How to Convert to a Roth IRA

There are a number of reasons to consider a Roth individual retirement account (IRA) rollover, which moves funds from an existing traditional IRA (or another retirement account) into a Roth IRA.

A Roth conversion is especially attractive if you expect your future tax rate to be higher than your current rate. And if your earnings are high enough to prevent you from contributing directly to a Roth IRA, you can use a Roth conversion as a backdoor entry into future tax-free income in retirement.

Here's a quick look at how to convert to a Roth IRA, plus considerations when deciding whether it makes sense for you.

Key Takeaways

  • A Roth individual retirement account allows investors to contribute after-tax dollars.
  • A Roth IRA rollover or conversion shifts money from a traditional IRA or 401(k) into a Roth IRA.
  • A Roth conversion is especially attractive if you expect your future tax rate to be higher than your current rate because you don't pay tax on withdrawals from Roth IRAs.
  • As a high-earner, you can also get around Roth IRA income limits by doing a rollover, a process commonly referred to as a backdoor Roth IRA.
  • You'll owe tax on any amount you convert and it could be substantial.

How to Roll Over Funds Into a Roth IRA

It is relatively easy, although it can be expensive, to roll funds into a Roth. In general, you follow this process:

  1. Fund your traditional IRA or employer-sponsored 401(k). If you don't have one already, you'll have to open and fund one first.
  2. Withdraw funds from your eligible retirement account. Once your plan gives you an eligible rollover check from your other retirement account, you will have 60 days to roll it into a Roth IRA.
  3. Roll funds into a Roth IRA account. If you don't have a Roth IRA yet, you'll open one during the rollover.
  4. Pay taxes on your contributions and earnings. You make Roth IRA contributions with after-tax dollars. If you already deducted your traditional IRA contributions, you'll owe taxes now. This sounds like an easy enough step, but keep in mind that the tax burden could be substantial.

Roth IRA Conversion Methods

There are several ways to enact a Roth conversion, depending on where you hold your retirement accounts:

  • With a 60-day indirect rollover, you receive a distribution in the form of a check paid directly to you from your traditional IRA. You then have 60 days to deposit it into your Roth IRA.
  • A simpler way to convert to a Roth IRA is a trustee-to-trustee direct transfer from one financial institution to another. Tell your traditional IRA provider that you'd like to transfer the money directly to your Roth IRA provider.
  • If both IRAs are at the same firm, you can ask your financial institution to transfer a specific amount from your traditional IRA to your Roth IRA. This method is called a same-trustee or direct transfer.

Converting from an Employer-Sponsored Plan

You can convert other retirement accounts, such as an employer-sponsored 401(k) or 403(b) plan, too, once you leave your job. Some plans let you access the money while you’re still working—an “in-service distribution.” However, you usually have to reach age 59½ before you can do so.

If you want to convert assets from your 401(k) or another employer-sponsored plan to a Roth IRA, make sure the money is transferred directly to the financial institution through a trustee-to-trustee transfer.

If your company issues the check to you, it must withhold 20% of the account balance for tax purposes. Then you’ll have just 60 days to deposit all the money into a new Roth account—including the 20% that you didn’t receive. That must come from another source. Miss the deadline and any money not rolled over to a Roth IRA will be subject to a 10% early withdrawal penalty if you're younger than 59 ½.

Roth IRA Advantages

Roth IRAs offer several key benefits not offered by other retirement plans.

For starters, Roth IRA earnings grow tax-free, and withdrawals in retirement are tax-free, as well. Also, you can withdraw your contributions at any time, regardless of your age. What's more, there are no required minimum distributions (RMDs) for Roth IRAs while you're alive. That means, if you don't need the money, you can leave the account alone and pass it to your heirs.

A Roth conversion is especially attractive if you expect your future tax rate to be higher than your current rate. And if your earnings are high enough to prevent you from contributing directly to a Roth IRA, you can use a Roth conversion as a backdoor entry into future tax-free income in retirement.

Should You Convert to a Roth IRA Now?

Once you’ve decided a Roth IRA is your best retirement choice, the decision to convert comes down to your current year’s tax bill. That’s because when you move money from a pre-tax retirement account, such as a traditional IRA or 401(k), to a Roth, you have to pay taxes on that income. It makes sense: If you had put that money into a Roth originally, you would have paid taxes on it for the year when you contributed.

