By: Elijah Workman, Financial Planner
A Roth IRA is a great place to save your money for retirement since it will have tax-free growth, no required distributions (or income taxes owed on the distributions) and can pass to the next generation to continue to grow and accumulate wealth. Be aware that you will also owe taxes on any of the money that you transferred from the traditional IRA that would have been taxed when you withdrew it. Often times, those interested in contributing to a Roth IRA are ineligible for one reason or another. In this scenario, a Roth Conversion may be a great alternative. Let’s go through what a Roth Conversion is, any rules or limitations, and who it makes sense for.
What is a Roth Conversion?
Let’s start by looking at what exactly a Roth conversion is. A Roth conversion, simply put, moves your assets from a Traditional IRA, SEP IRA, Simple IRA, or an eligible distribution from your qualified employer sponsored retirement plan into a Roth IRA.
The IRS has three ways to process a Roth conversion: a rollover from a traditional IRA in the form of a check that is then deposited into a Roth IRA, a trustee-to-trustee transfer which transfers money from a traditional IRA at one institution to a Roth IRA at another institution, or a same-trustee transfer which transfers money from a traditional IRA to a Roth IRA held at the same institution. Whichever method is used, you must report the conversion to the IRS on your tax return for the year in which you made the conversion on Form 8606: Nondeductible IRAs.
Rules and Limitations
As straightforward as this might seem, the IRS does have rules and limitations on Roth conversions that you should be aware of. If you decide to take the rollover check from a traditional IRA, then you must deposit it into the Roth account in 60 days. If you don’t you will be subject to regular income taxes on the amount plus a 10% penalty if you are under 59 1/2. Another big rule to remember is the “Five-Year Rule” which means that you must wait five years before withdrawing the converted funds or you can face a 10% early withdrawal penalty.
As for limits on the conversion, there technically are none! The caveat to that is if you take all your tax-deferred savings at once it could push some of your income into a higher marginal tax-bracket. It is best to spread out the conversions over multiple years to prevent an increase in your taxes.
Who it Makes Sense For
At this point you might be wondering, “Does this make sense for me?” There are quite a few different scenarios where starting Roth conversions would be beneficial for an individual or family. Give us a call to discuss your situation and to see if a Roth conversion is something worth exploring for you and your family.
Daugherty, Greg. “Roth IRA Conversion Rules.” Investopedia, Investopedia, www.investopedia.com/roth-ira-conversion-rules-4770480. Accessed 19 Sept. 2023.
“Converting to a Roth IRA.” IRA - Roth IRA Conversion Rules and FAQ - Wells Fargo, www.wellsfargo.com/investing/retirement/ira/roth-ira-conversion/#:~:text=What%20is%20a%20Roth%20conversion,b)%20to%20a%20Roth%20IRA. Accessed 19 Sept. 2023.
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