Individual retirement accounts (IRAs) allow individuals to set aside earned income for retirement in a tax-friendly manner. Traditional IRAs allow you to make pretax contributions and pay taxes when you take a distribution in retirement, while Roth IRAs let you pay taxes upfront to avoid taking a tax hit when you need to use the money in retirement.

Both types of IRAs come with rules related to income limitations and deductions. Roth IRAs in particular limit your contributions if you earn too much, though you can use a Roth IRA conversion, sometimes called a backdoor Roth IRA, to get around this. Here we will provide further insight into Roth IRA conversions, the rules involved and when you should consider one.

What Is a Roth IRA Conversion?

A Roth IRA conversion allows individuals to transfer assets from a tax-deferred account, such as a traditional IRA or 401(k), into a Roth IRA. Tax-deferred retirement accounts delay paying taxes on your contributions and returns until you take qualified retirement distributions, while Roth accounts have a tax-exempt status. This means you pay taxes upfront and see your investments grow tax-free.

When you convert from a tax-deferred plan to a tax-exempt plan — as in a Roth IRA conversion — you must pay the income taxes associated with those converted funds. This happens because you didn't pay taxes on the funds initially, but funds held in Roth accounts must have already had taxes paid on them.

When you make a Roth IRA conversion, it does not mean that you make contributions to that IRA, but rather that you have made what many commonly call a "backdoor Roth" conversion. In that case, your retirement plan assets would reside in a Roth IRA.

What Rules Apply to a Roth IRA Conversion?

When you are pursuing a backdoor Roth conversion, you will have to follow some rules set by the IRS. Otherwise, you may face penalties equal to 10% of the funds converted. If you make a conversion, you will need to report it to the IRS using Form 8606.

You can use one of three methods for the conversion:

1. Perform a rollover, which has your financial institution send you a check that you can then deposit into your Roth IRA within 60 days. Missing the deadline can lead to a 10% penalty unless you are 59 1/2 or older.
2. If you are switching institutions, you can direct your former institution to transfer money to your Roth IRA elsewhere.
3. If you are remaining with the same institution, you can direct it to make the change on your behalf.

When Should You Consider a Roth IRA Conversion?

Roth conversions make sense when you believe your future income tax bracket will be higher than your current one. This means the top tax rate at which you expect to pay income tax will be higher as a result of you earning more money or having more retirement income. You may decide to pay lower taxes now on your conversion and take these distributions tax-free in retirement.

A conversion can also make sense if you aim to take advantage of lower income in the current year to pay lower rates now. For example, if you experienced lower pay in 2020 due to the COVID-19 pandemic and have tax-deferred retirement funds, you might lower your tax burden by paying taxes now on a conversion. This can keep more money in your hands later when your income returns to normal.

Another common case for making a Roth IRA conversion is when you are near retirement, but you have not yet taken IRA distributions. If you don't need your IRA funds now but you expect to report lower taxable income as you near retirement, you might consider making the conversion.

Depending on your circumstances, holding your retirement assets in one type of account versus another might make more sense. In the event that your expectations change and you want to switch, you could take advantage of a backdoor Roth conversion.