Roth IRA conversion: Here’s everything you need to know before converting
According to many experts, the best retirement account available is a Roth IRA, which provides significant benefits such as tax-free income and the ability to leave tax-free money to heirs. A Roth IRA also provides flexibility in terms of taking retirement income due to its tax-free status.
But what if you have a different retirement strategy? The good news is that you can convert plans like a 401(k) or traditional IRA to a Roth IRA and reap the benefits.
“Converting to a Roth can be a great way to take advantage of historically lower tax rates and establish a tax-free retirement,” says Eva Victor, Northwestern Mutual’s senior director of high-net-worth wealth planning. “Once you have a Roth IRA, it can produce tax-free income for years, even decades.”
Here’s how to set up tax-free income for retirement with a Roth IRA conversion.
What is a Roth IRA?
A Roth IRA is a tax-favored retirement plan. A Roth IRA allows you to deposit after-tax funds, invest in a variety of assets, and withdraw the funds tax-free after the age of 59 1/2. The most significant benefit is tax-free withdrawals, but the Roth IRA also provides other benefits.
A Roth IRA can be especially useful if you are planning an estate. A Roth IRA can be passed down to heirs, who will benefit from significant tax benefits. A Roth IRA can be opened at any age as long as you have enough earned income to cover the contribution.
The Roth IRA also provides a great deal of flexibility. As with a traditional IRA, there are no required minimum distributions. You can also withdraw contributions (but not earnings) at any time without penalty. However, if you take your earnings out early, you may be subject to taxes and a 10% bonus penalty. However, in some cases, penalty-free withdrawals are permitted.
However, the withdrawal rules for a Roth conversion are slightly different. If you withdraw from a traditional IRA or traditional 401(k) that has been converted to a Roth IRA within five years of the conversion or before the age of 59 1/2, you will be taxed and penalized. This five-year rule, however, does not apply if you withdraw from a conversion after the age of 59 1/2. Furthermore, if you make multiple Roth conversions, each one is subject to a separate five-year rule.
How to do a Roth IRA conversion
Converting a 401(k) or traditional IRA to a Roth IRA is a simple process. However, when tax season arrives, things can become more complicated.
The three basic steps for converting your retirement account to a Roth IRA are as follows:
- Set up a Roth IRA account. A Roth IRA account must be opened at a financial institution. If you already have a Roth IRA, you can use it to hold the converted account as well. (Some of the best places to open a Roth IRA are listed below.)
- Contact the administrators of your plan. Contact both the new and old financial institutions to determine what they require to convert to the new account. If you’re simply opening a new account at the same institution, this step may be simpler.
- File the necessary paperwork. You can turn in your paperwork once you’ve determined what needs to be filed. You must specify which assets are being converted.
“If you manage your own funds,” says Kerry Keihn, a financial advisor and partner at Earth Equity Advisors in Asheville, “you should be able to find steps to do a Roth conversion on your investment platform’s site,” noting that each institution has a slightly different process or forms.
The conversion to a Roth IRA will take place within a few weeks, if not sooner.
When it comes time to file your taxes for the year in which you converted your account to a Roth IRA, you’ll need to submit Form 8606 to notify the IRS that you’ve converted an account to a Roth IRA.
Any funds transferred from a traditional account to a Roth will be taxed as ordinary income. This can result in a sizable tax bill, so you’ll need to be prepared to pay it. Alternatively, you can convert the account over time to limit the tax hit in any given year.
While a Roth IRA conversion may be unusual for some people, many others who earn too much for a traditional Roth IRA convert to a backdoor Roth IRA each year. They want to take advantage of the account’s numerous benefits, and this is the only way to do so.
Who should consider doing a Roth conversion?
A Roth IRA conversion can be a good option for many people, and here are some of the most common scenarios in which it makes sense.
You earn too much
A Roth conversion may be a good option for those who earn too much to qualify for a Roth IRA the traditional way. Individuals contribute to a nondeductible IRA first, then convert it to a Roth IRA using the so-called backdoor Roth IRA strategy.
You’ll pay higher tax rates later
According to Victor, there is also a rule of thumb for when a conversion may be beneficial. “If you’re in a lower income tax bracket than you’ll be in when you anticipate taking withdrawals, that would be more advantageous.”
You could be in a higher tax bracket for a variety of reasons, such as living in a state with income taxes, earning more later in your career, or paying higher federal tax rates later in your career.
“Let’s say you’re a Texas resident who converts your IRA to a Roth IRA and then moves to California in retirement,” says Loreen Gilbert, CEO of WealthWise Financial Services in Irvine. She cites high-tax California and tax-free Texas as examples. “While the state of California will tax IRA income, they will not tax Roth IRA income.”
In this case, you avoid paying Texas state taxes on the conversion and then avoid paying California income taxes when you withdraw the funds in retirement.
Your earnings are low this year.
Any money transferred from a traditional account to a Roth will be taxed as ordinary income (based on your tax bracket), so it’s best to do it during a year when your income is unusually low.
“If you’ve decided to take a few months off before starting a new job,” says Keihn, “a Roth conversion could be a great option for you this year due to temporarily lower income.”
You want to leave heirs tax-free income
A Roth conversion may also make sense if you want to leave tax-free income to your heirs. This method may be especially advantageous if you intend to give the money to someone other than your spouse, where the IRA inheritance rules are more favorable.
“Under the SECURE Act, if you leave your traditional IRA to someone you are not married to, they have to withdraw all of the funds from that account within 10 years,” says Keihn. “Depending on the size of the account, this could have significant tax consequences.”
