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Some people convert their traditional IRA to a Roth IRA for income-tax-free cash flow during retirement.

Converting your traditional IRA to a Roth IRA does come with some costs.

If you are thinking about setting up a Roth IRA or converting your traditional IRA to a Roth IRA, here are some things to consider:

What is a traditional IRA?

A traditional IRA is a retirement account that can allow you to save for retirement without paying taxes on the amount you contribute to the account, and any income and appreciation on that amount, until you make a withdrawal. Some characteristics of traditional IRAs include:

  • Minimum distributions once you reach the “Required Beginning Date” (age 75 if you were born in 1960 or later, age 73 if you were born in 1951 through 1959, or age 72 or 70½ if you were born in 1950 or earlier).
  • Limits on the deductibility of contributions based on income and whether or not you or your spouse is covered by a retirement plan at work.
  • Income tax payable at ordinary income rates on any distributions from the IRA (except no tax is owed on the distribution of after-tax contributions, if you made any).

In general, you won’t be able to contribute as much annually to a traditional IRA as you would to a 401(k) and some other employer-based retirement accounts.

What is a Roth IRA?

Roth IRAs are retirement accounts that don’t require the original owner to take distributions during his or her lifetime. However, contributions to Roth IRAs are never tax-deductible. Like with traditional IRAs, contribution limits for Roth IRAs are lower than those for many other retirement accounts. Some important things to know:

  • Distributions that are taken from a Roth IRA (including distributions to Roth IRA beneficiaries) are income-tax-free if they meet certain requirements.
  • Taxpayers with income that exceeds certain thresholds are not allowed to make contributions directly to a Roth IRA.

Are you able to convert a traditional IRA to a Roth IRA?

Yes. However, the conversion from a traditional IRA to a Roth IRA is not reversible—once you make the conversion, you can’t change it back.

What are some considerations and consequences of converting to a Roth IRA?

Investors converting a traditional IRA to a Roth IRA will generally need to pay ordinary income tax on the converted amount that is made up of pre-tax contributions plus the income and appreciation on all (pre- and post-tax) contributions. Post-tax contributions that are converted are not taxable. If you have one or more traditional IRAs with both pre-tax and post-tax contributions, the converted amounts will be deemed to be taken pro rata from pre-tax and post-tax amounts.

A conversion may not make sense if you plan to use the Roth IRA money soon after the conversion. You could face a 10% penalty if you withdraw funds from a Roth IRA within five years of funding it, whether you contributed directly to the Roth IRA or you put money into it through a conversion.

If the ordinary income tax due when you convert is paid from the converted funds, less money will be available to grow in the tax-favored Roth IRA. Also, using converted funds to pay the tax could mean you would need to pay the 10% early withdrawal penalty on those amounts. The tax and penalty together could cause the cost of conversion to outweigh the benefits of future tax-free withdrawals. As a result, you should think about whether it makes sense to use non-IRA funds to pay the ordinary income tax due upon conversion.

How can you save money in a Roth IRA if you are unable to fund a Roth IRA directly because your income exceeds the relevant thresholds?

Income limits don’t apply when converting a traditional IRA to a Roth IRA. Therefore, if you are a high-income earner who would like to save for retirement in a Roth IRA, you can contribute money to a traditional IRA and very shortly afterward convert the traditional IRA to a Roth IRA. This is one way that high-income earners can fund a Roth IRA even though they couldn’t create and fund a Roth IRA directly. This is sometimes called a “backdoor” Roth IRA.

This backdoor method of funding a Roth IRA may not make sense for you if you already have one or more IRAs with pre-tax money (including rollovers from 401(k)s). This is because you will likely owe some tax when you convert the traditional IRA to the Roth IRA since part of the conversion would be treated as coming from pre-tax assets. You should factor taxes in when deciding if a backdoor Roth IRA makes sense for you, and you should talk to your tax professional if you are thinking about using this backdoor Roth IRA method.

A J.P. Morgan professional can work with you and your legal and tax professionals to help you decide if it makes sense to convert your traditional IRA to a Roth IRA.

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