You can convert any portion of your ordinary IRAs to Roth IRAs. Even if you are under age 59.5, you do not pay the normal 10% penalty for early withdrawal on the part that you convert. You cannot convert if you have an AGI on your tax return of more than $100,000. You cannot convert at all if you are married filing separately. However, the $100,000 limit does not include the amount that you convert.

It is best to think of the conversion as a simple two-step process: First, cash in the ordinary IRA; second, put some or all of the proceeds in a Roth IRA. So of course you incur taxes on the part cashed in, to the same extent as if you were not converting. And if you are under age 59.5, you incur an extra 10% penalty on any part cashed in that is not deposited to a Roth IRA.

Because of the 10% penalty on unconverted withdrawals from an ordinary IRA before age 59.5, it is usually best to wait until you are past that age before you make conversions unless you can pay the taxes out of other savings. Another reason for waiting until you are close to retirement to make the conversion is that maximum advantage is obtained by accurate estimates of income in retirement (which is easier the closer you are to retirement). A third reason is that you cannot change your mind in a later year and convert a Roth IRA back to an ordinary IRA.

If you convert an ordinary IRA to a Roth IRA and find out later in the year that you went over the $100,000 AGI limit, you can convert it back without penalty. Or if the value of the Roth IRA drops substantially after the conversion, you can convert it back ("re-characterize") without penalty in the same year, then re-convert it at the lower amount. This means that taxes on the conversion will be lower. However, you cannot make such a tax-saving re-conversion more than once on any one amount of money.

We start by assuming you do not have any non-deductible contributions to your IRA (call this a pure IRA). This is true if your IRA came entirely from a 401(k) or 403(b). We also initially assume that you do not pay the taxes on the conversion with money outside the IRA. We will allow for paying taxes with outside money shortly, and consider non-deductible contributions at the end of this article.

The basic principle in such cases is, if you convert an amount to a Roth IRA at a certain income tax rate now and you could have converted part of that amount at a lower income tax rate some years later, then you would surely have been better off to have waited on at least part of the conversion. Remember, this applies if you pay the taxes on the conversion from the IRA itself.

Example: Assume (a) you convert quite a bit at the 31% tax rate now; (b) you will be able to convert $4000 at the 28% tax rate 9 years from now; and (c) the investments in your IRAs (Roth or pure) will double in those 9 years. If you leave $2000 unconverted, that reduces your Roth IRA by $1380 (=2000*(100%-31%)). So your Roth IRA will be $2760 less 9 years later (=2*1380). But the unconverted $2000 will grow to $4000 in those 9 years, which you can convert to $2880 in a Roth IRA (=4000*(100%-28%)). Clearly the latter is better, independently of the numbers I chose.

Say a married couple retires at age 60 with a company pension of $20,000 that rises with inflation, and they expect to begin at age 66 Social Security income equivalent to $16,000 in today's dollars. They also have $500,000 in pure IRAs (mostly rolled over from a 401(k) or 403(b)). They plan to spend a post-tax inflation-adjusted equivalent of $47,000 each year.

Federal income tax on a normal pre-tax $53,000 yields $47,000 post-tax with the standard deduction. Since at age 70 they will already have $36,000 in income, they can draw another $17,000 from their pure IRA. So they leave enough in their pure IRA that their MRD (Minimum Required Distribution) starting at age 70 is around $17,000 (all these numbers are inflation-adjusted).

Since the MRD is roughly 6.5 to 7% of total assets at age 70, that implies they should aim to have around $250,000 inflation-adjusted in pure IRAs at age 70, with the rest of their savings converted to Roth IRAs. They will have to make some of those conversions to Roth IRAs at the 28% tax rate.

What then happens after age 70 is that they spend what the MRD forces them to take out or a little less. The tax rate on those MRD withdrawals is only 15%, and they need not touch their Roth IRAs. By age 88 or so, the pure IRAs have been completely spent but the Roth IRAs have grown tremendously, enough to provide the extra income needed for as long as they live.

