Whether we admit it or not, taxes drive a lot of our personal finance decisions. Avoiding or lowering them can influence where we choose to live, what kind of car we buy, where we send our children to school, whether we purchase a house, and many other everyday decisions. Everyone tries to limit the amount of taxes they pay. Taxes play a large role when we invest for retirement as well.

One potential way to minimize taxes is by investing in a Roth individual retirement account (Roth IRA). With a Roth IRA, you contribute after-tax dollars and withdraw any earnings tax free in retirement. By contrast, although you generally get a tax deduction on your contributions to a traditional IRA—and the money grows tax free—you have to pay taxes when you withdraw the money in retirement.

To avoid this, many investors do a Roth IRA conversion, moving their money from a traditional IRA to the Roth variety. The strategy is also known as a backdoor Roth IRA, if it allows investors normally ineligible for Roth to set one up—sneaking in the back door, so to speak.

What Is a Roth IRA Conversion?

A Roth IRA conversion occurs when you move funds from a traditional IRA, simplified employee pension (SEP) IRA, or savings incentive match for employees (SIMPLE) IRA into a Roth IRA. Beginning in 2010, the federal government began allowing investors to convert their funds from traditional IRAs into Roth IRAs, regardless of the amount of income that they earned.

In general, people can invest in a Roth IRA only if their modified adjusted gross income (MAGI) falls below a certain limit. For example, if you’re married filing jointly and earn more than $214,000 a year in 2022 (up from $208,000 in 2021), you can’t invest in a Roth IRA; single and head of household filers have a cutoff of $144,000 (up from $140,000 in 2020).

But there are no income limits for conversions.

Sound good? It can be—but, like most investment decisions, a Roth IRA conversion has its advantages and disadvantages.

Advantages of a Roth IRA Conversion

A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. While there’s no up-front tax break with Roth IRAs, your contributions and earnings grow tax free. In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided that you take a qualified distribution. While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money and, therefore, be in a higher bracket.

Another perk to a Roth IRA is that you can withdraw contributions (not earnings) at any time, for any reason, tax free. (However, there is a caveat for converted funds, explained below.) Still, you shouldn’t use your Roth IRA like a bank account. Any money that you take out now will never get the opportunity to grow. Even a small withdrawal today can have a big impact on the size of your nest egg in the future.

Moving to a Roth IRA also means that you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. If you don’t need the money, you can keep your money intact and pass it to your heirs.

Disadvantages of a Roth IRA Conversion

The largest disadvantage of converting to a Roth IRA is the whopping tax bill. If, for example, you have $100,000 in a traditional IRA and convert that amount to a Roth IRA, you would owe $24,000 in taxes (assuming your effective tax rate is 24%). Convert enough and it could even push you into a higher tax bracket.

Of course, when you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. While you can make some educated guesses, there’s no way to know for sure what tax rates (and your income) will be in the future.

Yet another common issue that many taxpayers face is contributing the full amount and then converting it when they have other traditional IRA, SEP, or SIMPLE IRA balances elsewhere. When this happens, you’re required to compute a ratio of the monies in these accounts that have been taxed already vs. the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you deducted your contributions vs. those for which you didn’t). This percentage is counted as taxable income. Yeah, it’s complicated. Definitely get professional help.

Another drawback: If you’re younger, you have to keep the funds in your new Roth IRA for five years and make sure that you’ve reached age 59½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings but also a 10% early distribution penalty—unless you qualify for a few exceptions.

Paying the Tax Bill on a Roth IRA Conversion

If you do a Roth IRA conversion, how will you pay that tax bill? And when?

Many people don’t realize that they should pay the tax bill on the conversion before—not when—they file their taxes. You must send in a check as part of your estimated quarterly taxes. If you don’t, you may pay hefty penalties.

The best way to pay the tax bill is to use money from a different account—such as from your savings or by cashing out a certificate of deposit (CD) when it matures. The least preferred method is to get the money from the retirement investment that you are converting. Here’s why:

Paying your taxes from your IRA funds, instead of from a separate account, will erode your future earning power. Say you convert a $100,000 traditional IRA; after paying taxes, you end up depositing only $76,000 into the new Roth IRA. Going forward, you’ll miss out on all of the interest that you would have earned on the money. Forever.

While $24,000 may not seem like a lot, compounding interest means that money could grow to almost $112,000 over the course of 20 years all by itself at an interest rate of 8%. That’s a lot of money to forgo to pay a tax bill.

The Bottom Line

A Roth IRA conversion can be a very powerful tool for your retirement. If your taxes rise because of increases in marginal tax rates—or because you earn more, putting you in a higher tax bracket—then a Roth IRA conversion can save you considerable money in taxes over the long term. The backdoor strategy opens the Roth door to high-earners who normally would be ineligible for this sort of IRA, or who are unable to move money into a tax-free account by any other means.

However, there are several drawbacks to a conversion that should be taken into consideration—particularly a big tax bill that can be tricky to calculate, especially if you have other retirement accounts funded with pretax dollars. It’s important to think carefully about whether or not it makes sense to do a conversion and consult with a tax advisor about your specific situation.