Converting a traditional IRA to a Roth IRA isn't cheap. Turning a $20,000 IRA into a Roth, for instance, gives you $20,000 in added taxable income for the year. If you wait until you’re retired – and your income is lower – you’d likely save in taxes. However, once you convert, you're done with tax: Withdrawals from a Roth are never taxable.
Except for the tax, conversion works like rolling over assets between traditional IRAs. You simply withdraw some or all of the assets from your IRA – and then transfer them to your Roth. You have to do this within 60 days or pay a penalty, so it's usually safer to have the account manager handle it.
If you made taxable contributions to your IRA, you don't pay tax on them when you convert. You don't get to pick and choose: If 20 percent of your IRA was already taxed, then 20 percent of what you roll over is tax-free. To determine the tax hit, take the taxable part of the rollover and add it to your other taxable income for the year. Calculate your tax using the IRS tax tables or any of the online calculators available. The exact amount of tax you owe depends on your overall income and tax bracket. This means that if you want to roll over $40,000 before-tax dollars from a traditional IRA into a Roth IRA, you'll pay $12,000 in taxes this year if you're in a 25 percent tax bracket
Your account custodian typically takes out withholding when she transfers the assets to your Roth. You can also use your savings or other income to pay the income tax on the conversion. If you withhold part of your IRA, those assets are no longer earning interest for you. If you are nearing retirement, it might not make sense to convert since you won't have many years to accumulate tax-free earnings before withdrawal. If you're younger, a conversion makes more sense.
Before committing to a conversion, calculate just how it will affect your current and future finances. If the IRA withdrawal ups your adjusted gross income high enough, it can prevent you from qualifying for tax credits and limit your deductions for the year. For instance, you subtract 7.5 percent of your AGI from medical expenses before deducting them, so a higher AGI reduces the write-off. One option is to convert a little every year, minimizing the AGI effect, until you've rolled over everything.