Simply put… Roth IRA conversion is the process transferring of your money from a Traditional IRA or 401k plan into a Roth IRA.
Rollovers into a Roth IRA from a Traditional IRA and 401k plans came to the forefront in 2010 due to a change in the tax law. Before 2010, the tax law stated that to make a rollover into a Roth IRA, the worker had to have Adjusted Gross Income of $100,000 or less. Since it was mostly the higher paid workers who were interested in doing rollovers into a Roth IRA, the subject was rather dead until 2010.
In 2010, a revision to the tax code eliminated the earnings limitation on rollovers from Traditional IRAs and 401k plans to a Roth IRA. This prompted a deluge of articles being written by knowledgeable, and some not so knowledgeable, people on why you should do a Roth Conversion or 401k conversion. As a result, everyone, including lower paid workers, suddenly became interested in doing a conversion.
To understand why you would want to do a Roth IRA conversion, you need to understand the tax status of contributions you have already made into a Traditional IRA or 401k plan, and how that would change in a Roth IRA plan.
Current Tax Status of Your Retirement Plans:
Your contributions to a Traditional IRA or 401k have been made with Before- Tax dollars. Any contributions to an existing Roth have made with After-Tax dollars
Traditional IRA and 401k – In these plans, you received a tax deduction on any money you put in, and you will get taxed on the entire account value when you take the money out at retirement. Tax status of money in a Traditional IRA or 401k plan is Before-Tax dollars. This money has not been taxed yet. Your contributions aren’t taxed until you withdraw the money.
Roth IRA – here you put in After-Tax dollars, and when you retire, all withdrawals will be received tax free. You paid taxes on your salary, and then used part of your take-home salary to contribute to the Roth IRA.
Normal Rollovers without Roth Conversion
The normal type of rollover occurs when you leave a job and want to roll over your 401k balance into an IRA. In these instances, the tax status of your money must remain the same as before the rollover. A regular Pre-Tax 401k must be rolled into a pre-tax Traditional IRA
This move preserves the tax status of the money. Your regular 401k money and your Traditional IRA money will all be taxable when you eventually take the money out.
The Roth IRA Conversion
The purpose of a Roth conversion is to change the tax status of money. In other words, you want to transfer money from your Traditional IRA or 401k (Before tax dollars) into a Roth IRA (After Tax dollars). It would be great if you could do this without any tax issues since you would get a tax deduction for the money you put into a Traditional IRA, convert it to a Roth, and then receive tax free withdrawals at retirement. Unfortunately, you can’t just change the tax status of money without the IRS getting involved.
The IRS always gets their slice somewhere along the line. They are willing to wait years by giving you tax deferrals, but in the end they always get their portion of your money. So, if you want to do a Roth IRA conversion, you will have to pay ordinary income taxes now on any money you move into the Roth from the Traditional or 401k
Since you have to pay tax at time of conversion, Roth IRA conversions don’t make sense for everyone. The question is: what is your tax situation is at time of conversion compared to what it might be at retirement?
The 5 point process for a Roth IRA conversion
1. Look at your IRA and 401(k).
2. Consider financial and tax aspects.
3. Calculate the tax due to the IRS.
4. Decide when to convert.
5. Complete conversion paperwork.
Look at your current IRA and 401k – Generally, all funds you hold in a traditional IRA, whether or not you have taken prior tax deductions, are eligible for conversion to a Roth. If you did not deduct prior IRA contributions, they won’t be taxed when you make a conversion, though earnings from those contributions are taxed. If you have a 401(k) at a former employer, you can convert those assets into a Roth IRA.
Under IRS rules, if you have money in several traditional IRAs, you must convert at least a portion of each. You cannot convert one IRA and leave the others untouched or untaxed. This is to avoid your converting only an IRA in which the investments have lost money, and not touching IRAs where the investments may have performed well.
Consider the Financial and Tax aspects of the conversion. You need to look not just at your tax bracket now, but how much time you have before you will retire and start receiving payments. The higher your tax bracket, the more tax you will have to pay at time of conversion. However, if you expect your taxes to go up over time, a conversion might make sense because your tax bracket in retirement might actually be higher than it currently is.
Using a tax calculator sum the taxes due on conversion. You will owe federal and state taxes on the entire value of your IRA, unless you made nondeductible contributions.
Current IRA account: $50,000
Nondeductible IRA contributions: -$10,000
Total taxable account: $40,000
Times the current federal tax rate x 0.25
Plus the current state tax rate x 0.05
Tax bill for conversion $12,000
So, if you want to roll over $40,000 Before-Tax dollars from a Traditional IRA or 401k into a Roth IRA, you will have to pay $12,000 in taxes this year if you are in a 25% tax bracket. On the other hand, your Roth balance will now continue to grow and will eventually come out totally tax free at retirement.
An important point to look at here is how long you have until you retire. If you are in your late 50’s, it probably does not make sense to convert since you will not have many years to accumulate tax free earnings. If you are younger, it will probably make sense to do the conversion.
Another important aspect is that you have to be able to pay the taxes from assets you have on hand outside the IRA or 401k. If you try to pay the taxes from part of the withdrawal out of the IRA or 401k, you will have to pay IRS penalties for early withdrawal. This defeats the purpose of converting the IRA.
Considering when to convert is not difficult. Convert early in your career when you have many years left to accumulate tax free earnings.
Completing the paperwork for a Roth IRA conversion is relatively simple. You’ll need to let the mutual fund, bank or other financial services company that holds your account and open an IRA if you don’t already have one. The paperwork is the same as you completed when you opened your original IRA.
Think and Calculate
The decision to convert to a Roth IRA involves a lot of thinking and projecting. What is your current financial situation, what will the situation be at retirement, how much will I currently have to pay in taxes, do I have sufficient funds outside the IRAs to pay the taxes? It is not easy to decide. However, if you take the time to go through the process and make the conversion, you will be very glad in retirement when you start withdrawing money on a totally tax free basis.