Earn too much for a Roth IRA? You can still score tax-free retirement income with this strategy.

With a Roth IRA conversion, you roll funds from a traditional IRA or 401(k) into a Roth IRA. You’ll need to pay the tax bill on the money you convert, and your converted funds continue growing tax-free until you take withdrawals in retirement.

However, this strategy has some rules and processes you should familiarize yourself with before making the conversion leap. From there, you can choose the path that makes the most sense for your finances.  

What is a Roth IRA conversion?

A Roth IRA conversion is the act of moving retirement assets from a traditional IRA or 401(k) into a Roth IRA. When you move the funds, you’ll pay income tax on the amount you convert since contributions to a traditional IRA or 401(k) are made with pre-tax money. By paying that tax bill today, you’ll get to make tax-free qualified withdrawals in retirement (providing you meet certain rules).

A Roth IRA conversion can be advantageous for high-earners who don’t qualify to contribute to a Roth IRA. Those with significant balances in their traditional IRAs and 401(k) could be looking at hefty tax bills on their retirement income as they enter their second act.

“A lot of people that are about to retire are doing so with massive tax liabilities as part of their balance sheet,” says Patrick Rogers, a CFP and financial planner with SmartPro Financial in Greenville, SC. “With a Roth IRA conversion, you get the benefit of being able to create a tax-free legacy or create more freedom and flexibility around what you do down the road by avoiding additional taxes.”

3 ways to do a Roth IRA conversion

If you decide that a 401(k) or traditional IRA to Roth conversion might be helpful for your retirement income goals, you have three ways to make it happen: an indirect rollover, direct rollover, or same-trustee transfer. 

Indirect rollover

One way to do a traditional IRA to Roth conversion is through an indirect rollover. In this case, your traditional IRA or 401(k) provider writes you a check for the amount you want to convert. From that point, you have 60 days to deposit that amount into your Roth IRA. If you miss that 60-day deadline, the entire amount could be taxed and subject to a 10% penalty. Yikes.

One major downside of this approach is that your current custodian may withhold taxes from the distribution. For instance, 401(k) providers must withhold 20% of an indirect rollover distribution due to IRS regulations. Your traditional IRA custodian will withhold 10% of your rollover amount for taxes unless you opt out or choose a different withholding amount. However, you are still responsible for depositing the entire amount into your Roth IRA, so the withheld money must come from another source.

For example, if you have $50,000 in your Traditional IRA and choose an indirect rollover, your custodian will withhold 10% ($5,000) and send you a check for $45,000. Then, you’ll need to come up with an additional $5,000 to complete the rollover deposit so that you can deposit the entire $50,000 into your new Roth IRA. If you only deposit $45,000 in your new Roth IRA, the missing $5,000 will count as taxable income and could be subject to early withdrawal penalties.

Direct rollover

A direct rollover avoids the primary complications of an indirect rollover. When you do a 401(k) or traditional IRA to Roth conversion via a direct rollover, your current custodian won’t withhold taxes from the rollover amount. Instead, your current custodian makes the rollover check payable to your Roth IRA custodian, and the funds never touch your hands. Therefore, you don’t have to navigate the 60-day rule or worry about coming up with cash to make up for taxes withheld.

You can do a direct rollover one of two ways:

1. Your previous IRA or 401(k) provider can send the money directly to your new Roth IRA provider.
2. Your previous IRA or 401(k) provider can send you a check made out to your new Roth IRA provider. You must then send that check to your new Roth IRA provider.

The first option is more straightforward, but some custodians might not offer this path. If you’re curious about which rollover paths are available, call your current custodian’s customer service department, and they can walk you through your options.

Same-trustee transfer

The simplest way to execute a Roth IRA conversion is when your retirement accounts are at the same financial institution or custodian. For instance, if your traditional IRA is with Fidelity and you want to use a Fidelity Roth IRA for the conversion, that’s a same-trustee transfer. You can typically complete this process in a few steps through your provider’s online interface.

If you’re converting traditional 401(k) funds to a Roth IRA, you might want to first roll those funds over into a traditional IRA.

“I typically recommend doing the [Roth IRA] conversion once the money has already been transferred to a traditional IRA with the custodian,” says Brett Polzin, CFP, Founder of Eight Peaks Wealth Management in Parker, Colorado. “I just think it’s cleaner from a tax reporting standpoint to have everything converted at [a single] firm.”

Roth IRA conversion rules

Choosing how to complete your Roth IRA conversion is only one step towards tax-free retirement income. You’ll also need to ensure that—during and after the conversion—you follow the five-year rule and know your tax obligations.

