I love the Roth IRA.
If I could wrap them up and give them away as birthday gifts, I would probably do it.
Scratch that. I would definitely do it!
Still, I don't think a Roth IRA is the answer to everything. As much as I love the Roth IRAs, deciding to convert your traditional IRAs and old 401(k)s to a Roth IRA is a personal decision. And in the real world, it isn't necessarily the slam dunk it's made out to be. In fact, there are have been several instances where I made the recommendation that clients steer clear of a Roth IRA conversion.
To better understand if a Roth IRA conversion is best for you, we have to understand the rules first. Here's a look at at the IRA to Roth IRA conversion tax rules.
My favorite online broker is Scottrade but you can check out our recap on the best places to open a Roth IRA and the best online stock broker sign up bonuses. There are many good options out there, but I have had the best overall experience with Scottrade. No matter which option you choose the most imporatant thing with any investing is to get started
Why Would You Want to Convert a Traditional IRA to a Roth IRA?
The primary advantage of converting your traditional IRA accounts to Roth IRAs is that the funds will not be subject to income tax upon withdrawal – ever.
Traditional IRAs in employer-sponsored retirement plans, such as 401(k) plans, are largely based on income tax deferral. That enables you to get a tax break on any contributions you make to those plans in the year the contributions are made. The money in the account accumulates (also on a tax-deferred basis), allowing you to build up a healthy nest egg by the time retirement rolls around. Once it does, any withdrawals that you take from the plans will be subject to income tax at whatever tax rate you happen to be in at the time.
With Roth IRAs however, there is no tax deferral on contributions. And just like other tax-sheltered retirement plans, the investment earnings in your plan will build up without being subject to income taxes. If you are tired of paying taxes and want to put at least some of your taxes behind you, this is a huge benefit.
However, that's where the similarity ends.
With a Roth IRA, not only do you not have to pay income tax on your plan contributions (which were never tax-deductible in the first place), but your investment earnings will not be subject to income taxes either. The only requirements are that you must be at least age 59 ½ when you begin taking withdrawals from the plan, and that you have been participating in the plan for a minimum of five years.
With traditional IRAs and other tax-deferred retirement plans, much of the good news is on the front end: when you make your contributions, you get a tax break. With a Roth IRA, the good news is on the back end: when you begin taking withdrawals from the plan, you have no income tax liability as a result.
No Required Minimum Distributions at age 70 ½
Roth IRAs have another advantage over other tax-sheltered retirement plans, and it’s one that becomes increasingly important as you move through your retirement years.
Virtually every other tax sheltered retirement plan requires that you begin taking required minimum distributions (RMDs) beginning no later than age 70 ½. In fact, there are stiff penalties if you don’t. Roth IRAs stand alone as the tax-sheltered retirement plan that does not require RMDs.
That will allow you to continue accumulating money in your Roth IRA while you are forced to draw down the balances of other retirement accounts. It makes it far less likely that you’ll ever outlive your money.
Where to Open a Roth IRA?
Nearly any online or brick-and-mortar brokerage firm will allow you to open a Roth provided you are eligible. You can save a ton of money and still get great service by going with one of these three online brokers.
Scottrade – Personally, I think Scottrade is one of the best options for opening up a Roth IRA account. Scottrade offers several benefits, like inexpensive trading fees, no set up fees, and no maintenance fees. They offer $7 trading costs for stocks and EFT trades and mutual fund trade fees will never be higher than $17.
Scottrade has a unique benefit of also having physical buildings that you can go to if you ever need to meet a broker face-to-face at one of their 500+ branches across the U.S.
Betterment – Betterment is one of the newer investing firms to enter into the finance arena. As an online brokerage firm, Betterment has several unique qualities that the other two firms don’t.
The first is that Betterment doesn’t charge a base fee for trades, instead they charge a percentage based on the total amount you’ve invested annually. They will charge between 0.15% to 0.35% of your total investment account. The more money you’ve invested, the lower the annual fee.
The other interesting aspect of Betterment is the ability to have your investing handled automatically. With Betterment you can have your investments handled by their algorithm using your risk profile, making investing easy for people that might not be financial geniuses.
E*Trade – One of the most popular brokerage firms in America, E*Trade was established in 1992 and has always been one of the leading companies in innovation. While their trading fees are a little higher than Scottrade, with E*Trade charging $9.99 per a stock or ETF trade, they also have no account set up fees or maintenance fees.
One thing to note with E*Trade is that they offer over 1,000 different mutual funds that have no transaction fees. These mutual funds can jump start your Roth IRA without having to pay the $9.99 fee, which can add up to some serious savings.
For a more detailed overview of each of these firms and a few other very good options, check out this comprehensive guide: Best Places to Open a Roth IRA.
