Making the switch: Your guide to Roth IRA conversions

MANY OF US PREPARE FOR RETIREMENT by contributing to a 401(k) or a traditional IRA (or both). We save on federal (and possibly state) income taxes up front, and our funds potentially grow tax deferred. The tax bite doesn’t come until we withdraw funds down the road in retirement.

But there is another way —  by converting your savings to a Roth IRA, you’ll pay taxes now, but you can withdraw your funds tax-free later on. It’s a tradeoff you can make today that could possibly provide valuable tax-planning options later. And you don’t have to wait until retirement to do it.

From the potential best time to convert to ways to save on conversion taxes, here are answers to some of the most common Roth IRA conversion questions. If you work with an advisor, they can help you decide whether switching makes sense for you. As with anything tax-related, you should also consult your tax and/or legal advisors before doing a Roth IRA conversion.

CONTENTS

• How does a Roth IRA work?
• What are the rules for a Roth IRA conversion?
• What are the potential benefits of converting?
• When is the best time for a Roth IRA conversion?
• What are five ways to potentially save on conversion taxes?
• Can you convert a 401(k) to a Roth IRA?
• Does the five-year rule apply to Roth conversions?

How does a Roth IRA work?

With a traditional IRA or workplace retirement account, you contribute pre-tax compensation, any growth in the account is federal (and possibly state) income tax deferred, and withdrawals taken in retirement are taxed as ordinary income.¹ A Roth account is the opposite: You contribute after-tax money, but withdrawals in retirement can be federally (and possibly state) tax-free if taken in a qualified distribution. A qualified distribution is when at least five years have elapsed from the first day of the year of your initial Roth contribution — or conversion if earlier — and you have reached age 59½ or become disabled or deceased.

What are the rules for a Roth IRA conversion?

You can convert a traditional IRA to a Roth IRA at any time. You don’t have to meet an income requirement to qualify, so the option is open to everyone. You can convert the entire balance at once, or bit by bit over time.

To the extent you haven’t paid income taxes on your 401(k) and traditional IRA contributions, you will owe ordinary federal (and possibly state) income taxes on the value of the assets you convert at the time of conversion, including any investment earnings.

Tip: If you inherit a traditional IRA from someone other than your spouse, you can’t convert it to a Roth IRA. And you must withdraw the funds within 10 years (unless an exception applies).

What are the potential benefits of converting a traditional IRA to a Roth IRA?

A Roth conversion creates a potential bucket of savings you can draw upon federally (and possibly state) tax-free in retirement, which gives you more tax-planning options. Here’s an example: If you are still working at an age when you need to take distributions from your traditional IRA and you get a bump in income — from a bonus, say — taxable withdrawals from a traditional IRA could push you into a higher tax bracket. Qualified distributions from a Roth IRA would not be taxed, nor would they count toward your taxable income, so you would not get bumped into a higher tax bracket in that scenario.

The other potential benefit is that you’re never required to take withdrawals from your Roth IRA. With a traditional IRA, required minimum distributions (RMDs) begin at age 73. (That number rises to 75 in 2033.) A Roth IRA has no RMDs for the original account owner. If you let your Roth IRA potentially grow tax-free and leave it to your heirs, their withdrawals are federally (and perhaps state) tax-free, too. (When your beneficiaries inherit your Roth IRA, they may have to draw down the account within 10 years.) You may want to discuss the trade-offs with your tax advisor.

Tip: If you’re considering naming a charity the beneficiary of your IRA and do not plan to take withdrawals from your IRA, there might be no need to convert it to a Roth IRA. When you leave any IRA to charity, the withdrawals are not taxed.

When is the best time for a Roth IRA conversion?

While you can convert a traditional IRA to a Roth IRA at any age, the longer your time horizon until retirement, the more sense it may make. You’re likely to be in a lower tax bracket earlier in your career than when you’re nearing retirement, so the tax hit will be less. And the more years you have before you retire, the greater the potential will be for your Roth IRA balance to grow federally tax-free.

One crucial consideration in deciding to convert to a Roth is whether you have the cash available to pay the income taxes at the time of conversion. Tapping your IRA to pay the bill will shrink your account, making those funds unavailable to grow, and may potentially subject you to an additional 10% tax for early withdrawal unless an exception applies.

One last note: Tax laws change, and there’s no way of knowing what rates you’ll face in the future. However, even if income taxes are lower years from now, the potential benefit of years of tax-free growth can potentially exceed the benefits of lower taxes later. You should consult your tax and/or legal advisor to determine what might be best for your personal circumstances.

Can you convert a 401(k) to a Roth IRA?

You can roll over and convert a retirement plan account from a previous job into a Roth IRA. If you’re contributing to a traditional 401(k) now and your employer also offers a Roth 401(k), you might also have an option to convert your account to a Roth if your plan allows what is called an in-service Roth conversion.²

Tip: Once you switch from a traditional IRA to a Roth IRA, you can’t reverse your decision and undo the conversion.

Does the five-year rule apply to Roth conversions?

With a Roth IRA, you can withdraw contributions to the account fully tax-free if you take a qualified distribution — that is, at least five years have elapsed from the first day of the year of your initial contribution. When you convert a traditional IRA to a Roth IRA, the conversion starts the clock on the five-year holding period for qualified distributions, assuming you had not previously made a Roth contribution. Each Roth conversion has a separate five-year holding period for purposes of a 10% additional tax, so keep careful records.

If more than five years have passed since your first conversion or contribution to a Roth IRA and you are age 59½ or older, you can withdraw money from the Roth IRA fully tax-free regardless of when the five-year period for the additional conversions occurred. However, if your first conversion or contribution to a Roth IRA occurred less than five years before the withdrawal, any earnings will be subject to income tax because it is not a qualified distribution. But if you are over 59½, the 10% additional tax will not apply.

In the end, the decision to convert your traditional IRA to a Roth will come down to a variety of factors, including your time horizon, your future sources of retirement income, your current tax rate and your ability to pay the income taxes on the conversion without dipping into your IRA. Your advisor and tax professional can walk you through these considerations and help you make an informed decision as to the best strategy for managing your retirement accounts.