Preface: “Some people shave before bathing.
And about people who bathe before shaving they are scathing.
While those who bathe before shaving,
Well, they imply that those who shave before bathing are misbehaving.” – Ogden Nash
History of the Retirement Plan, Part IV
The following is the fourth in a series of blog posts on the subject of retirement plans. The first three installments can be found here, here, and here. In them we have:
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- Briefly reviewed the history of government-defined retirement models in the United States,
- Introduced the tax-deferred model,
- Explained the difference between Qualified plans and Individual Retirement Accounts (IRAs).
- Discussed limits to deductibility of retirement contributions, and
- Tax treatment of non-deductible contributions.
- And introduced the Roth model.
In this fourth installment, we will conclude our discussion of Roth IRAs with a review of:
Roth Conversions
In the previous post in this series, we extolled the virtues of the Roth IRA and the advantages it offers account holders. In particular, it allows all money contributed to grow tax-free with no reporting requirement or tax due at any time. Given a sufficient time horizon, this advantage will more than compensate for the fact that contributions to Roth IRAs cannot be deducted from taxable income.
The Empire Strikes Back against Roth Account Holders
The government is aware of these rather unfair advantages that the Roth IRA gives to the taxpayer. For this reason, they have placed limits on who can contribute to one. This is not a limit on deductibility of contributions, as exists with the traditional IRA, but a limit on the contribution itself.
For 2025, income limits are:
The Roth Conversion
But have no fear. You can continue to contribute to your Roth no matter how high your AGI is. Yes. Really.
The way to do this legally is a provision, some would call it a loophole, known as a Roth conversion. A Roth conversion is really just a rollover, but one from a traditional to a Roth status.
Some people will tell you that a Roth conversion is taxable. They are mostly correct. Specifically, the pre-tax portion of a Roth conversion is taxable. This is true since going from pre-tax to after-tax by definition means that tax is being paid in the process. There is not a special tax that applies to Roth conversions. It is the same tax that you would pay on any qualified withdrawal of pre-tax money. This is because, as mentioned, a Roth account must always have an entirely after-tax status.
You must report the Roth conversion on Form 8606, where you will compute the taxable amount.
Example: You have a traditional IRA with $20,000 in it. All of it is pre-tax. You decide to convert it all into a Roth. You can do this, regardless of your AGI, and regardless of the fact that the annual contribution limit to a Roth in 2025 is $7,000. The only catch is that this conversion will be taxed at your marginal rate. If you are in the 22% tax bracket, you are looking at an additional $4,400 in income tax.
Example: As above, but $10,000 of your traditional IRA has an after-tax status. Your tax rate is the same as before, but since only the pre-tax amount is subject to tax, you owe only $2,200 on the conversion.
If the logic here sounds eerily similar to our discussion of Tax Treatment of Withdrawals from Mixed-Status IRAs in Part Two of this series, that is because it is essentially the same issue. Just as a withdrawal from a traditional IRA is taxed only on its pre-tax proportion, so too is a Roth conversion, and for the same reason. And the calculation of the pre-tax proportion is done on the same tax form, Form 8606.
Roth conversions are also subject to the same mistake people make where they assume they can avoid paying taxes by designating which monies to convert. When converting a traditional IRA, you must consider the total value of all traditional, SEP, and SIMPLE-IRAs (but not qualified plans).
Example: You have two traditional IRAs, each worth exactly $10,000. One is wholly pre-tax and the other is wholly after tax. You want to convert one of them to a Roth. “I will convert the after-tax one,” you think happily to yourself, “That way I will not owe any tax on the conversion.”
Unfortunately, that is not how the IRS is going to see things. They consider that you have a total IRA value of $20,000 with a total after-tax basis of $10,000. Therefore, exactly 50% ($10,000/ $20,000) of any withdrawal or conversion from either account is taxable. No more. No less.
