an IRA conversion, the amount transferred is added to your taxable income for the year. 

This can push you over a higher tax bracket, increasing not only your federal taxes, but also your Medicare premiums, state taxes and even the taxable portion of your Social Security.

For example, if you convert $30,000 while in a 22% marginal bracket, you’ll owe $6,600 in federal taxes, not including other tax charges. If part of this conversion puts you in the 24% bracket, the bill climbs even higher.

So it’s often a good idea to spread conversions over several years, to avoid bracket creep and smooth out the tax burden.

Advantages of a Roth conversion

Despite the short-term tax implications, a Roth conversion offers some long-term advantages:

• Tax-free growth and withdrawals: As long as you meet the five-year rule and are over age 59 and a half, your withdrawals (principal + gains) are tax-free.
• No Required Minimum Distributions (RMDs): Unlike Traditional IRAs, the Roth does not impose RMDs after age 73 or 75, offering greater flexibility.
• Beneficial inheritance: Your heirs can withdraw the money without paying federal income tax, under certain conditions.
• Tax diversification: Having both a Traditional IRA and a Roth allows you to better control your taxes in retirement, depending on your needs.

Beware the five-year rule

A little-known trap: every Roth conversion starts a “five-year period”. If you withdraw the converted money within this period, you risk a 10% penalty, with some exceptions.

This rule applies regardless of your age, even if you’ve already had a Roth open for a long time.

Mistakes to avoid

• Paying taxes with the IRA itself: If you use the converted money to pay taxes, you diminish your retirement capital, and if you’re under 59 years and a half, you also incur the 10% penalty.
• Ignore the pro rata rule: If you have both deductible and non-deductible contributions in your IRAs, the IRS imposes a proportional (pro rata) calculation on any conversion. You cannot choose to convert only the non-taxable portion.
• Converting too much at once: This can explode your taxable income, jeopardize certain tax credits, and affect your Medicare premiums or the taxation of your Social Security benefits.

When is conversion relevant?

Here are a few cases where the Roth conversion may make sense:

• You anticipate an increase in your tax rate in retirement (for example, if you have little income today, or if you believe taxes will rise in the future).
• Your investments have fallen: converting during a market downturn allows you to transfer more units for less tax.
• You’re young or far from retirement: the longer the money stays invested in the Roth, the greater the tax gain.
• You don’t need RMDs and want to optimize your children’s inheritance.

When avoid conversion?

• If you’re going to need the money in less than five years, it’s best not to convert.
• If you’re in a high tax bracket today, but anticipate a drop when you retire.
• If you don’t have the non-IRA cash to pay the taxes due on conversion.

How to convert a Traditional IRA to a Roth?

The simplest and safest method is a direct transfer between institutions (trustee-to-trustee). You can also request a transfer between accounts in the same bank, or proceed by check within 60 days, which is more risky.

Don’t forget to complete form 8606 with your tax return to notify the IRS of the conversion.

A strategic tool, but not universal

Roth conversion is a powerful tool for retirement planning, but it requires personalized analysis. It’s not an “all or nothing” decision: you can convert in stages, choosing amounts according to your tax brackets, future needs and wealth objectives.

Before making any decisions, it’s best to consult a tax advisor or financial planner. The wrong conversion can be costly. The right strategy, on the other hand, can optimize your retirement income and reduce your tax burden for decades to come.