Democrats tried to put a moratorium on backdoor Roth conversions, primarily for the wealthy through the Build Back Better bill, which was first introduced by President Joe Biden in 2020. The bill aimed to create RMDs for accounts that exceeded $10 million while closing the door on additional contributions. This would, thus, close loopholes used by many wealthy individuals. The bill did not pass and was replaced by the Inflation Reduction Act of 2022.

Pros
  • Huge tax advantages, including tax-free growth and tax-free withdrawals in retirement 

  • Withdrawals are allowed at any time, for any reason, tax-free

  • Doesn't have required minimum distributions

Cons
  • You pay tax on the conversion—and it could be substantial

  • You may not benefit if your tax rate is lower in the future

  • You must wait five years to take tax-free withdrawals from the Roth after a rollover, even if you’re already age 59½

A Roth IRA rollover is most beneficial when:

  • You have the cash on hand to pay the taxes. You may be tempted to use some of the converted funds to cover your taxes. But that means you'll miss out on years or decades of tax-free growth on that money. And, you might owe a 10% penalty on the money.
  • It doesn’t trigger onerous tax consequences. But be careful: The amount you convert, when you add it to your current year’s income, could move you into a higher tax bracket or subject you to taxes you otherwise wouldn’t pay. For example, retirees who convert assets to a Roth IRA could end up paying more tax on their Social Security benefits and higher Medicare premiums if the converted amount lifts their income above certain levels. A tax advisor can help crunch the numbers.
  • Your existing IRA account has suffered recent losses. A lower balance in your traditional IRA means you’ll owe less tax at conversion time and have a greater potential for tax-free growth. If you convert existing retirement account balances to a Roth IRA this calendar year, you’ll pay the tax when you file your tax return at the tax deadline next year.
  • You're in a lower tax bracket than usual, perhaps because you worked less, switched jobs, or missed a bonus.
  • You have more itemizable deductions than usual, which can help lower your taxable income.
  • You earn too much to contribute to a Roth in the current year, but you expect to have a higher tax rate during retirement.

Should I Roll Over Traditional IRA Funds to a Roth?

It depends on your tax situation. If you are in a lower tax bracket this year than you plan to be during retirement, a rollover may make sense. For example, if you had been furloughed or laid off due to the coronavirus pandemic, that year might be a good year to consider transferring some of your retirement funds into a Roth IRA. On the other hand, if you expect to be in a lower tax bracket during retirement, it is wise to keep your funds where they are currently.

When Shouldn't You Convert to a Roth IRA?

If you're approaching retirement or need your IRA money to live on, it's unwise to convert to a Roth. Because you are paying taxes on your funds, converting to a Roth costs money. It takes a certain number of years before the money you pay upfront is justified by the tax savings.

Is There a Limit on How Much I Can Roll Over Into a Roth?

No, there are no limits on the total amount you can roll from your other retirement account into a Roth IRA. However, it may be beneficial to spread out your rollovers over multiple tax years to limit your tax bill. In contrast, the annual contribution limit for direct contributions to Roth IRAs for the tax years 2021 and 2022 is just $6,000 per year ($7,000 per year for those over the age of 50).

How Long Before I Can Withdraw Rollover Funds From a Roth?

You will be subject to a 10% early withdrawal penalty if you do not wait five years from the rollover. Note that the rollover is considered to have been made at the beginning of the calendar year in which the rollover is complete. For example, if you roll $5,000 from your traditional IRA to your Roth IRA on Feb. 15, 2022, you will be eligible for tax and penalty-free withdrawal of the funds as early as Jan. 1, 2027.

How Are Taxes Paid on a Roth IRA Conversion?

The federal tax on a Roth IRA conversion is collected by the IRS with the rest of your income taxes due on the return you file for the year of the conversion. The ordinary income generated by a Roth IRA conversion can typically be offset by losses and deductions reported on the same tax return.

The Bottom Line

Converting to a Roth IRA is easier than ever. You can transfer some or all of your existing traditional IRA or employer-sponsored retirement account balance to a Roth IRA, regardless of your income. Once the conversion is complete, congratulate yourself. You’ve just signed on for years of tax-free growth. It can be all the difference between a stressful—and a blissful—retirement.

Article Sources
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