Many financial experts consider a Roth IRA to be the premier choice for retirement accounts due to its significant advantages. These include earning tax-free income and having the option to pass on tax-free funds to your beneficiaries. Additionally, thanks to its tax-exempt nature, a
Roth IRA
offers you adaptability when it pertains to receiving retirement funds.
However, what if you possess a different kind of retirement plan? The positive aspect is that you can transform plans like a
401(k)
or
traditional IRA
into a Roth IRA and reap its various advantages.
Switching to a Roth IRA can be an excellent strategy to benefit from currently low tax rates and secure a tax-free retirement,” explains Eva Victor, who serves as the senior director of high-net-worth wealth planning at Northwestern Mutual. “After establishing a Roth IRA, it has the potential to generate tax-free income for many years, potentially even several decades.
Here’s how you can utilize a Roth IRA conversion to establish tax-free income during your retirement.
What exactly is a Roth IRA?
A Roth IRA is a retirement account with tax benefits. In this type of account, you contribute funds that have already been taxed, allowing investment across various asset classes. The key advantage comes when withdrawing funds; these become exempt from taxes once you reach 59½ years old. This tax-free withdrawal feature stands out as the primary benefit, though the Roth IRA provides additional perks too.
When planning your estate, a Roth IRA stands out for its value. It allows you to transfer the account without incurring taxes, offering substantial tax benefits to your beneficiaries. Additionally, you’re eligible to contribute to a Roth IRA regardless of your age, provided you have sufficient earned income to meet the contribution requirements.
The Roth IRA provides considerable flexibility as well. Additionally, there are no restrictions here.
required minimum distributions
, similar to how you would with a traditional IRA. Additionally, you can withdraw your contributions (not earnings) at any time without penalties. If you choose to withdraw earnings before age 59½, you may face taxes and an extra 10 percent penalty. Nonetheless, certain circumstances
permit you to make withdrawal without penalties
.
It’s crucial to remember that converting a traditional IRA or traditional 401(k) into a Roth IRA means you’ll face taxes and penalties if withdrawals occur within five years after the conversion and before reaching age 59½. Nonetheless, this
five-year rule
This exception does not apply if you’re withdrawing converted funds after reaching 59 1/2 years of age. Additionally, whenever you perform several Roth conversions, each one must adhere to its individual five-year regulation.
What steps are involved in performing a Roth IRA conversion?
The real procedure for transforming a
401(k) or traditional IRA
Contributing to a Roth IRA is straightforward. However, when tax season arrives, matters can become more complex.
The following are the three fundamental steps for converting your retirement account into a Roth IRA:
-
Open a Roth IRA account.
You’ll need to establish a Roth IRA account with a financial organization. Should you already possess a Roth IRA, you may utilize that same account for the conversion as well. (Below are some examples)
the top locations for starting a Roth IRA
) -
Contact your plan administrators.
Contact both your former and current financial institutions to determine their requirements for transitioning to the new account. This process might be simpler if you’re just establishing another account with the same institution. -
Submit the required paperwork.
After identifying all the necessary documents that must be submitted, you can proceed with turning them in. It’s important to specify which assets will undergo conversion.
If you handle your own finances, you can locate instructions for performing a Roth conversion on your investment platform’s website,” explains Kerry Keihn, a financial advisor and partner at Earth Equity Advisors based in the Asheville, North Carolina region, adding that every firm has a somewhat distinct procedure or paperwork.
In just a few weeks – and sometimes even sooner – the switch to the Roth IRA will be completed.
Once the tax-filing period arrives for the year you completed the conversion, you must submit Form 8606 to inform the IRS about converting your account into a Roth IRA.
If funds are transferred from a traditional account to a Roth, they’ll be considered regular income and subject to taxes. This could result in significant tax liability, requiring you to have sufficient funds set aside for payment. As an alternative, consider spreading the conversion out over multiple years to reduce the tax impact in each individual year.
Although converting to a Roth IRA might not be common for certain people, numerous others who have incomes exceeding the limits for contributing directly to a Roth IRA opt for this strategy.
backdoor Roth IRA conversion
Every year, they aim to utilize the numerous advantages offered by the account, as this is the sole method available to them.
What individuals might benefit from converting their traditional IRA into a Roth IRA?