The ideal amount to convert before age 70 is the amount that leaves them not much more than $250,000 inflation-adjusted in their pure IRA at age 70. If they convert several thousand more before age 70, that conversion will be at 28% and replace MRD withdrawals between ages 70 and 88 at 15%, which costs them money (per the "basic principle"). If they convert several thousand less, the MRD will force that extra money out of the pure IRA in their early seventies, but they will not be able to spend it for over 10 years. That means that the taxes saved by converting at 15% instead of 28% are eaten up by the taxes paid on the post-tax earnings over more than a decade.

With reasonable assumptions on market returns, the current $500,000 can be allocated to four portions: about $220,000 to cover expenditures from age 60 to age 70, about $160,000 to grow to be worth $250,000 inflation-adjusted in the pure IRA at age 70, and about $120,000 to be converted to a Roth IRA between the ages of 60 and 70. Roughly $4,000 can be converted at the 15% rate each of those 10 years, and the rest can be converted at the 28% rate at any time. So the couple could convert about $50,000 to Roth IRAs in each of the first two years and thereafter convert just enough to "fill out" their 15% tax bracket.

However, this all depends on estimates of inflation and market performance, which can vary so greatly that the couple would be better off converting only about $50,000 now (giving them about $32,000 net in the Roth IRA after taxes). Then they wait until the two years before they start the MRD to convert the rest. On the other hand, they can save another $1000 a year or so in taxes if they finish converting before they start drawing Social Security, because of the odd way Social Security is taxed. So the best they can do is hazard a guess and hope it comes out close to right.

In general, if you convert but your tax rate drops by the time you cash in, conversion comes out behind; if it rises, conversion comes out ahead; and if it stays the same, conversion comes out even. However:

If you have to pay the 10% penalty due to being under 60 and using part of the pure IRA to pay the taxes, you can only gain by converting if your tax rate rises in retirement by at least 11% (e.g., from 30% to 34% rate).

If you have the money in a taxable account to pay the taxes, in effect adding to your IRA, you gain by converting if the tax rate stays the same. But you should not convert if your tax rate decreases, unless you have a long time between the conversion date and the time you spend it. If the drop in the tax rate is from 31% to 28%, this time period is on the order of 5 to 10 years. But if the drop is from 28% to 15%, you would have to wait more than 40 years to come out ahead by converting earlier at the 28% rate.

How much you convert can make a difference in estate taxes. But if you have that much money that you want to leave to your descendents, you should definitely consult professionals for advice. Or you could use the simplest and most effective way known to avoid estate taxes: Leave everything to the spouse; whichever dies second leaves about half-a-million in assets to descendents and friends and all the rest to charity. Money left to a bona fide charity does not incur either income tax or estate tax; even if it is pure IRA money, the tax is avoided.

The higher the percentage of your ordinary IRAs that is non-deductible contributions (the "basis"), the better it is to convert them to a Roth IRA. For instance, if over half is basis, you should almost always convert it. If less than 10% is basis, that only gives a small tilt in favor of conversion. This basis is the amount you keep track of on 8606 forms, filed with your federal income tax each year.

You cannot convert only the non-deductible contributions of your IRA to a Roth IRA, even if you have kept them separate. If the "basis" part is X% of the whole, then a conversion causes taxes on all but X% of the amount converted.

Example: Say you have $20,000 in ordinary IRAs, of which half ($10,000) is the basis. If you convert it at the 34% tax rate, it will cost you 17% of the total value, and thereafter you will not pay any more tax. If you let it ride for 2 to 4 years to where the $20,000 grows to say $25,000 and then you convert it or cash it in at the 30% tax rate, the basis is only 40% of the total. You will then pay 30%*60% = 18% of the value in taxes. So you would have gained by the earlier conversion at the higher rate.

You can see that the calculation of how much to convert is not at all simple. The examples did not even allow for state income tax or for pensions that are not inflation-adjusted. A spreadsheet with each year separately calculated, or the equivalent, is the only decent way to get a halfway reliable estimate.