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Roth IRAs are an incredible way for the average person to build their net worth. Ever since they were first proposed by Senator William Roth (hence the name) and become part of the Taxpayer Relief Act of 1997, financial experts have been singing the praises of their unique tax advantages.
To quickly recap, distributions from a Roth IRA account are completely tax-free. Unlike contributions and earnings in a traditional IRA which are tax-deferred until withdrawn, contributions to a Roth IRA are taxed up front. This small change has helped millions of Americans to optimize their tax situation and enjoy more of their money when they’re retired.
However, savers are only allowed to put up to $6,000 annually into their Roth IRAs each year (or $7,000 if they’re age 50 and older). Additionally, some people may earn too much to participate. In these cases, what they need is to exercise what’s known as a Roth IRA conversion.
A Roth IRA conversion is when someone transfers a portion of their traditional IRA into a Roth IRA. Although there will be taxes that come due, the account owner gets all the benefits of the money being in a Roth such as tax-free withdrawals when they retire.
Additionally, people who want to retire early or avoid required minimum distributions can leverage these Roth conversions to their advantage. However, there are some potential pitfalls to avoid such as penalties and excessive tax rates. In this post, we’ll explain the logistics surrounding a Roth IRA conversion and why you should consider them for improving your financial future.
What is a Roth IRA Conversion?
Simply put, Roth IRA conversions are when an account owner takes money from their traditional IRA and moves it into their Roth IRA account. Of course, the process isn’t as simple as transferring funds between two bank accounts. There are several IRS rules in place regarding any money going into or out of these accounts, and so they must be followed strictly.
Currently, the IRS recognizes that Roth IRA conversions can occur in one of three ways:
- Manual rollover. Money is physically withdrawn from a traditional IRA (generally by check) and then redeposited into the Roth IRA. Account owners who choose to do this must manually request the check and then deposit it all on their own. This transaction must also be completed within 60 days or the withdrawal will be considered taxable and subject to a penalty.
- Trustee-to-trustee transfer. Money is transferred from a traditional IRA at one financial institution to a Roth IRA at another (usually electronically). The account owner doesn’t have to do anything except authorize the transfer.
- Same-trustee transfer. Money is transferred from a traditional IRA to a Roth IRA within the same financial institution. This is generally the easiest type of transfer because the transaction happens in-house. Again, the account owner doesn’t have to do anything except authorize the transfer.
In each case, the transfer always originates from a traditional IRA. Investors who don’t already have a traditional IRA can convert some or all of their 401k into what’s called a rollover IRA (which is essentially the same thing as a traditional IRA).
People who are self-employed or who have side hustles can also contribute to a SEP IRA; another variation of a traditional IRA. If none of those apply, then you always have the option of taking taxable income and starting a traditional IRA with what’s called nondeductible contributions (meaning they can’t be subtracted from your income when you file your tax return).
The Tax Implications of Roth IRA Conversions
In case you’re wondering why people don’t just take their entire 401ks, roll them over into a traditional IRA, and then convert them into a Roth IRA, there’s a good reason for that: taxes!
Anytime pre-tax money from a traditional IRA or 401k is converted to post-tax money (i.e., Roth-style account), the account owner must report this transfer on their federal income tax return. This means that taxes will come due, and if you’re not careful, the bill could be staggering.
How? Remember that any pre-tax amount of money that gets converted is considered to be taxable income. To illustrate this point, consider that someone who earns $100,000 from their job and then decides to convert $500,000 from a traditional to a Roth IRA will effectively have $600,000 of taxable income for the year from the perspective of the IRS.
Since U.S. taxes are based on a progressive tax bracket system based on income, this means that this single filer’s tax rate would jump from 24 percent to 37 percent. That’s the difference between a $120,000 and a $185,000 tax bill. In other words, they’d be paying a whole lot more unnecessarily for this conversion.
This is why it's generally not advised that a Roth IRA conversion is done all at once. Instead, a better and more strategic approach is to transfer a little bit at a time every year. For instance, the person in our earlier example could convert up to $70,000 before they crossed over into the next tax bracket.
How Much Money Can I Convert To A Roth?
Under the current law, there are no limits to the size or number of conversions that can be made from a traditional IRA to a Roth IRA. The account owner could make one per year or one per month – whatever they’d like.
However, it’s again important to think about how much this will cost in taxes. Going back to our example from earlier, even a moderate amount of $20,000 would trigger a tax bill of approximately $4,800. If the account owner is not prepared for this $4,800 tax bill, then it may cause some undue financial hardship.
