What are common mistakes to avoid with IRA conversions?
A Roth IRA and a Traditional IRA share the same basic mission, helping you save for retirement, but they take two very different paths to get there. Understanding the tax treatment, eligibility, and withdrawal rules of each can make a real difference in your long-term strategy.
Let’s start with taxes. With a Traditional IRA, contributions may be tax-deductible in the year they’re made. This can lower your current taxable income. However, the IRS taxes all retirement withdrawals as ordinary income. In contrast, you make Roth IRA contributions with after-tax dollars. There’s no deduction now, but qualified withdrawals, including earnings, are entirely tax-free. That’s the central difference in the conversation between the Roth IRA and the Traditional IRA. You’re choosing whether to pay taxes now or later.
The benefit Roth IRA accounts provide is evident if you think your tax rate will be higher in retirement. Pay now, skip taxes later. Traditional IRAs work better if you expect to be in a lower tax bracket later, allowing you to take a deduction when your income is higher and pay taxes at a lower rate during retirement.
Next is eligibility. For 2025, anyone with earned income, which includes wages, salaries, tips, and other taxable employee compensation, can contribute to a Traditional IRA, though the deductibility phases out at higher incomes if you or your spouse has a workplace retirement plan. Roth IRAs come with income caps: single filers making more than $165,000 and joint filers making more than $246,000 cannot contribute directly.
Both account types have the same contribution limits: $7,000 annually (or $8,000 if you’re 50 or older). But remember, you can’t contribute more than you earn.
Withdrawal rules are another key difference. With a Traditional IRA, withdrawals before age 59½ are taxed and usually penalized an extra 10%. You must also begin taking required minimum distributions (RMDs) at age 73. Roth IRAs don’t have RMDs during the account holder’s lifetime, which makes them attractive for estate planning or simply for those who prefer to let investments grow untouched.
As for taxes on Roth IRA accounts, the rules are more lenient. You can withdraw contributions at any time without taxes or penalties. Once you’re 59½ and the account has been open for at least five years, you can also withdraw tax-free. That flexibility can be beneficial. However, withdrawals of earnings can be subject to income tax and a 10% penalty if both the age requirement and 5-year holding period have not been met.
To recap:
The Roth IRA vs Traditional IRA debate isn’t one-size-fits-all. It comes down to your current income, expected future tax rate, and when you want (or need) access to your funds. If you value flexibility, tax-free withdrawals, and no RMDs, the benefits Roth IRA accounts offer could make them the better fit. If you would rather save taxes now and expect lower rates in the future, then a traditional IRA might make sense for you.
What is Roth IRA Conversion?
A Roth IRA conversion is the process of moving assets from a traditional IRA, SEP IRA, SIMPLE IRA, or eligible employer plan into a Roth IRA so the funds can grow tax free and be withdrawn tax free in retirement. Unlike traditional IRAs, Roth IRAs are funded with after tax dollars, meaning income taxes are paid at the time of conversion. Once inside the Roth IRA, future qualified withdrawals including earnings are free from federal income tax as long as the five year rule and age or exception requirements are met.
This strategy is often used for long term planning because Roth IRAs are not subject to required minimum distributions (RMDs), providing increased flexibility in retirement planning. For individuals expecting to be in a higher tax bracket in the future, converting now and paying taxes at today’s rate may provide significant long term benefits, especially given scheduled tax law changes introduced under Trump’s One Big Beautiful Bill.
Understanding how do Roth conversions work starts with knowing the available transfer methods allowed under IRS rules. Conversions can be executed in three main ways:
1. Direct Rollover
Funds move directly from an employer plan (such as a 401(k)) into a Roth IRA. The administrator transfers assets to the Roth account or issues a check payable to the new custodian. This option minimizes risk of errors and avoids mandatory withholding.
2. Trustee-to-Trustee Transfer
This occurs when the financial institution holding the traditional IRA sends assets directly to the institution holding the Roth IRA. Because the transfer bypasses the account owner, the IRS treats it as the cleanest, safest method.