The Rules for Converting a Traditional IRA to a Roth IRA
Though there are income limits that apply to making Roth IRA contributions, there are no income limits regarding conversions. Mechanically, there are three ways to accomplish the conversion:
- 60-Day Rollover. You can take direct delivery of the funds from your traditional IRA (check made payable to you personally), and then roll them over into a Roth IRA account, but you must do so within 60 days of the distribution. If you don’t, the amount of the distribution (less non-deductible contributions) will be taxable in the year received, the conversion will not take place, and the IRS 10% early distribution tax penalty will apply.
- Trustee-to-Trustee Transfer. This is not only the easiest way to work the transfer, but it also virtually eliminates the possibility that the funds from your traditional IRA account will become taxable. You simply tell your traditional IRA trustee to direct the money to the trustee of your Roth IRA account, and the whole transaction should proceed smoothly.
- Same Trustee Transfer. This is even easier than a trustee-to-trustee transfer, because the money stays within the same institution. You simply set up a Roth IRA account with the trustee who is holding your traditional IRA, and direct them to move the money from the traditional IRA into your Roth IRA account.
You Will Pay Taxes on The Conversion
No matter how the transfer is accomplished, the funds coming out of your traditional IRA will be subject to regular income tax in the year that it occurs. However, any nondeductible contributions that you made to your traditional IRA will not be taxable, since they never had the benefit of tax deferral. If the conversion is done properly, you will not be subject to a 10% early withdrawal penalty.
If you have begun taking “substantially equal periodic payments” from your traditional IRA, you can convert those amounts to your Roth IRA as the payments arrive. The payments will be taxable, but the 10% early withdrawal penalty will not apply.
Earlier I mentioned RMDs, which are required to be distributed from most other tax-sheltered retirement plans. You will not be able convert these distributions to a Roth IRA.
Roth IRA Conversion “Pro-Rata Rule”
Some taxpayers mistakenly believe that they can get around the income tax liability created as a result of making a Roth IRA conversion by rolling over only the portion of their IRA plans that were made with non-deductible contributions. For example, if a taxpayer has $200,000 in an IRA account, which includes $100,000 in investment earnings, $60,000 in tax deductible contributions, and $40,000 in non-deductible contributions, he may reason that he can avoid creating an income tax liability by rolling over the $40,000 in non-deductible contributions. It sounds right, doesn’t it?
The IRS won’t a agree. They have a Roth conversion pro-rata rule, which holds that the tax exempt portion of your rollover contribution must constitute only a pro-rata share of the total rollover.
Under this rule, since $40,000 of the taxpayer’s total IRA balance is comprised of non-tax deducible contributions, then he will be eligible for tax relief on only 20% ($40,000 in non-deductible contributions, divided by the $200,000 total balance) of the amount of any rollover he converts to a Roth IRA.
Because of the pro-rata rule, if the taxpayer were to convert $40,000 to a Roth, only $8,000 of it would be exempt from income tax ($40,000 X 20%), not the full $40,000.
Please keep this rule in mind as we move through the examples below.
Working Examples of a Conversion from a Traditional IRA to a Roth IRA
When ever you’re dealing with numbers, it’s always helpful to demonstrate the concept with examples. Here are two real live examples that I hope will illustrate how the Roth IRA conversion works in the real world.
Parker has a SEP IRA, a Traditional IRA, and a Roth IRA totaling $310,000. Let’s breakdown the pre- and post-tax contributions of each:
- SEP IRA: Consists entirely of pre-tax contributions. Total value is $80,000 with pre-tax contributions of $12,000.
- Traditional IRA: Consists entirely of after-tax contributions. Total value is $200,000 with after-tax contributions of $40,000.
- Roth IRA: Obviously all after tax contributions. Total value is $30,000 with total contributions of $7,000.
Parker is wanting to only convert half of the amount in his SEP and Traditional IRA’s to the Roth IRA. What amount will be added to his taxable income in 2014?
Here’s where the IRS pro-rata rule applies. Based on the numbers above, we have $40,000 total after-tax contributions to non-Roth IRA’s. The total non-Roth IRA balance is $280,000. The total amount that is desired to be converted is $140,000.
The amount of the conversion that will be subject to income tax is 14.29%, and here’s how that is calculated:
Step 1: Calculate non-taxable portion of total Non-Roth IRA’s:
Total after-tax contributions / Total Non-Roth IRA Balance = Non-Taxable %:
$40,000 / $280,000 = 14.29%
Step 2: Calculate the non-taxable amount by converting the result to Step 1 into dollars:
14.29% x $140,000 = $20,000
Step 3: Calculate the amount that will be added to your taxable income:
$140,00 – $20,000 = $120,000
In this scenario, Parker will owe ordinary income tax on $120,000. If he is in the 28% income tax bracket, he will owe $33,600 in income taxes, or $120,000 X .28.
