Free for 90 days: Sign up now and get 90 days managed free after your first deposit. See offer details

<title>Dismiss</title>
IRA Management

Roth IRA Rules: Smart Ways to Minimize Taxes on a Conversion

Roth IRA rules can appear limiting on first glance—but you may be able to fund a Roth by rolling over funds from another account.

Articles by Alex Benke, CFP®

By Alex Benke, CFP®
VP of Advice and Investing, Betterment  |  Published: November 15, 2018

Even if you are not able to contribute directly to a Roth IRA because your income is too high, you may be able to rollover funds from a 401(k) or traditional IRA.

Plan ahead to use the times in life where you have a lower income to do the conversion—and minimize your tax bill.

Roth IRA rules can appear limiting on first glance—but you may be able to fund a Roth by converting funds from another IRA.

Say you want to fund a Roth IRA to take advantage of those tax-free withdrawals in retirement, but your income is too high (over $135,000 if you’re single and $199,000 if you’re married filing jointly for 2018, and over $137,000 if you’re single and $203,000 if you’re married filing jointly for 2019).

The good news: Roth IRA rules allow you to get around this restriction if you convert funds from a traditional IRA to a Roth.

There are no income limits for converting to a Roth, and no limit on the amount you can convert. If your traditional IRA is already at Betterment, the conversion just takes a couple clicks.

The not-so-good news: In most cases, when you convert funds from a tax-deferred account to a Roth, it’s considered a taxable event, meaning you may owe taxes on some or all of the amount converted.

How can you minimize the tax hit?

One strategy that could enable you to take advantage of a Roth, but not get hit with a super high tax bill, is to do what’s known as a backdoor Roth conversion—the how-to is detailed below—or plan ahead and take advantage of upcoming life or career changes that could nudge you into a lower tax bracket.

Here’s how to make that Roth conversion happen.

Note: Betterment is not a tax advisor, nor should any information in this article be considered tax advice. You should contact a tax professional to discuss your specific situation.

High Earners Go for Roth IRAs

If a Roth conversion sounds appealing, you’re in good company. Roth IRAs suit many high-income earners because they want a way to help minimize taxes in retirement—and unlike distributions from a traditional IRA, Roth funds are withdrawn tax-free if they meet basic requirements.

Indeed, when the IRS removed the income limit on Roth conversions in 2010, the number of conversions “increased over 800%, to $64.8 billion,” according to a January 2014 IRS report. It was the first time conversions exceeded contributions. And 57% of the conversions were from people with six-figure incomes.

With the income barrier removed, the big question now is the taxes: What’s the best way to minimize the amount you have to pay when you convert?

The Backdoor Roth

The so-called backdoor Roth is one way one can avoid a big tax bill when you earn more than the income limit for a Roth.

In that case, if you’re also covered by an employer retirement plan like a 401(k), you likely wouldn’t be able to fund a deductible IRA, because of IRS rules. But you could contribute to a nondeductible IRA, and then convert to a Roth.

When you contribute to a nondeductible IRA, you’re effectively depositing after-tax dollars, so you’d only owe tax on the earnings when you withdraw (or convert). If you convert to the Roth soon after, any earnings, and therefore taxes, are likely to be minimal.

This method is most beneficial tax-wise if you don’t have other deducted IRA funds, including those previously rolled out of a 401(k). If you do, then the portion that you convert to the Roth has to be prorated over the total amount you have in all your traditional IRAs. This is an important point that often surprises IRA converters at tax time.

As you can see in this Roth conversion example, if you have $15,000 in traditional IRAs for which you’ve received a deduction, and want to deposit $5,000 into a nondeductible IRA and convert it to a Roth, you would divide $5,000 by $20,000 (the total value of all IRAs) to get the amount you can convert tax-free, which is 25%. So you’d owe tax on the other $3,750 based on your current tax bracket.

If you have an employer plan that allows you to “roll in” funds from IRAs, you can avoid the taxes on conversion by first moving any previously deducted IRA balances into your employer plan. You’d do this first, before any conversions.

So to review, execute a backdoor Roth conversion with these three steps:

  1. Minimize pre-tax IRA account balances by rolling them into your employer plan, if possible.
  2. Make a current year traditional IRA contribution, and don’t deduct it on your taxes (also report on Form 8606).
  3. Execute a Roth conversion of the contributed amount

Carpé Career Change

Another way to help minimize taxes is to plan ahead, if you can, when you know that a career or life change is coming that will push you into a lower tax bracket. Then, when you convert from a traditional IRA to a Roth, the tax you’d owe would be based on that lower bracket.

Consider these major life events:

  • Going to graduate school
  • Making a career change that lands you in a lower-paying (but perhaps more rewarding) line of work
  • A planned or unplanned period of unemployment.
  • Starting your own business

In each case, you can and should continue to save in tax-deferred accounts prior to making the conversion. Then, when the life transition is underway, you can strategize about the amounts you plan to convert and when, depending on your new tax bracket.

Bear in mind that the amount you convert is considered income, so you want to make sure that amount doesn’t bump you up into a higher tax bracket. Again, this example is only an illustration; individual specifics could change the numbers.

The greater point is that converting to a Roth may be highly desirable from a tax perspective down the road—so understand the Roth IRA rules and don’t let the tax bill today stand in your way.

We recognize that many investors are interested in this technique, so we’ve created a quick process that allows an investor to authorize a Roth conversion online in less than a minute. Betterment also supports hassle-free IRA rollovers.

This article is intended for educational purposes only. The information provided is educational in nature, and is not intended to be relied upon as financial or tax advice. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.

When deciding whether to roll over a retirement account, you should carefully consider your personal situation and preferences. The information on this page is being provided for general informational purposes and is not intended to be an individualized recommendation that you take any particular action.

Factors that you should consider in evaluating a potential rollover include: available investment options, fees and expenses, services, withdrawal penalties, protections from creditors and legal judgments, required minimum distributions, and treatment of employer stock. Before deciding to roll over, you should research the details of your current retirement account and consult tax and other advisors with any questions about your personal situation.

Recommended Content

View All Resources
Our Team of Experts

Our Team of Experts

Our executive investing committee includes experts from a range of backgrounds. We make strategic decisions based on a systematic, evidence-based approach.

Roth IRA Rules: Smart Ways to Minimize Taxes on a Conversion

Roth IRA Rules: Smart Ways to Minimize Taxes on a Conversion

Roth IRA rules can appear limiting on first glance—but you may be able to fund a Roth by rolling over funds from another account.

How would you like to get started?

Your first step toward a smarter investing future starts here.

Create a Betterment account

Go ahead and join the smart, modern way to invest.

See what we can do for you

Tell us a bit about yourself, and we'll show you the benefits of investing with us.

Get a free investing checkup

Help us get a sense of your investing approach and see how you could improve.

Transfer a 401(k) or an IRA

Move an existing retirement account into a Betterment IRA.

Download the mobile app

Enjoy the Betterment experience anywhere on the go.

<title>Close</title>

Search our site

For more information and disclosures about the Betterment Resource Center, click here. | See our contributors.