Converting to a Roth IRA might be a wise choice for numerous people, and below are several typical scenarios where this makes sense.
You earn too much
A Roth conversion may be a suitable choice for people earning too much to qualify for a traditional Roth IRA. In this process, individuals transfer funds into a Roth account.
non-deductible IRA initially and later convert it into a Roth IRA
– the so-called backdoor Roth IRA approach.
You anticipate facing higher tax rates during your retirement.
Victor mentions a guideline for determining when a conversion might be advantageous: “It could be beneficial if your current income tax rate is lower than what you expect it will be at withdrawal time.”
The reasons you may find yourself in a higher tax bracket can include various factors such as residing in a state that imposes income taxes, experiencing increased earnings later in your career, or facing elevated federal tax rates at some point.
Suppose you’re a resident of Texas and decide to convert your traditional Individual Retirement Account (IRA) into a Roth IRA before retiring,” explains Loreen Gilbert, CEO at WealthWise Financial Services based in Irvine. “If you later relocate to California during your retirement years,” she continues, highlighting states with contrasting policies like zero-tax Texas versus high-tax California. “In this scenario, although California would impose taxes on distributions from an IRA, withdrawals from your Roth IRA remain untaxed.
In this scenario, you sidestep state tax obligations during the conversion process in Texas and subsequently evade income taxation upon withdrawals in California once retired.
Your earnings are quite modest this year.
Any funds transferred from a traditional account to a Roth will be subject to taxation as ordinary income, based on your
tax bracket
Therefore, it makes sense to perform this conversion in a year when your income is significantly lower than usual.
“If you’ve decided to take some time off before beginning a new career, a Roth conversion might be an excellent choice for you this year because of your temporarily reduced income,” explains Keihn.
You aim to provide heirs with income that is free of taxes.
Converting to a Roth IRA might also be advantageous if your aim is to provide your beneficiaries with tax-free earnings. This approach can be especially useful if you plan for the funds to benefit someone besides your spouse.
Where the IRA inheritance rules are distinctive and offer greater benefits.
.
According to the SECURE Act, if you bequeath your traditional IRA to a non-spouse beneficiary, they must completely empty that account within ten years, as stated by Keihn. The implications could lead to substantial tax ramifications, depending on the account’s value.
However, the Roth IRA spares your beneficiaries from dealing with tax implications, according to Keihn. “Even though the 10-year rule will still be applicable when a non-spousal heir inherits your Roth IRA, they won’t owe income taxes on the distributions,” she explains.
Which types of accounts have the option to convert into a Roth IRA?
Performing a Roth IRA conversion entails moving retirement funds into either an established or newly created Roth IRA account. Typically, these transferable accounts fit within one of two classifications.
-
Current IRA accounts like traditional IRAs,
SEP IRAs
or
SIMPLE IRAs
All of them can potentially be switched to Roth IRAs to enjoy the associated tax advantages. This conversion process is quite simple and requires reaching out to the financial organizations managing your current accounts and completing the necessary forms. - Workplace retirement plans, such as 401(k)s from former jobs, can also undergo conversion into Roth IRAs via a rollover process. This allows for the transfer of funds from these accounts provided you pay the required taxes. In contrast, converting a Roth 401(k) does not incur immediate tax obligations. Typically, when making this switch, investors often find they gain access to a wider range of investment choices within an IRA compared to their original workplace plan.
What you should be cautious about during conversion
Although setting up a Roth IRA conversion may be fairly straightforward, it’s important to adhere to certain regulations to ensure you take full advantage of the opportunities while minimizing tax liabilities. Below are some key recommendations from professionals regarding what to keep an eye on:
A conversion could result in higher tax liabilities.
If you transfer funds from a traditional IRA or a traditional 401(k) to a Roth IRA, you will face a tax liability. This is because you’re treating those contributions as taxable income, which means you have to pay taxes on them—unlike when they were initially deposited into the traditional accounts using pretax money.
If you convert a
Roth 401(k)
into a Roth IRA, you skip the tax hit, because they’re both after-tax accounts. However, any
employer match
In a Roth 401(k), funds might be kept within a traditional 401(k). This means that section can’t be moved without facing tax implications.
