The Ultimate Roth IRA Conversion Guide – Everything You Need to Know

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!

As much as I love the Roth IRA’s you would think that I would be all about converting your traditional IRA’s and old 401k’s to them, right?

Well, kinda.

Unfortunately, doing a Roth IRA conversions is not a total black and white decision.  In fact, there are have been several instances for I suggested that clients don’t do 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.

Roth IRA Conversion Tax Rules

Why Would You Want to Convert a Traditional IRA to a Roth IRA?

The primary advantage of converting your traditional IRA accounts to a Roth IRA 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 that you make into 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.

With Roth IRAs however, there is no tax deferral on contributions. And just as is the case with other tax-sheltered retirement plans, the investment earnings in your plan will build up without being subject to income taxes.

But that’s where the similarity ends.

With a Roth IRA, not only do 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 and get a tax break. With a Roth IRA, the good news is on the backend – when you begin taking withdrawals from the plan, but 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 RMD’s.

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.

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.

Example #1:

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.

Example #2:

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 2014?

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 401k’s and current 401k’s do not factor into the equation. Remember this if you are planning on considering on converting large IRA balances and have an old 401k. By leaving it in the 401k, 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.

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.

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!

(Partial source: IRS Publication 590.)

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