The Basics of a Roth IRA Conversion

There are several reasons why you may want to consider a Roth IRA conversion. Perhaps you moved into a lower tax bracket, recently experienced a sharp decline in the value of your pre-tax retirement accounts, or just want to avoid the prospect of taking required minimum distributions (RMDs) when you get older. No matter your reason, this post will help you evaluate whether or not a Roth IRA conversion is right for you.

What is a Roth IRA conversion?

A Roth IRA conversion is the process of rolling over all (or a portion) of your balances from either an existing traditional IRA, SEP, or SIMPLE IRA into a Roth IRA.

How does a Roth IRA conversion work?

There are two primary ways in which you can roll over your IRA assets into a Roth IRA: either through a direct or indirect rollover.

With an indirect rollover—also known as a 60-day rollover—you take actual custody of the funds since a check is provided for you to deposit. In this scenario, you can use the funds for any purpose for 60 days. However, you’ll need to eventually redeposit the funds into a new IRA by the end of the 60-day period to avoid paying income tax and a 10% early withdrawal penalty (assuming you are under the age of 59 ½). This is one reason why indirect rollovers are usually only recommended if you need to urgently use the money and can execute this transaction within a 60-day window in the absence of risk. One such example is relocating for a new job and using the funds as a short-term loan while you await reimbursement from your employer.

The IRS also stipulates that only one indirect rollover is permitted within a 12-month period and that you cannot split transfers across multiple accounts.

A direct rollover is the simplest and oft-recommended way to move retirement money, wherein the existing plan’s administrator sends funds directly to your new Roth IRA account without you ever touching the money. No taxes are withheld from your transfer amount if you employ this strategy.

Tax implications of a Roth IRA conversion

It’s important to know that you can only roll over post-tax dollars into a Roth IRA. Consequently, you’ll need to pay taxes on the amount you convert. Assuming all accounts you are converting from contained only pre-tax contributions, the total amount converted is taxed at your normal income rate.

However, if the account you’re converting from contains both pre-tax and after-tax contributions, you’ll need to follow the pro-rata rule to determine your taxes. This means the IRS will examine all of your IRA accounts, combined—not just the one you may have used for the conversion—and tax you proportionality.

More specifically, if the cumulative amount of your IRAs reflects 60% pre-tax money and 40% after-tax money, this ratio determines the taxable percentage of funds converted to a Roth IRA. In this scenario, 60% of the amount converted is taxable: regardless of how much money you choose to convert.

When a Roth IRA conversion makes sense

One of the most common reasons to convert a traditional IRA into a Roth IRA is the ability to enjoy tax-free withdrawals in retirement. Unlike a traditional IRA—whereby you must pay taxes on investment gains and any tax-deductible contributions—Roth IRA withdrawals are tax-free, provided you meet specific requirements.

This tax benefit is why Roth IRAs are appealing to so many investors, especially those with many tax-deferred investments such as traditional IRAs. Because it’s extremely difficult to predict what your tax rate will look like during retirement (especially if retirement is several years away), having a mix of investments—some tax-deferred, some not—is often a sound strategy.

Another common reason why investors choose a Roth IRA conversion is to avoid required minimum distributions (RMDs): the amount of money specified by the IRS that you must withdraw from your account, generally starting at age 72. Unlike its IRA counterpart, a Roth IRA isn’t subject to any RMD rules—meaning you won’t need to make any withdrawals at any point during your lifetime. As a result, the money in a Roth IRA can remain in the account and continue to grow tax-free.

A Roth IRA conversion may also make sense if your income drops significantly (perhaps due to a job loss) or if there is a sharp decline in the value of your investments, as these conversions become less expensive from a tax perspective.

Finally, Roth IRAs also have fewer restrictions than traditional IRAs with respect to asset inheritance. For example, Roth IRA beneficiaries are spared the pain of paying taxes, provided the account was open for at least five years.

When a Roth IRA conversion may NOT make sense

As with any investment, Roth IRA conversions aren’t for everyone: usually due to the prospect of high tax bills as well as timing, meaning when you may need the money.

For example, if you lack the funds needed to pay Uncle Sam taxes owed on your conversion, it may not make sense to proceed with a Roth IRA conversion. What’s more, Roth IRA conversion withdrawals are subject to a five-year waiting period. Therefore, you may have to pay a 10% penalty along with any income taxes owed if you access those funds any earlier.

It’s also important to know that the five-year waiting period begins on January 1 of the year you converted your IRA. For example, if you do this in December 2022, your window actually would have begun on January 1, 2022.

What’s more, each conversion made has its own five-year period. For example, let’s assume you made one Roth IRA conversion in 2022 and another in 2023. In this case, the five-year period would begin on January 1, 2022 for your 2022 conversion, and the window for your 2023 conversion would start on January 1, 2023.

Exceptions to the 5-year rule

Specific situations can help you skirt the early withdrawal penalty on the five-year rule for a Roth IRA, such as making a $10,000 withdrawal for a first-time home purchase, withdrawing up to $5,000 in the year following the birth or adoption of a child, withdrawing for qualified higher education expenses (including books, tuition, fees, and room and board) for you or an immediate family member, and withdrawing funds to pay for unreimbursed medical expenses (those exceeding 10% of your adjusted gross income). In addition, if you lose your job and your health insurance, you can use funds from your Roth IRA to pay for insurance premiums while you’re unemployed.

Other Roth IRA conversion considerations

As mentioned earlier, a Roth IRA conversion does have potential income tax implications. More specifically, the amount you convert is taxed as ordinary income and can therefore push you into a higher Federal income tax bracket.

Climbing into a higher tax bracket can also adversely impact your involvement in Federal programs such as Medicare and Social Security.

For example, IRMAA—which stands for income-related monthly adjustment amount—is the additional amount you might need to pay in addition to your Medicare premiums, as Medicare imposes surcharges on higher-income beneficiaries.

The surcharge is calculated based on tax returns reported from two years prior, meaning your 2022 income determines your IRMAA in 2024, your 2023 income determines your IRMAA in 2025, and so on. Surcharges can amount to several hundred dollars a month, depending on your income.

A higher income can also take a chunk out of your Social Security benefits, as your least-favorite uncle—Uncle Sam—can tax Social Security benefits depending on the earnings listed on your income tax return.

Currently, if your total income is more than $25,000 for an individual or $34,000 for a married couple filing jointly, you must pay Federal taxes on your Social Security income. Your benefit amount subject to taxation varies based on income.

A third consideration is a tax on capital gains. If your income is low enough—below $41,675 in 2022 (or $83,350 for married couples filing jointly)—you can avoid taxes on capital gains, which is sometimes very beneficial for retirees (especially those living on a fixed income).

In sum: what you should know about Roth IRA conversions

While including a Roth IRA in your investment portfolio is often recommended, whether or not you should convert to one is a different story. As you can see, you’ll need to take many tax-related implications into consideration. A CFP® professional can help you evaluate whether a Roth IRA conversion makes sense, given your own unique situation.

Want to know if a Roth IRA conversion is right for you? Schedule a FREE Discovery call with one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.