Roth IRA Conversion Basics
By: Financial Hotline
Summer 2024 (Vol. 42, No. 2)
The difference between a Roth IRA and other types of IRAs is that the Roth account is funded with after-tax dollars. That means you pay taxes on funds before contributing them to the Roth, and you can’t deduct contributions from your taxable income.
While choosing the Roth IRA gives you little or no benefit upfront, you will reap rewards when it is time to take your money out. The money in the Roth account grows tax-free and you can withdraw funds after you retire without paying taxes. So, let’s say you put $7,500 in a Roth today and it grows to $27,500 by the time your retire in ten years. You could take the entire sum out and pay no taxes on the entire amount of $27,500.
Q: I already opened a traditional IRA. Can I switch those funds to a Roth?
A: You can convert funds in pre-tax IRA accounts to a Roth IRA. This includes traditional IRAs, SEP IRAs and Simple IRAs. That sounds simple enough but the big drawback is when you convert pre-tax money in a regular IRA to a Roth IRA, you have to pay taxes on it at your current rate. The conversion amount is treated as regular income, which can bump you into a higher tax bracket and cause a high tax bill for the conversion year.
For example, if you are in the 22% tax bracket and convert $40,000. Your income for the tax year will increase by $40,000. Assuming that this doesn’t push you into a higher tax bracket, you could owe around $8,800 in taxes on the conversion.
Q: Do I have to convert an entire account or can I do small amounts each year?
A: You can choose the amount you want to convert. There are no limits on conversions. A taxpayer with a pre-tax IRA can convert any amount of funds in a year to a Roth IRA. This can be helpful for higher-income taxpayers who are restricted from making new contributions. Most taxpayers can contribute up to $6,500 ($7,500 if you’re age 50 or older), according to the IRS. But contribution limits are lower for higher-income taxpayers and, after a point, no Roth contributions are allowed at all.
Roth IRAs also are exempt from required minimum distributions (RMDs). These mandatory withdrawals from retirement accounts begin at age 73 and can create a tax burden on affluent retirees. But Roth owners don’t have to take RMDs for as long as they live, which makes the Roth IRA particularly useful for leaving inheritances.
Q: What are the downsides to a Roth Conversion?
A: The biggest obstacle for most is having to pay a large amount of taxes on the converted amount. Another potential drawback is that you can’t just transfer pre-tax money and immediately start withdrawing tax free. The Roth is still subject to a 10% penalty for early (before age 59.5) withdrawals. Roth accounts also must be open for five years to avoid paying taxes on withdrawals. Finally, the process of converting a regular IRA to a Roth IRA can’t be undone. A taxpayer who is not certain post- retirement income taxes will be lower than they are today might want to think twice about a conversion.
Q: What steps do I take to convert my pre-tax IRA to Roth?
A: A first step is to determine how a conversion will affect your tax liability. You may want to limit the amount according to how it affects your tax bracket. It is also important to know how much you will pay in taxes.
Next, contact your current IRA holder for advice on how to initiate the process. There are different ways you can accomplish this including a rollover or a trustee-to-trustee transfer. For a rollover, you would simply request a check from your traditional IRA and deposit it into your Roth IRA within 60 days. That can be a little risky because if you miss that deadline for some unforeseen reason you would be taxed for a regular withdrawal.
The more common route is to ask your traditional IRA provider to move the money directly to your Roth IRA provider at another financial institution. If both IRAs are at the same firm, you simply request a specific amount to be transferred.