Bentley is over the age of 50 and in the process of changing jobs. Because his employer had been bought out a few times, he has rolled over previous 401k’s into two different IRA’s. One IRA totals $115,000 and the other consists of $225,000. Since he’s never had a Roth IRA, he’s considering contributing to a nondeductible IRA for a total of $6,500 then immediately converting in 2014.
- Rollover IRA’s: Consists entirely of pre-tax contributions. Total value is $340,000 with pre-tax contributions of $150,000.
- Old 401k: Also consists entirely of pre-tax contributions. Total value is $140,000 with $80,000 pre-tax contributions.
- Current 401k: Plans out maxing it out for the rest of his working years.
- Non-deductible IRA: Consists entirely of after-tax contributions. Total value will be $6,500 of after-tax contributions and we will assume no growth.
Based on the above information, what will be Bentley’s tax consequence in 2016?
Did you notice the curve ball I threw in there? Sorry – I didn’t mean to trick anybody – I just wanted to see if you caught it. When it comes to converting, old 401(k)s and current 401(k)s do not factor into the equation. Remember this if you are planning on considering on converting large IRA balances and have an old 401(k). By leaving it in the 401(k), it will minimize your tax burden.
Using the steps from above, let’s see what Bentley’s taxable consequence will be in 2014:
Step 1: $6,500/ $346,000 = 1.88%
Step 2: 1.88 X $6,500 = $122
Step 3: $6,500 – $122 = $6,378
For 2014, Bentley will have a taxable income of $6,378 of his $6,500 Traditional IRA contribution/Roth IRA conversion, and that’s assuming no investment earnings. As you can see, you have to be careful when initiating conversion.
If Bentley had gone through with this conversion and didn't realize the tax liability, he would need to check out the rules on recharacterizing his Roth IRA to get out of those taxes.
Ineligible Roth IRA Contribution Work-Around
Example #2 describes what can be referred to as a backdoor Roth IRA contribution, that is, a way for taxpayers who exceed the income limits for Roth IRA contributions to make them anyway (it happens all the time). You make a non-deductible IRA contribution, then immediately roll it over into a Roth IRA since there are no longer any income limits on Roth conversions.
But as you can see, the pro-rata rules insure that income taxes are due on the great majority of the traditional IRA conversion amount.
But not to fear, there may be a work-around for the work-around wrinkle.
The reason why most of Bentley’s Roth conversion will be taxable is because he has substantial money sitting in traditional IRAs, most of which has never been subject to income tax. But if Bentley’s employer 401(k) plan permits it, he can avoid tax liability on future conversions by rolling his current IRA balances over into the 401(k).
Not every employer plan allows this, but if Bentley’s will, he will be able to get around the pro-rata rules by effectively eliminating his current IRAs.
Other Retirement Accounts You Can Convert Into a Roth IRA
Beyond a traditional IRA, there other tax-deferred retirement plans that can also be converted to a Roth IRA. They include:
- SIMPLE IRA (after two years)
- SEP IRA
- 457(b) Plan
- 403(b) Plan
- Designated Roth Account (401(k), 403(b), or 457(b) )
Except for the Designated Roth Account, all income must be included as taxable in the year of conversion.
Concluding Thoughts on a Roth IRA Conversion
Converting a traditional IRA to a Roth IRA is really a pretty simple process, as long as you know what you’re doing and follow all of the rules. However since most of us have no better than a superficial understanding of the US tax code, my (strong) suggestion is that you work with a professional tax preparer – preferably a CPA or tax attorney – when attempting a conversion. The penalties if you get it wrong are too high to take a chance on the do-it-yourself route.
Is a Roth conversion right for you?” It depends, says Taylor Schulte, CFP® the founder of Define Financial, a commission-free financial planning firm in San Diego.
“Like a Doctor, it's important to diagnose before you prescribe – especially when considering a meaningful planning tool like this. Either on your own or with a trusted professional, start with basic financial plan. What are your goals? Where do you want to be in 10, 20, 30 years from now? Are you on track to get there? If not, what do you need to do to fill that gap? Once you go through this exercise and gain a clear understanding of your financial picture, start to dive deeper into the components of a Roth conversion to see if it fits within your plan.”
The major downside of a Roth conversion is that you will be paying taxes on the amount converted in the current year, and depending on your income tax bracket and the amount you’re converting, the tax bite could be substantial.
But it’s worth remembering that you’re exchanging a current tax obligation for tax-free distributions in retirement. This is a powerful advantage, especially if you believe that income taxes will be higher in the future than what they are now.
That’s something I would never bet against!