Nevertheless, with the passage in late 2022 of the
SECURE Act 2.0
Now permits matching contributions to be deposited into a Roth 401(k). This means you won’t owe taxes upon converting since you paid them at the time of depositing the funds. Therefore, make sure to verify this information with your plan administrator prior to initiating any transfer.
Think about transitioning gradually over several years.
Advisors like Victor recommend meticulous planning to reduce the tax impact associated with conversions. People might distribute their conversion amounts across several years instead of converting everything at once within a single year. This approach can help them bypass moving into a higher tax bracket and prevent paying increased taxes on additional dollars from the converted funds.
A transformation works out better when you have ample time.
The greater the duration between converting the funds and utilizing them, the better,” states Gilbert. “This allows the money to keep growing even after the tax payment has been made.
Be cautious of the five-year rule.
The IRS typically mandates that conversions must happen at least five years prior to withdrawing funds; otherwise, you may face a 10 percent early withdrawal penalty.
“If you anticipate needing to access those funds within fewer than five years of establishing your Roth IRA, it might be wise to reassess converting to this type of account or discuss with a Certified Public Accountant whether it remains the optimal choice for you,” advises Keihn.
Nevertheless, people aged 59½ and above are exempt from the early withdrawal penalty, regardless of whether they adhere to the five-year rule for conversions.
A change might impact governmental initiatives.
Should you have been involved in government-run health care initiatives or similar programs that consider your income level for participation, converting might impact your qualification status or alter the costs associated with these programs.
The Roth conversion is considered taxable income in the same year it happens,” explains Keihn. “As such, it might impact your qualification for Obamacare or financial assistance, or even your children’s financial aid. If you are enrolled in Obamacare, this could be particularly relevant.
completing a FAFSA application
it’s crucial to consider this when deciding how much, if any, to convert.
People who are about two years away from getting Medicare benefits or those who have already started receiving them should understand that their Medicare premium will probably increase two years after they switch to a Roth IRA,” explains Gilbert. “Medicare reviews your finances over a two-year period to set these premiums, and during the year of conversion, your income will appear higher compared to previous years. However, this is just an initial surge that typically drops back down the next year.
This fee on
Medicare
Part B and Part D premiums are referred to as the
income-related monthly adjustment amount
, or IRMAA.
The IRMAA depends on the adjusted gross income figure you provided in your IRS tax return from two years ago, with calculations following a graduated scale. Earnings increase as does this adjustment sum.
In 2024, Medicare recipients who had an income over $103,000 in 2022 for individual returns or more than $206,000 for joint filings by married couples will incur extra charges ranging from $69.90 to $419.30 above their regular monthly Part B premiums, as well as an additional amount between $12.90 and $81.00 added onto their monthly Part D premiums.
After your earnings have decreased, you may finish
This document is from the Social Security Administration.
To ask for a decrease in your IRMAA.
Complete it promptly
Don’t delay a Roth conversion until December; remember, the IRS doesn’t offer any extensions,” states Keihn. “Ensure you finish the process by December 31st of the relevant tax year for it to be applicable.
Watch out for the pro-rata rule during conversions.
If you own traditional IRAs with deductible contributions, you must take them into account when converting any non-deductible portions to a Roth IRA. The IRS mandates adherence to the pro-rata rule, requiring you to assess the overall tax impact based on all of your IRA assets collectively.
Essentially, you’ll need to determine the portion of your funds that consists of untaxed amounts – such as deductible contributions and earnings – relative to all your IRA assets. This specific percentage will be taxable upon conversion.
ordinary income tax rates
.
This is a complicated computation and may lead to considerable bewilderment.
Call in an advisor
If this is all too complex, it can be worthwhile to work with a financial advisor to help you make the best possible decision. Look for an advisor who you’ll pay to work in your best interest. SofTechoffers a
financial advisor matching tool
to pair clients with nearby advisors within minutes.
Bottom line
Converting to a Roth IRA might be beneficial if your aim is to generate tax-free income during retirement; however, it’s crucial to weigh the pros and cons, particularly the upfront taxes involved in the process. If you’re dealing with a substantial account balance, strategizing ways to reduce the taxable amount becomes essential. Therefore, consulting with a tax advisor may prove highly valuable and even save you money.
Editorial Disclaimer: It is recommended that all investors perform their own thorough research into investment strategies prior to making an investment choice. Additionally, it should be noted that previous performance of investment products does not ensure future growth in value.
