How a Roth conversion works
While the allure of a current tax benefit can be an enticing reason to consider traditional retirement accounts, many savvy investors are recognizing the benefits Roth accounts provide.
However, whether it’s because your income limits you from directly contributing to a Roth IRA or you haven’t had as much opportunity to contribute to Roth accounts, you may not have as many Roth assets as you’d like. So, what can you do? A Roth conversion may be able to help.
A Roth conversion occurs when you move funds from a traditional individual retirement account (IRA) to a Roth IRA. With a Roth conversion, you pay taxes now to convert your funds, but you can gain access to tax-free distributions in the future as well as some other benefits Roth IRAs have to offer.
What are the benefits of a Roth IRA?
As mentioned, Roth IRAs have many benefits, which include:
- Tax-free income in retirement if you make qualified withdrawals, giving you more control over your tax bill in retirement
- You may pay lower taxes if your current tax rate is lower than your expected tax rate in retirement
- No required minimum distributions (RMDs) while the original account holder is alive, allowing your assets to grow tax deferred over a longer period
- A tax-free asset for your heirs
- The ability to access contributions tax- and penalty-free before retirement
What are the rules of a Roth IRA conversion?
Before converting your IRA, you should be aware of some important tax rules and limitations.
- A Roth IRA conversion is nonreversible. Once you convert funds from a traditional IRA, you can’t undo or reverse the transaction. So, make sure you’re aware of the tax consequences and financial impacts before you convert.
- If you have a mix of pretax and after-tax dollars in your traditional IRA(s), the amount taxed is based on the percentage of your IRA(s) that is made up of pretax amounts. This is known as the Pro Rata rule. While a couple of exceptions can allow you to separate your pretax and after-tax contributions, generally, you cannot.
- If you’re under 59½, and do not qualify for a penalty exception, you must not withdraw your converted assets from your Roth IRA before meeting the five-year holding period requirement or you’ll be subject to a 10% penalty. It’s important to note that the five-year holding period requirement applies separately to each Roth conversion you make.
- The deadline for a conversion to count for a given year is Dec. 31. It is not the tax deadline, like it is for an IRA contribution counting in a given year (typically April 15 of the following year).
Should you consider a Roth conversion?
Now that you understand the benefits and potential limitations of a Roth IRA conversion, you may be wondering if this strategy is right for you. In general, a good candidate for a Roth IRA conversion is someone who:
- Doesn’t need access to the funds for five years;
- AND can pay any related taxes from sources other than their conversion;
- AND meets one or more of the following:
- Holds a sizable amount of assets in traditional retirement accounts but wants access to tax-free assets or to reduce RMDs in the future.
- Expects their future tax bracket to be higher than it currently is.
- Expects their taxable income to be high in retirement (in one of the top four federal tax brackets).
If you fit these criteria, you may be able to benefit from a Roth IRA conversion.
Final thoughts on maximizing your benefits
If a Roth IRA conversion is something you’re interested in, there are some additional considerations you should be aware of to help maximize the benefits:
- While it’s generally a good idea to wait until the end of the year to complete a Roth conversion, converting earlier in the year if markets are down can be beneficial, especially if you have a good sense of your taxable income for the year.
- Because you’re not limited in the number of times you can complete a Roth conversion, it can make sense to convert smaller amounts over time. By executing Roth conversions in smaller pieces, you can avoid concentrating the tax bill in any one year. And if you have years when your income is lower, you can use those years to avoid a bump in your tax bracket.
- It’s typically better to pay taxes related to the conversion out of pocket (rather than having them withheld). Otherwise, you’ll end up with less converted and could owe a penalty on the withheld amount.
Interested in seeing if a Roth IRA conversion is right for you? We can help.
While a Roth IRA conversion may be beneficial, many variables (such as timing and the size or number of conversions you make) could hinder your ability to reap the full benefits of this strategy. As such, it’s important to consult with your tax professional and Edward Jones financial advisor to better understand how it will impact your personal situation.
Edward Jones, its employees and financial advisors cannot provide tax or legal advice. You should consult your attorney or qualified tax advisor regarding your situation.