United States
Hong KongRoth conversions: filling the bracket, not the account
Converting a traditional IRA to a Roth pays tax now to avoid it later. It works where the current marginal rate is below the expected future rate, and it is usually sized to fill a bracket rather than to convert an account.
A conversion is a deliberate decision to pay tax early. It pays when the rate now is lower than the rate later.
When it works
- A low-income year - early retirement, a career break, a business loss.
- The window between retiring and claiming Social Security or reaching required distribution age.
- An expectation of higher rates later, whether personal or legislative.
- A desire to reduce future required minimum distributions.
- Estate planning, where heirs would face a higher rate.
- Where tax can be paid from outside the account.
That last point is the one that decides many cases. Paying the conversion tax from the IRA itself reduces the amount converted and, if under 59½, triggers a penalty on the withheld amount.
Filling the bracket
The technique is to convert only enough to reach the top of the current bracket, not to convert an entire account.
A retiree in a low bracket with a large traditional IRA converts a slice each year for several years, keeping each conversion inside the bracket. That is materially better than one large conversion pushing income into higher rates.
A conversion raises adjusted gross income, which affects the taxation of Social Security, Medicare surcharges two years later, the net investment income tax, and several phase-outs. The effective marginal cost can exceed the stated bracket considerably.
The pro rata rule
Where a client holds both deductible and non-deductible amounts across traditional IRAs, a conversion is taxed proportionally across the whole balance. You cannot choose to convert only the non-deductible part.
All traditional, SEP and SIMPLE IRAs are aggregated for this. Employer plan balances are not, which is why rolling an IRA into a 401(k) before a backdoor Roth works.
The five-year rule on conversions
Each converted amount has its own five-year clock for penalty purposes if withdrawn before 59½. It is separate from the five-year rule governing whether earnings are tax free.
A client who converts at 57 and withdraws the converted amount at 59 faces a penalty on it, despite being past 59½ by then in age terms only if the timing works out - which is exactly the kind of detail questions probe.
What cannot be undone
Recharacterization of a conversion was eliminated. Once converted, it stays converted, even if the market falls immediately afterwards.
That removed the free option that used to make conversions low risk, and it is why conversions are now spread across years rather than executed as a single large decision.
Contribution and benefit limits are indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS before relying on it.
Common questions
When does a Roth conversion make sense?
When the current marginal rate is below the expected future rate - a low-income year, the window between retiring and claiming Social Security, or where heirs would face a higher rate.
How much should you convert?
Usually enough to fill the current bracket rather than to convert an entire account. Slicing conversions across several years beats one large conversion pushing income into higher rates.
Should you pay the tax from the IRA?
No, where avoidable. It reduces the amount converted and, if under 59½, triggers a penalty on the withheld amount. Paying from outside the account is materially better.
What is the pro rata rule?
A conversion is taxed proportionally across all traditional, SEP and SIMPLE IRA balances. You cannot convert only the non-deductible portion, though employer plan balances are excluded from the calculation.
Can a conversion be undone?
No. Recharacterization was eliminated, so a conversion stays converted even if the market falls immediately afterwards. That is why conversions are spread across years.