Roth Conversions Explained: Taxes, Five-Year Rules and the Backdoor Roth

A Roth conversion moves money from a pre-tax retirement account, such as a traditional IRA or a traditional 401(k), into a Roth account. You pay ordinary income tax on the pre-tax amount you convert in the year of the conversion, and in return the money can grow and later be withdrawn tax-free under the Roth rules. It is a trade: a known tax bill today against an uncertain tax bill later.

Conversions are also the engine behind the backdoor Roth, the route higher earners use to get money into a Roth IRA when their income is too high to contribute directly. Both depend on the same handful of rules, and the details decide whether a conversion is efficient or expensive.

If you need a refresher on how traditional and Roth accounts differ in the first place, FC Markets covers that in 401(k) vs. IRA vs. Roth IRA.

How a conversion is taxed

The amount you convert is added to your taxable income for the year, as if you had earned it. That has three consequences:

• It is taxed at your marginal rate. A large conversion can push part of your income into a higher bracket. Many people convert in slices over several years to fill up a lower bracket rather than jumping into a higher one.
• No 10% additional tax on the conversion itself. Converting before age 59½ is not treated as an early withdrawal, as long as the full amount lands in the Roth account.
• Withholding is a trap. If you ask the custodian to withhold tax from the converted amount, the withheld money never reaches the Roth. It counts as a distribution and, if you are under 59½, may face the 10% additional tax. Paying the tax from cash outside the retirement account keeps the whole conversion working for you.

Only pre-tax money is taxed. If part of your IRA balance came from nondeductible (after-tax) contributions, that part has already been taxed and converts tax-free. How much of each conversion counts as after-tax is governed by the pro-rata rule, below.

The calendar: December 31, not April 15

Roth IRA contributions for a tax year can be made up to the tax-filing deadline the following spring. Conversions are different: a conversion counts in the calendar year it is completed. To have a conversion fall in a given tax year, the money has to move by December 31, and custodians can get busy in the last weeks of the year.

Two more timing points:

• No undo button. Since 2018, a conversion can no longer be recharacterized back to a traditional IRA. If markets fall after you convert, you still owe tax on the amount converted.
• RMDs come first. If you are subject to required minimum distributions, the RMD for the year cannot itself be converted; it must be taken out before converting additional money. FC Markets explains the RMD mechanics in Required Minimum Distributions Explained.

The two five-year rules

Roth accounts have two separate five-year clocks, and they are easy to confuse.

Withdrawals from a Roth IRA follow an ordering rule: your regular contributions come out first, then converted amounts (oldest first), then earnings. Because contributions come out first and tax-free, many people never touch converted money or earnings early. But if you plan to rely on converted funds before 59½, the per-conversion clock matters. After 59½, the conversion clock no longer carries a penalty.

The backdoor Roth

Direct Roth IRA contributions phase out above income thresholds the IRS publishes each year. There is no income limit on conversions, and anyone with earned income can make a nondeductible contribution to a traditional IRA. Put together, the backdoor Roth works like this:

1. Contribute to a traditional IRA and do not deduct it, so the contribution is after-tax money.
2. Convert that balance to a Roth IRA, often shortly afterward so little or no investment growth has built up.
3. Report the nondeductible contribution and the conversion on Form 8606 with your tax return.

If the after-tax contribution is the only money in any of your traditional IRAs, the conversion is mostly tax-free, with tax due only on any small gain before converting.

The pro-rata rule: the catch

The IRS does not let you choose to convert only after-tax dollars. For the tax calculation, it treats all of your traditional, SEP and SIMPLE IRA balances as one pot, measured as of December 31 of the conversion year, and every conversion is deemed to contain the same ratio of pre-tax and after-tax money as that pot.

A simple illustration with round, hypothetical numbers: suppose you make a nondeductible contribution and also hold a rollover IRA from an old job that is entirely pre-tax and nine times larger. Roughly 90% of anything you convert is treated as pre-tax and taxable, no matter which account the money physically leaves.

Ways people deal with it:

• Roll pre-tax IRA money into a workplace plan. Balances in a 401(k), 403(b) or governmental 457(b) are not part of the pro-rata pot. Many employer plans accept incoming rollovers; check yours before relying on this.
• Convert everything and accept the tax bill, sometimes spread over several years.
• Skip the backdoor if neither option is practical.

Because the measurement date is December 31, a rollover or other IRA activity late in the year can change the outcome of a conversion made earlier in the year.

Conversions inside a 401(k)

Many workplace plans allow in-plan Roth conversions (sometimes called in-plan Roth rollovers), moving pre-tax 401(k) money into the plan's Roth account. The tax treatment is similar: the converted pre-tax amount is taxable income for the year.

Some plans also accept after-tax (non-Roth) contributions above the regular employee deferral limit and let participants convert them to Roth, a strategy often called the mega backdoor Roth. It only works if the plan permits both after-tax contributions and in-plan conversions or in-service withdrawals, so it depends entirely on your plan document.

Costs that do not show up on the conversion form

Because a conversion raises your income for the year, it can ripple through other parts of the tax code:

• Medicare premiums. Higher-income Medicare enrollees pay income-related monthly adjustment amounts (IRMAA) on Parts B and D, generally based on income from two years earlier. A conversion at 63 can affect premiums at 65.
• Social Security taxation. Extra income can increase how much of your Social Security benefit is taxable.
• Marketplace health coverage. For people buying coverage through HealthCare.gov or a state exchange, higher income can reduce premium tax credits.
• Capital gains and other thresholds. Added ordinary income can push long-term gains and qualified dividends into a higher rate band or bring in the net investment income tax.
• State income tax, which varies widely; moving between states can change the math.

When conversions are commonly considered

There is no universally right answer, but conversions tend to be discussed in a few situations:

• Low-income years, such as a gap between jobs, early retirement before Social Security and RMDs begin, or a year with large deductions.
• Expectations of higher future tax rates, whether from rising income, future RMDs or possible legislative changes.
• After a market decline, when the same tax bill moves more shares into the Roth (though there is no way to know the decline is over).
• Estate considerations, since heirs generally receive Roth money income-tax-free, although most non-spouse beneficiaries still have to empty inherited accounts within ten years.

Conversions are generally less attractive when you expect a meaningfully lower tax rate in retirement, when the tax would have to be paid out of the retirement account itself, or when the added income would cost you a valuable credit or benefit.

A practical checklist

Before converting, it helps to gather the balances of every IRA you own as of year-end, any after-tax basis from past Form 8606 filings, a projection of this year's taxable income, and how you will pay the tax. Then run the numbers for several conversion sizes rather than one. The IRS rules are in Publication 590-B, and a tax professional can model the side effects on Medicare, Social Security and credits that a simple bracket calculation misses.

This article is for general information and education only and is not financial, investment, tax or legal advice. Consider your own circumstances and consult a licensed professional.