Retirement Planning

Roth IRA Conversion

What is a Roth IRA Conversion?

A Roth IRA conversion involves transferring retirement assets from a traditional simplified employee pension (SEP) or SIMPLE IRA, or from a defined contribution plan such as a 401(k), to a Roth IRA. While account owners must pay income tax on the money they convert, they are eligible for tax-free withdrawals from the account in the future.

key takeaways

  • A Roth IRA conversion involves transferring retirement funds from a traditional type of IRA or 401(k) into a Roth account.
  • Account holders must pay tax on the money they convert, but money they withdraw from Roth accounts will be tax-free in the future.
  • This strategy makes sense if the person believes they will be in a higher tax bracket in the future and that they will save money by paying taxes now rather than later.
  • Roth conversions completed after December 31, 2017 cannot be converted back to a traditional IRA as before.

How a Roth IRA Conversion Works

Conversion can be done in a number of ways.

  1. direct rollover If you are leaving or leaving an account with a former employer, you can withdraw from a defined contribution plan such as a 401(k) or 403(b). The administrator of the program can send money to your new account, or send you a check to the new account, which you can then deposit.
  2. Assignment from trustee to trustee, Where assets are transferred directly from the financial institution (or trustee) that holds your traditional IRA, and the financial institution (or trustee) that will hold your new Roth IRA. It can be the same financial institution (same trustee transfer) if you wish.
  3. 60-day extensionwhere the money is paid to you and then you deposit all or part of it into a Roth IRA within 60 days.

The first two methods are usually the safest and most practical. During a 60-day rollover, if you fail to deposit funds within that period, it will be considered taxable income and you may also face an early distribution of 10% tax if you are under 59½ years of age. Additionally, a 60-day rollover (unlike the other two methods) may be subject to a 10% tax withholding. So if you roll over an IRA of more than $10,000, you’ll only receive $9,000, and if you want the full $10,000 into your Roth account, you’ll have to take out $1,000 from another source.

Note that Roth conversions completed after December 31, 2017 can no longer be requalified as they were – in other words, converted back to a traditional IRA.

When Roth IRA Conversions Make Sense

The main advantage of converting a traditional IRA or 401(k) to a Roth IRA is the ability to make tax-free withdrawals at some point in the future. This can be especially attractive if you want to retire in a higher marginal tax bracket. While most people’s incomes (and tax brackets) drop in retirement, that’s not always the case. For example, if you have a lot of money in a traditional IRA, your required minimum distribution (RMD) starting at age 72 could significantly increase your income.

Furthermore, future tax brackets and tax rates cannot be predicted. If taxes increase when you retire, it may make sense in the long run to switch to a traditional IRA and get hit with taxes now rather than later.

Another consideration involves estate planning. Unlike other types of retirement accounts, Roth IRAs are never subject to required minimum distributions over your lifetime. So if you don’t need the money to cover living expenses, you can let it grow undisturbed and leave it to your heirs someday. If the account beneficiary is your spouse, they also do not have to accept the RMD. Other types of beneficiaries, such as children, will eventually have to accept distributions, but those distributions will be tax-free as long as they follow the rules.

The Build Back Better Act (HR 5376), passed by the House of Representatives in 2021, would make changes to existing rules for IRA rollovers for wealthier taxpayers. But Senate passage seems unlikely as of March 2022, and the fate of the proposals is unclear.

Roth IRA Conversion Example

By carefully timing your transition, and possibly spreading it out over several years, you may be able to reduce your tax burden.

For example, let’s say you’re single, have $80,000 in taxable income this year, and have $100,000 in a Traditional IRA that you want to convert to Roth. Based on your taxable income, your current maximum marginal tax rate is 24%. Because the 24% rate ends at $170,050, you can convert up to $90,050 ($170,050 minus $80,000) this year and pay no more than 24% in tax. If you were to convert the entire $100,000, the remaining $9,950 would be taxed at the next highest rate of 32%.

In this case, you can save some money by spreading the conversion over two tax years.

What is the purpose of a Roth IRA conversion?

The main reason people switch from a traditional IRA or other retirement account to a Roth IRA is so they can enjoy tax-free income in retirement. They also have the flexibility to not withdraw money if they don’t need it. This is because Roth IRAs, unlike traditional IRAs, are not subject to required minimum distributions over the owner’s lifetime.

How Much Tax Do You Pay for Roth IRA Conversions?

The amount of tax you have to pay for a Roth IRA conversion will depend on your current tax bracket and the amount you convert. It is taxed as ordinary income.

How Do I Avoid Taxes on Roth IRA Conversions?

You can’t completely avoid taxes, but you can reduce your tax burden by converting enough money to stay under the limits of the next marginal tax bracket. For this reason, it is worth spreading the conversion over several tax years. Another potential way to reduce taxes is to switch during a year when your other income is unusually low, such as after a layoff.

What is a backdoor Roth IRA conversion?

A backdoor Roth IRA is a colloquial term referring to a technique that wealthier taxpayers can use to circumvent the income limitations of opening a Roth IRA. Because traditional IRAs have no income restrictions on eligibility, high-income taxpayers can contribute to a traditional IRA and then convert those accounts into a Roth IRA. Washington has taken steps to eliminate the practice, but it remains legal as of March 2022.

bottom line

Roth IRA conversion allows you to convert a traditional IRA or 401(k) plan account to Roth. You have to pay income tax on the money you convert, but you can make tax-free withdrawals from your Roth account in future years. Roth IRA conversions make the most sense if you expect higher tax rates in retirement, or if your future tax rates will increase significantly overall.

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