According to Keihn, a Roth IRA shields your heirs from the tax consequences. “While the 10-year rule would still apply in this case if your non-spouse beneficiary inherited your Roth IRA, your beneficiary would not have to pay income taxes on withdrawals,” she explains.
What account types can be converted into a Roth IRA?
Converting a Roth IRA entails transferring retirement assets into a new or existing Roth IRA account. Accounts that are eligible for conversion generally fall into one of two categories.
- Pre-existing IRA accounts, such as traditional IRAs, SEP IRAs, or SIMPLE IRAs, can all be converted to Roth IRAs to take advantage of the tax advantages. The procedure is fairly simple and consists of contacting the financial institutions where your accounts are held and completing some paperwork.
- Through a rollover option, employer-based retirement plans are also eligible for Roth IRA conversion. This means that 401(k) accounts from previous employers can be converted to Roth IRAs as long as the necessary taxes are paid. A Roth 401(k) can be converted without incurring tax consequences. You will almost certainly have more investment options in an IRA than you did in your employer-sponsored plan.
What to watch out for when converting
While a Roth IRA conversion is relatively simple to set up, you should follow a few rules to maximize your opportunity and minimize taxes. Here are some tips from experts on what to look out for:
A conversion may result in additional taxes.
When you convert a traditional IRA or 401(k) to a Roth IRA, you will face a tax bill. You’re recognizing that contribution as income, and you’ll have to pay taxes on it – the taxes you didn’t have to pay when it was put into the traditional account with pre-tax dollars.
Because they are both after-tax accounts, converting a Roth 401(k) to a Roth IRA avoids the tax hit. However, any employer match in a Roth 401(k) may be held in a traditional 401(k), which means that this portion cannot be converted tax-free.
However, the SECURE Act 2.0, which was passed in late 2022, now allows matching funds to be held in a Roth 401(k), which means you can avoid taxes on a conversion (because you pay taxes when the money enters the account). So, before you convert, check with your provider to see which you have.
Think about converting over time.
Experts like Victor recommend careful planning to reduce the tax hit associated with a conversion. Individuals could spread out the conversion over several years rather than converting the entire amount in one year. They may be able to avoid moving to a higher tax bracket and paying more on each incremental dollar of converted money by doing so.
If you have more time, a conversion is preferable.
“The longer the time between conversion and using the money, the better,” Gilbert says. “That way, the money continues to grow even after you’ve paid the tax bill.”
Watch out for the five-year rule
The IRS generally requires that any conversion take place at least five years before you access the money, or you will be charged a 10% early withdrawal penalty.
“If you think you’ll need to withdraw the assets from a Roth IRA in less than five years, you may want to reconsider a conversion or speak with a CPA to see if it’s still the best path for you,” says Keihn.
Individuals 59 1/2 and older, on the other hand, are not subject to the early withdrawal penalty even if they do not meet the five-year rule on conversions.
A conversion may have an impact on government programs.
If you participate in government healthcare programs or others that are based on your income, a conversion may affect your eligibility or the cost of those programs.
“The Roth conversion is viewed as taxable income in the year it occurs,” Keihn says. “This could impact your eligibility for Obamacare, financial aid, or your children’s financial aid.” If you are on Obamacare or completing an FAFSA application, you must consider this when deciding how much to convert, if any.”
“People who are two years away from receiving or are already receiving Medicare benefits should be aware that their Medicare premium will most likely increase two years after converting to a Roth IRA,” Gilbert says. “Medicare has a two-year look-back to determine premiums, and your income will be higher in the year you convert than in other years.” However, this is a one-year spike that will subside the following year.”
The income-related monthly adjustment amount, or IRMAA, is a fee on Medicare Part B and Part D premiums.
The IRMAA is calculated on a sliding scale and is based on the adjusted gross income amount you reported on your IRS tax return two years prior. The higher your earnings, the greater the adjustment amount.
Medicare beneficiaries whose 2021 income exceeded $97,000 for single filers or $194,000 for married couples filing jointly will pay an additional $65.90 to $385.60 in addition to their standard monthly Part B premiums, and an additional $12.20 to $76.40 in addition to their monthly Part D premiums in 2023.
Once your income has decreased, you can use this Social Security Administration form to request a reduction in your IRMAA.
Complete it on time.
“Don’t wait until December to consider a Roth conversion; the IRS does not grant extensions,” says Keihn. “You must finish the conversion by December 31 of the year you want it to count towards.”
Be wary of the conversion pro-rata rule.
If you have traditional IRA accounts with deductible contributions, you must take that into account when converting any nondeductible amounts to a Roth IRA. You must follow the IRS’s pro-rata rule, which requires you to calculate the tax consequences based on your total IRA assets.
In essence, you’ll need to calculate the percentage of your funds that have never been taxed – that is, deductible contributions and earnings – to your total IRA assets. That portion of the conversion is taxed at ordinary income tax rates.
It’s a complicated calculation that can lead to a lot of confusion.
Request the assistance of an advisor.
If this all seems too complicated, it may be worthwhile to hire a financial advisor to assist you in making the best decision for you. Look for a financial advisor who will work in your best interests.
The bottom line
A Roth IRA conversion can be a great way to generate tax-free income in retirement, but you should be aware of the trade-offs, particularly the immediate tax consequences of converting. If you’re converting a particularly large account, you’ll want to think about how to minimize the tax hit, so working with a tax professional may pay for itself and then some.
Before making an investment decision, all investors should conduct their own independent research into investment strategies. Furthermore, investors are cautioned that past performance of investment products is no guarantee of future price appreciation.