Another piece of advice you will sometimes hear is to wait until after retirement to convert your IRA to a Roth because you will be in a lower tax bracket then. But consider that the longer you wait, the more your pre-tax earnings grow, which means more taxable income later, even if it is taxed at a lower rate. Converting earlier means all future growth will be after-tax, which means you will never pay tax on it no matter how much it grows. If you are planning on retiring next year and withdrawing all the money within say, five years, then it is worth waiting the year or two and doing the conversion after you retire. But if your time horizon to withdrawal is longer than that, it might be more advantageous to not postpone the conversion. Conversion also gets you out of the Required Minimum Distribution, since there is no RMD on Roths.
Unlike traditional IRA and Roth IRA contributions which have an annual limit, there is no limit to how much existing traditional money you can covert to a Roth in a single year. However, larger conversions of pre-tax money mean more taxable income. In some cases, a large conversion can even move you into a higher tax bracket for the year. For this reason, people sometimes stagger conversion of an IRA over a number of years. Luckily, there is no limit on the number of times you can do a conversion.
The Back-Door Roth Conversion
Some of you may be thinking: “My income is too high to contribute directly to a Roth IRA. I would love to convert money from a traditional IRA, but I don’t have a traditional IRA.”
You’re in luck. You don’t need to have a pre-existing traditional IRA. You can create a traditional IRA for the express purpose of contributing to it and immediately converting it. This is sometimes known as a “back-door Roth conversion.” That is not a technical term. There is no box for you to check when you open the account that says “back-door.” It is just an informal term used to mean that the traditional IRA was opened solely to convert future contributions to Roth status. You can contribute the limit to the traditional, up to $7,000 in 2025, immediately roll it over to a Roth, and it’s as if you contributed directly to the Roth, with the one key difference that it is not limited by your AGI.
As long as you don’t deduct your contribution to the traditional IRA from your taxable income, and there is no requirement that you must deduct it, the conversion is entirely non-taxable because the contributed amount is entirely after tax. Just make sure you document the conversion on Form 8606.
If you leave the money in the traditional IRA for long enough for it to earn any kind of interest or other earnings, the earnings portion will be taxable at the time of conversion.
Example: You open a traditional IRA and contribute $7,000 to it. You do not deduct any of this from your taxable income. The account earns $10 in interest. You convert the entire $7,010 to your Roth IRA.
Remember that the IRS considers your entire IRA value and your entire pre-tax basis. So in this case $10 of the conversion will be taxable at your marginal rate because that is 0.14% ($10/$7,010) of the $7,010 conversion.
Even if you convert only the $7,000 and leave $10 in the traditional IRA, $9.99 of the conversion will still be taxable at your marginal rate because that is 0.14% ($10/$7,010) of the $7,000 conversion.
So what happened to that missing one cent of taxable income? It remains with the traditional IRA. Another way to look at it is: we are partitioning out the $7,000 in after-tax basis so that 6990.01 is allocated to the conversion and $9.99 to the traditional IRA. So going forward, the traditional IRA as it continues to grow will have a $9.99 after-tax basis.
Bottom Line: the IRS will not allow you to avoid or decrease tax due on a conversion by choosing which part of the money you are converting.
Beware of Pre-Existing Traditional Accounts
When figuring the taxable proportion of a Roth conversion, the IRS requires that you consider the value of “all your traditional, traditional SEP, and traditional SIMPLE IRAs”. This makes the back-door conversion not a particularly good strategy for those with pre-existing IRA-type accounts.
Example: You open a traditional IRA and contribute $7,000 to it. You do not deduct any of this from your taxable income. You convert the entire $7,000 to your Roth IRA.
It turns out you had a SEP-IRA from a past job that is now worth $100,000, all pre-tax. So $6,542.06 your conversion will be taxable at your marginal rate because that is 93.46% ($100,000/$107,000) of the $7,000 conversion.
Note that this does not apply to Qualified plans, which can be ignored for purposes of Roth conversions.
If you have a pre-existing IRA with a large pre-tax component, you can increase the after-tax proportion each year by contributing after-tax amounts to it or to any other traditional IRA. However, any future earnings in these accounts will count towards the pre-tax component, because that is the nature of traditional IRAs.
See Part Two of this series for two possible strategies to directly decrease the pre-tax component of a traditional IRA. However, be forewarned that these strategies might not be applicable to all taxpayers.