Roth IRA Rules for 2016
If you're hoping to contribute to a Roth IRA (and not do a conversion), it's important to know the Roth IRA rules for 2016. The first thing you should know is that there are income limits that govern who can contribute to a Roth IRA. However, it's also important to know that there are guidelines that limit how much each individual can contribute. Here is a general rundown of the Roth IRA rules for 2016:
Roth IRA Income Limits
Outside of doing a Roth IRA conversion, there are income limits that govern who can contribute to a Roth IRA. In addition, there are phase-outs that decrease contribution limits for individuals and married couples in certain income brackets. Here's how the limits look for contributions made during 2016:
- Individuals who are married and filing a joint tax return with a MAGI (Modified Adjusted Gross Income) of less than $184,000 in 2016 can contribute the maximum to their Roth IRA. Contributions begin phasing out at $184,000 and end at $194,000. Married couples with a MAGI higher than $194,000 in 2016 cannot contribute to a Roth IRA.
- Married individuals filing a separate tax return who have lived with spouse at any time during the year must have earned more than zero but less than $10,000 to contribute in 2016.
- Single individuals, heads of household, or those married filing separately without living with spouse at any time during the year with a MAGI less than $117,000 can make the full contribution for 2016. Those with incomes between $117,000 and $132,000, however, will see their maximum contribution phase out. Individuals that fall into this category in 2016 with a MAGI over $132,000 cannot contribute to a Roth IRA.
Roth IRA Contribution Limits
If your income makes you eligible to contribute to a Roth IRA this year, you'll want to know the maximum amount of money you can contribute each year. This figure tends to increase every few years, and it also depends on your age. Here are the Roth IRA contribution limits for 2016:
- If you're under the age of 50, you can contribute up to $5,500 to your Roth IRA and traditional IRA accounts combined.
- If you're over the age of 50, you can contribute up to $6,500 across both accounts with what is known as a “catch up contribution.”
Frequently Asked Questions
How is a Roth IRA different than a traditional IRA?
Where a traditional IRA is funded with your pre-tax income, a Roth IRA is funded with after-tax dollars. Because of this, your Roth IRA won't require you to pay taxes on your distributions once you begin withdrawing funds after retirement. Taking distributions from a traditional IRA or any other tax-advantaged account upon retirement, on the other hand, will require you to pay income taxes when you begin taking withdrawals.
What is a MAGI, or modified adjusted gross income?
Since income eligibility to contribute to a Roth IRA is dependent on the MAGI, or modified adjusted gross income, it's important to understand that term. Generally speaking, your MAGI is the total of your household's Adjusted Gross Income and any tax-exempt interest income you may have.
Do I have to contribute the maximum to my Roth IRA?
While there are limits on how much you can contribute to a Roth IRA any given year, you are not required to meet those limits. In summary, you can contribute as little or as much as you like, provided you don't contribute more than the maximum and you earn and income that year.
Can I contribute to a Roth IRA even after I max out my work-sponsored 401(k)?
Yes, and this is a huge benefit. Even after you max out your work-sponsored 401(k) retirement plan, you can invest another $5,500 combined into a Roth IRA or traditional IRA. If you're hoping to save as much for retirement as possible, using multiple accounts can be a smart move.
Can I really take my money out of my Roth IRA at any time?
Because of the way Roth IRAs were set up and the fact that are contributed to with after-tax dollars, you can take your contributions out of your account at any time without penalty. However, the same cannot be said about your earnings. The amount of money you can take out without penalty is limited to the contributions you have made.
How long can I make contributions to a Roth IRA?
As long as you are earning an income and your MAGI doesn't rise beyond the IRS limits for contributions, you can contribute to a Roth IRA. Once your Modified Adjusted Gross Income reaches the limit where phase-outs begin, the maximum amount you can contribute each year will decrease incrementally.
Do I have to take contributions when I retire?
No, and this is one of the biggest benefits you'll get by contributing to a Roth IRA. Unlike other types of retirement accounts which force you to begin taking distributions at age 70 1/2 or pay a penalty, the Roth IRA doesn't have any rules governing when you have to take distributions. This makes the Roth IRA the perfect account for anyone who wants utmost flexibility in how and when they use their retirement funds.
What is the deadline for contributing to a Roth IRA?
Contributions to a Roth IRA can generally be made until April 15th, or tax day, of the following year. If you're unsure whether your income will be too high to contribute, this extended deadline allows you to wait and see how much you earn before you decide to contribute for the prior year.
Can I contribute to both a Roth IRA and traditional IRA during the same year?
You can definitely contribute to both a Roth IRA and a traditional IRA during the same tax year, but you can only contribute the maximum IRA contribution across both types of accounts. For 2016, the contribution limits are $5,500 for those under the age of 50, and $6,500 for individuals ages 50 and older.
(Partial source: IRS Publication 590.)