The 5-year rule

If you’re under age 59 ½, you’ll need to wait five years before you can withdraw the converted amount from your Roth IRA without penalty—this is an IRS regulation, not an arbitrary rule. For instance, if you convert  $20,000 in a Roth IRA conversion in 2023, you’ll have to wait until 2028 before withdrawing that money penalty-free.

Each conversion has its own five-year clock. Therefore, if you’re executing multiple conversions across multiple years, you’ll need to track when each conversion hits its penalty-free withdrawal date.

This rule doesn’t apply if you are already age 59 ½ since the 10% early withdrawal penalty is waived for all distributions at that point.

Taxes and Roth IRA conversions 

Any pre-tax money in your traditional IRA is taxed upon conversion to a Roth IRA. This typically means the entire conversion amount is taxed since traditional IRAs are usually funded with pre-tax dollars. The exception would be if you have made nondeductible IRA contributions. In that case, the amount attributable to nondeductible contributions wouldn’t be subject to taxes.

The 10% early withdrawal penalty doesn’t apply to Roth conversions, even if you are under the age of 59 ½.

Roth IRA conversion limits 

Here’s the good news: Roth IRA conversions don’t have limits. You can convert any amount at any time, regardless of age or income—so long as you can pay the tax bill. 

However, you don’t have to convert your entire pre-tax balance all at once. To better manage taxes, you can convert a bit at a time over multiple years. Doing so lets you plan for the tax bill on each conversion and avoid the larger bill that might accompany converting all your traditional assets at once. Rogers says that a scheduled strategy also gives you room to take advantage of favorable tax bracket and income tax rate changes should they come along.  

Should you do a Roth IRA conversion?

A Roth IRA conversion can be a great way to secure tax-free income in retirement, especially if you don’t have access to a Roth 401(k) and make too much to contribute directly to a Roth IRA. But there’s a price for that tax-free income; in some cases, the cost may be more than it’s worth.

“Roth conversions are not one-size-fits-all, and there’s probably never going to be a perfect analysis,” says Polzin. “Every situation is different, so it’s essential to consider your individual financial situation, your tax bracket, and your long-term goals before making any decisions.”

When a 401(k) or traditional IRA to Roth conversion makes sense

Converting your Traditional IRA or 401(k) to a Roth IRA could be a smart move in any of the following situations:

• You are in a relatively low tax bracket. If you expect your tax bracket to be higher in retirement or are temporarily earning less than usual, converting to a Roth IRA and taking the tax hit now could make sense.
• You want tax-free money in retirement. A Roth IRA conversion may be your best(or the only) avenue for getting money into a Roth account and ensuring you have some tax-free income during retirement.
• Avoid RMDs. Unlike 401(k)s and traditional IRAs, Roth IRAs are not subject to required minimum distributions (RMDs).
• Tax diversification. A Roth IRA conversion with some of your retirement assets can help manage taxes in retirement by giving you the choice of tax-free or taxable income—or a blend of both. 
• The stock market is down. If a Roth conversion is already part of your plan, a temporary dip in the stock market could allow you to convert the same number of holdings at a lower price and, therefore, a lower tax cost.
• You plan to move. If you currently live in a state with no income tax and plan to move to a state with income tax in retirement, converting now could help you avoid that state income tax hit.

When a 401(k) or traditional IRA to Roth conversion doesn’t make sense

If any of the conditions below apply to you, a Roth IRA conversion may not be your best bet at present:

• You’re in a relatively high tax bracket. If you’re already in one of the top tax brackets, today’s tax cost may outweigh the tax-free withdrawals later.
• You have significant Roth assets. If you already have significant assets in a Roth IRA or 401(k), converting more may not benefit much.
• You can’t pay the tax bill. If you would have to pay the taxes on the conversion out of retirement assets, you could lose most or all of the Roth conversion benefit.
• You’ll need the money within five years. If you are under age 59 ½, you must wait five years before accessing the money you converted without penalty.
• You’re charitably inclined. Once you reach age 70 ½, you can make tax-free contributions to eligible charities of up to $100,000 per year from your traditional IRA assets.
• You’re unsure if it’s the right move. You can’t reverse a Roth conversion, so you’ll need to be sure this is the best move. 

The takeaway

Roth IRA conversions can help those without traditional access to Roth IRAs and 401(k)s build up a stash of tax-free retirement income. You could also consider a backdoor Roth IRA if you’re a high earner with significant after-tax contributions to your 401(k).

Whichever conversion strategy you choose, you’ll likely want to consult a tax advisor, certified financial planner, or other financial advisor before converting your funds. Doing so can help you understand the tax implications and avoid unnecessary taxes and penalties in the conversion process.