This is why conversions should be performed under the guidance of a tax professional. Together, the two parties can work together to ensure all aspects of the conversion are considered and properly accounted for.
Who Would Need A Roth IRA Conversion?
There are several types of people who might benefit from making Roth IRA conversions. For starters, anyone who thinks they might be in a higher tax bracket when they retire than they are now should start the process now while they’re at a lower rate.
Related to this are people who believe their investments might grow and put them in a position to be in a higher tax bracket. One very interesting (and extreme) example of this is when PayPal co-founder Peter Thiel contributed $2,000 into his Roth IRA and it grew to $5 billion two decades later. Technically, all of that money is now tax-free.
Another notable group is anyone who earns too much to contribute directly to a Roth IRA. As of 2022, only people with a MAGI (modified adjusted gross income) of $109,000 (single filers) or $204,000 (joint filers) are able to contribute up to the full $6,000.
In this circumstance, these high-income earners will need to use what’s known as a “backdoor Roth IRA”. A backdoor Roth IRA works like this:
- The account owner makes a nondeductible contribution to their traditional IRA.
- Those funds are then converted to a Roth IRA.
Again, this is allowed because account owners are free to convert as much money as they want from a traditional IRA to a Roth IRA. However, if there were already pre-tax dollars inside the traditional IRA when you made the nondeductible contribution, then the conversion will be subject to something called the Pro-Rata rule. The calculation for this can get a bit complex, so it would be best to work with a good tax professional to ensure that it’s done correctly.
Be Mindful Of The Five-Year Rule
Another aspect of Roth IRA conversions to consider is that there’s a five-year holding period before the money becomes eligible as a penalty-free withdrawal. As you may already know, withdrawals taken from most retirement accounts before age 59-1/2 will incur a 10 percent penalty.
Since Roth IRA contributions are considered to be free of this penalty, the IRS doesn’t want people to take advantage of the conversion process and have instant access to their money. Therefore, that’s why this five-year rule is in place.
Note that the five-year period starts at the beginning of the calendar year that the conversion was made. To illustrate, if you initiate a conversion in October 2022, then the clock would start on January 1st, 2022. Therefore, these conversions would be available penalty-free five years later on January 1st, 2027.
Anyone who is over the age of 59-1/2 doesn’t have to worry about the five-year rule because technically penalties no longer apply. Also, people who are still working and don’t need the money yet shouldn’t be bothered. The five-year rule is really only something to be mindful of if you plan on making withdrawals and you’re under age 59-1/2.
Retire Early By Making Roth IRA Conversions
One group of people who may find Roth IRA conversions particularly useful are those who plan to retire before age 59-1/2 and need early access to their money. To do this, they’ll want to use what’s known as a Roth IRA conversion ladder.
Here’s how it works:
- In the first year, the account owner takes funds from inside the traditional IRA and converts them to the Roth IRA. It might be the entire amount they need for one year’s worth of living expenses or some other amount.
- In the second year, the account owner makes another conversion of a similar size. They continue this process every year afterward.
- Starting in the sixth year, the Roth conversion from the first year becomes eligible for a penalty-free withdrawal.
- In the seventh year, the Roth conversion from the second year also becomes eligible for a penalty-free withdrawal. And so on …
As you can see, this strategy creates a system of moving funds (like a person moving their hands and feet up the rungs of a ladder). But to do this correctly, the process has to be started five years before the first date that the funds are needed, so planning is key.
This strategy also assumes that Roth conversions will be allowed indefinitely. If the tax laws ever change or limitations are put on them, then this could significantly alter the usefulness of this strategy.
Avoiding RMDs Using Roth IRA Conversions
Early retirees aren’t the only people who can benefit from Roth IRA conversions. Someday, all account owners will have to start taking what are known as required minimum distributions (RMDs). This is when the IRS starts forcing retirees to take out a certain amount of pre-tax funds each year.
RMDs start at age 72 and get incrementally larger as the account owner gets older. The penalty for not following the IRS rules is a ridiculous 50 percent charge.
To fight back, many financial professionals will often recommend that retirees start making Roth IRA conversions as early as possible. Since distributions from a Roth IRA are tax-free, there are no RMDs. Therefore, the more money you can start converting now, the less tax you’ll have to pay later on in life.
This is the entire premise behind the best-selling book “The Power of Zero” by David McKnight. Within the pages, McKnight makes the case that tax rates are currently at a historically low point, and probably will never be this good ever again. Additionally, he argues that even if readers think they will be in a lower tax bracket when they retire, they’ll still be at risk because the government could increase them at any time.