3. 60-Day Rollover
Funds are distributed to the individual, who must deposit the amount into a Roth IRA within 60 days. If the deadline is missed, the distribution becomes taxable income and may incur penalties. These rollovers also require 10 percent mandatory withholding, meaning the owner must supply the withheld amount from other resources to convert the full balance.
Conversions may be completed all at once or spread over multiple years. Phasing conversions strategically allows taxpayers to stay within preferred tax brackets and avoid pushing taxable income into higher marginal rates.
When converting to Roth IRA, the amount moved is treated as ordinary income for the year of conversion. The taxable amount generally equals pre tax contributions and earnings. Taxpayers with after tax contributions in their IRAs must calculate the basis of conversions Roth IRA using the pro rata rule to determine what portion of the conversion is taxable.
Since conversions raise adjusted gross income, they may create secondary tax effects that should be considered. These include potential increases in Medicare IRMAA premiums, taxation of Social Security benefits, the loss of certain deductions or credits, and impacts to eligibility for ACA premium subsidies. Careful modeling helps avoid unexpected tax costs.
For many individuals, timing conversions during low income years can significantly reduce the tax burden. Others prefer phased conversions before scheduled tax law changes. These strategies are often used for Tax Planning for Retirees who want predictable long term tax treatment and greater control over taxable income.
Several situations make a conversion especially beneficial:
1. Years With Lower Taxable Income
Converting during a year with unusually low income helps reduce the overall tax bill. This is often true early in retirement, during career transitions, business downturns, or years with significant deductible events.
2. Expectation of Higher Future Tax Rates
If you expect your tax bracket to increase or anticipate federal tax increases, paying taxes now may be more favorable than paying higher taxes later.
3. Large Traditional IRA Balances
If traditional IRA balances are high, RMDs may push future income into higher tax brackets. Conversions help manage future taxable income and reduce the impact of RMDs.
4. Estate Planning Benefits
Roth IRAs provide tax free distributions to beneficiaries and are not subject to lifetime RMDs. This allows more assets to remain invested for a longer period and may increase the value passed to heirs.
5. Tax Diversification
Balancing tax deferred and tax free accounts offers flexibility when comparing Roth IRA vs. Traditional Retirement Accounts. This can improve the management of taxable income throughout retirement.
Conversions may not be ideal when an individual needs the money soon, does not have cash to cover the conversion tax, or intends to use Qualified Charitable Distributions which benefit from remaining tax deferred balances. Since the rules on conversion vs recharacterization IRA changed in 2018, recharacterizations are no longer allowed, making conversions permanent decisions that must be carefully evaluated.
The primary benefit is the ability to create tax free income in retirement. Roth IRAs grow tax free and qualified withdrawals do not generate taxable income, which can reduce future tax burdens and support long term wealth planning. They also do not require RMDs, giving retirees more control over how and when they create taxable income.
Converted funds are taxed as ordinary income in the year of conversion. The taxable portion depends on how much of the IRA consists of pre tax contributions and earnings. After tax contributions reduce the taxable amount based on the pro rata rule. Some states also tax conversions at the state income tax level.
There are no income limits for conversions. While direct Roth IRA contributions are restricted for high earners, conversions are permitted at any income level. This allows high earning taxpayers to use a backdoor Roth strategy to obtain long term tax free growth.
No. Since 2018, Roth conversions are irrevocable. Once converted, funds cannot be moved back into a traditional IRA. Because of this, taxpayers should carefully evaluate the expected tax cost before completing the conversion.
Ideal times include low income years, years before RMDs begin, or when future tax rate increases are expected. Conversions may also make sense when business losses, reduced income, or unusual tax events lower taxable income, creating an opportunity to convert at a reduced tax rate.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Ben Bowers, partner in charge of Bennett Thrasher’s Personal Financial Services practice, or call us at 770.396.2200.
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