A Simple Guide to Roth IRA Conversion
By Nicole Young on October 11, 2023
To help you understand the basics, here’s a brief guide to Roth IRA conversion.
As the Baby Boomer and Gen X generations reach retirement age, many are taking another look at their retirement savings plans hoping to identify opportunities for tax management. For those with tax-deferred plans like traditional IRAs and 401(k)s, Roth conversion has become an increasingly popular method among those seeking future tax savings in exchange for paying an upfront tax bill. This process involves moving — or “rolling over” — funds from a traditional IRA or another retirement plan to a Roth account.
A Roth IRA conversion won’t make sense for everyone, so knowing how they work, the pitfalls they entail, and how best to execute them is crucial to mapping out your individual retirement strategy. To help you understand the basics, here’s a brief guide to Roth IRA conversion.
What Makes Roth IRAs Special?
With a traditional IRA or 401(k), you make contributions with pre-tax dollars (these contributions entitle you to an income tax deduction) and you pay your tax obligation down the road when you start taking distributions. This is essentially reversed in the case of the Roth IRA; your contributions are made with after-tax dollars, but your investments get to grow tax-free over time. With a Roth, you pay your tax obligation upfront and, in exchange, you get to enjoy tax free income in retirement as long as certain conditions are met.
Additionally, Roth IRAs afford investors superior flexibility when it comes to deploying the funds within their accounts. You can withdraw contributions — but not the earnings on these contributions — at any time should a sudden cash need arise, so your money isn’t “locked up” as it would be with a traditional IRA or 401(k).
Roth IRAs also don’t entail Required Minimum Distributions (RMDs) as other retirement plans do. That means that you won’t need to take out a certain amount of money each year after turning 72 (73 if you reach age 72 after Dec. 31, 2022), which allows you to save unused money to potentially share with your beneficiaries. Roth IRAs can make useful inheritance vehicles, too, because your heirs may not have to pay income taxes on their withdrawals.
Potential Pitfalls of Conversion
While Roth IRA conversions are used in many retirement saving strategies, they aren’t without risks or restrictions and they may not make sense for every investor. For instance, getting to pay your taxes today is only a boon if your tax rate ends up being higher in retirement. If this isn’t the case and your future tax rate ends up being lower than it is today, you may ultimately surrender less in taxes by sticking with your tax-deferred account over opting for a Roth. Be sure to account for both your state taxes and your income tax bracket when trying to predict what your future tax obligations will be.
Even if you determine that using a Roth IRA will reduce your total tax obligation, having to pay a potentially large sum at the time of conversion may not work for you. Assuming a relatively low effective tax rate of 24%, making a $200,000 conversion would result in you owing $48,000 in taxes. That’s not an insignificant check to write.
Another wrinkle to consider is that Roth accounts necessitate a five year holding period following contributions. Once you convert your funds, you can’t use the earnings on those funds for five years without subjecting yourself to costly early withdrawal penalties.
Utilizing a Roth Conversion
Though the IRS imposes a limit on the amount that can be directly contributed to a Roth IRA each year, there’s no such limit on the amount that can be indirectly contributed via rollover. Simply reach out to your financial institution or plan provider to initiate the process.
Moreover, if your income exceeds a certain amount — $138,000 for individuals and $218,000 for married couples filing jointly — you may not be eligible to contribute to a Roth IRA directly, or your contributions may be limited. However, you can still get funds from your IRA or 401(k) into a Roth by leveraging a so-called “backdoor Roth IRA.”
Backdoor Roth IRA
A backdoor Roth IRA is an informal name for a method used by high-income taxpayers to create a permanently tax-free Roth IRA, even if their incomes exceed the limits that tax law prescribes for regular Roth ownership. This tax management strategy helps you if your income is too high to contribute to a Roth IRA directly, whereby you can still get your money into the account by adding a few steps to the process:
- Contribute to a traditional IRA or 401(k). Ensure that the contributions you make are non-deductible (i.e., post-tax funds) and that you’ve accounted for those contributions in your submission of IRS Form 8606. Alternatively, you can roll money into an IRA from a traditional 401(k) account.
- Convert your contributions to a Roth IRA. It’s important that you convert your traditional IRA to a Roth IRA as soon as possible. Failing to do so could allow your non-deductible contributions to accumulate investment gains while within the traditional IRA, which you would be responsible for paying taxes on upon conversion.
- Enjoy the tax protection of a Roth IRA. If you’ve executed it properly, all the taxes you owe will be paid upfront. Assuming you’ve fulfilled certain requirements, the funds within your Roth will grow tax-free until you’re ready to start making withdrawals in retirement.
Similarly, you’re able to contribute after-tax income to your 401(k) and then make an in-service distribution of those funds into a Roth IRA. This is what’s known as the “Mega Backdoor Roth IRA” and it’s another potential tax savings strategy for high-earners to consider.
Is a Roth Conversion Right for You?
In general, Roth IRAs are best for people who envision having to pay more taxes later in life than they do currently, whether from an increase in income, a change in state residency, or higher expected tax rates. Rather than go the traditional IRA or 401(k) route and defer taxes until retirement, paying tax obligations now — while your taxes are lower — can mean you’ll ultimately get to hold onto more of your money and enjoy tax-free income later in life.
Here are a few scenarios you may find yourself in that could make a Roth conversion beneficial for you:
- You’ve just retired and have enough to sustain yourself for five years on a relatively lower income.
- You’re a young person who’s looking to convert your traditional IRA during a short-term income reduction.
- You’re likely to be in a higher tax bracket or moving to a state with higher income taxes in the future.
- You want to save
If you meet any of these criteria and wouldn’t mind footing a larger tax bill upfront in order to potentially save money down the road, think about reaching out to a financial advisor today to discuss your rollover options. Private Vista advisors can help you determine whether or not moving your money into a Roth makes sense for you, as well as help you navigate the rollover process.
This material is intended for informational/educational purposes only and should not be construed as tax, legal or investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Certain sections of this material may contain forward-looking statements. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results. Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption of any kind. Please consult with your financial professional and/or a legal or tax professional regarding your specific situation and before making any investing decisions. Converting an employer plan account or Traditional IRA to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including but not limited to, a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA.
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