For the reader to optimize their tax situation, McKnight tells them to think of their savings in terms of three buckets:
The more savers can move from their taxable and tax-deferred buckets to their tax-free bucket, the fewer RMDs they’ll have to make and the lower their tax bill will be someday.
Given the name of the book, the ultimate goal that McKnight is trying to help the reader achieve is to get to zero taxes when they retire. There are many nuances to accomplishing this and the process has to be carefully planned out. However, the root of the entire strategy begins with properly utilizing Roth IRA conversions.
How To Make A Roth IRA Conversion
For anyone thinking about converting some or all of their retirement savings into a Roth, the process is fairly straightforward. However, given the potential consequences of taxes and penalties, it will be important to make this decision with care. Here are the steps to take before starting the process.
1. Determine Why You Want To Make A Conversion
What is the end game with making Roth IRA conversions?
- More tax-free money at retirement?
- The ability to access your money before reaching age 59-1/2?
- Not having to deal with RMDs and all the taxes that will be due after you’re age 72?
There are a lot of good reasons to use this strategy, but each one will dictate how it works going forward. For instance, someone who wants to retire early will have to start making conversions much sooner and probably more aggressively than someone else who just wants to avoid RMDs later on.
If you’re not sure how to move forward, then consider working with a financial advisor from someone like Personal Capital. Personal Capital provides wealth management services that include tax optimization and personal strategy. At a minimum, signing up for their free account gives you access to their suite of financial tools such as a net worth tracker, savings planner, and budgeting app.
2. Decide How Much You'd Like To Convert
The next part is to decide how much you can comfortably afford to convert to a Roth each year.
This will tie in directly to your answer for Step 1. For example, if your goal is to retire early and start a Roth IRA conversion ladder, and you believe you’ll need $40,000 from your Roth IRA every year, then you’ll have to be prepared to start paying the taxes on this conversion now. If you’re in the 22 percent tax bracket, that means around $8,800.
This is a very important step because if the tax bill is too high, then you may have to go back to Step 1 and reconsider your original intention. Talk about it with your spouse and a trusted financial professional to determine what you believe will be appropriate.
3. Place The Money In Your Traditional IRA
After you know how much you plan to convert, it's time to get your ducks in a row. Start by consolidating the funds that are needed into your traditional IRA.
For most people, this will be their employer-sponsored plans like a 401k, 403b, or 457. Usually, you’ll be separated from your job before this rollover can take place. If you’ve got old accounts with previous employers, then those should be available for rollover immediately.
Remember that even taxable income can be put into your traditional IRA as nondeductible contributions. However, it will make the tax calculations a bit trickier due to the Pro-Rata rule, so work with a professional to do them correctly.
4. Initiate The Transfer
With the funds in place, it’s time to make it official. Go online or call your financial institution to initiate the process.
Generally, this step is fairly easy and only involves filling out a few forms. If the transfer is taking place between two separate financial institutions, then it may be a good idea to inform each one separately.
5. Pay Your Taxes And Wait 5 Years
Again, remember to report this conversion on your federal income taxes for the year. Also, be prepared for the taxes that will come due.
If you’re younger than age 59-1/2, don’t start taking out withdrawals from your Roth just yet. Those conversions need to age five calendar years before they’re available penalty-free. If you’re already older than age 59-1/2, then this rule doesn’t apply.
Is A Roth IRA Conversion Right For You?
Roth IRAs are a great way to save for retirement. However, given the contribution and income limits, not everyone will be eligible to participate or contribute as much as they'd like. For these reasons, savers can use what's called a Roth IRA conversion to transfer their money from a traditional IRA into a Roth IRA.
Roth IRA conversions can be done as many times as the account owner wishes and be any amount. However, with each conversion of pre-tax dollars, there will be taxes that will come due that year. Therefore, it will be important to plan ahead, not convert more than is needed, and inadvertently pay higher taxes unnecessarily.
The typical candidate for a Roth IRA conversion is someone who believes they will be in a higher tax bracket in the future than they are right now. People who earn too much can use conversions with a technique called a backdoor Roth IRA. Conversions can also be used for more niche reasons such as funding an early retirement and reducing RMDs later on in life.
Making a Roth IRA conversion is fairly straightforward. Move your funds into a traditional IRA and then fill out any necessary forms to initiate the transfer. Don't forget to report the conversion on your federal tax return so that any applicable taxes can be paid.
The most important step in this process is understanding why you'd like to make the conversion in the first place. Spend some time determining how these conversions might benefit your financial future. Be sure to also run your plan by a trusted financial professional so that you'll be prepared for any taxes or limitations that might impact your decision.