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Roth Conversions: Everything You Need to Know

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If you already have a traditional IRA, you may have wondered if you should initiate a Roth conversion. Doing so can help increase your retirement savings with tax-free investment growth, and it also means access to tax-free withdrawals when you eventually retire.

However, the Roth conversion process can come at a cost: it’s what the IRS likes to call a “taxable event,” which could make for a tidy tax bill the year you make the conversion.

So are Roth IRA conversions a good idea? How do you get them started in the first place?

Here’s what you need to know about converting your traditional IRA to a Roth, including whether or not you should consider one and a step-by-step guide to the conversion process.

A Roth IRA conversion allows you to convert a traditional IRA, or individual retirement account, to a Roth IRA. Although both of these accounts can help you save for retirement with or without the help of an employer-sponsored plan like a 401(k), Roth IRAs have become popular account types for a number of reasons.

For starters, Roth investments are allowed to grow tax-free and no tax is paid on withdrawals once you hit retirement age. Roth IRAs also don’t come with the required minimum distributions (RMDs) that other retirement accounts do, making them a great vehicle for passing tax-free cash on to your loved ones.

But just because you won’t pay taxes when you take money out of an IRA doesn’t mean you won’t pay taxes on the money at all. Make no mistake, the IRS wants its cut — which means only after-tax funds can go into a Roth account in the first place. And since you likely deducted the contributions you made to your traditional IRA, you’ll have to pay those deferred taxes at the time you make the conversion.

This can lead to a potentially heavy tax bill, depending on your income bracket and the untaxed balance of your traditional IRA. But the benefits of a Roth can still outweigh these costs for some — and there are ways to minimize the cost of the conversion.

Before learning how to convert your traditional IRA to a Roth, you should probably first ask yourself the question: Should I convert my traditional IRA to a Roth?  As with all things financial, the answer is, “It depends!” A Roth IRA can be a great tool for those craving more flexibility in their retirement accounts, but in some cases, it actually does make more sense to stick with a traditional IRA.  Here’s a basic rule of thumb: you’re going to pay taxes either way, so try to think about when you’d rather pay them.
  • If you’re planning to make more income — and thus be in a higher tax bracket — when you start making withdrawals, a Roth could help you save money overall. That’s because you’ll pay taxes now in a lower bracket than you might later on.
  • If you suspect your tax bracket will be lower at retirement, then a traditional IRA might be a better choice — because you’ll only pay taxes at withdrawal, when your bracket will be lower.
You should also consider whether or not you can afford the tax burden of the Roth conversion today, as converting a large balance could easily lead to a four-figure tax bill or higher. There are however, ways to time your Roth IRA conversion to minimize the damage.

If you decide a Roth conversion is right for you, doing it at one of the following times might make it more affordable:

  • During a lower-income year. Because the money you convert from your traditional IRA to a Roth account will be taxed as ordinary income, choosing a year when the rest of your income is low will help keep your overall tax rate from skyrocketing. Of course, you’ll still need to weigh this benefit against your ability to actually afford the tax bill, especially if things are a little tight for now.
  • While the untaxed balance of your traditional IRA is low. A lower untaxed balance means a lower total tax bill… and also more tax-free growth potential for your fledgling retirement fund. Win-win.

Some people also choose to break up their Roth IRA conversion process into smaller sections, converting a little bit of their retirement balance at a time so as to make for more affordable tax bills each year they do so. There’s no rule stating you have to convert the whole balance at once, so this is a good workaround to consider!

That said, it’s always worth consulting with a tax professional or fiduciary advisor before making major money decisions.

If you’ve decided it’s the right move for you, here’s how to convert a traditional IRA to a Roth IRA.

Notify your IRA provider. In most cases, you can keep your funds at the same IRA provider, and even invested in the same assets, for the conversion. If you decide to perform your Roth conversion piecemeal, you may need to open a separate Roth IRA account and initiate smaller conversion transfers one by one. Your IRA provider will have all the specific instructions you need.

Prepare for tax time. The amount of untaxed funds you convert from a traditional to a Roth IRA will be taxed as regular income, so be sure you have money on hand to pay the IRS when the time comes.

Maintain your new account. Make sure you’re comfortable with the investments that are in your Roth account once the conversion has happened. If you don’t have an employer-sponsored account like a 401(k), consider making regular contributions to the Roth account. One way to keep your retirement fund growing is to set up an automatic transfer into the account from each paycheck.

While you can’t convert your old traditional 401(k) into a Roth IRA directly, you can do so with a two-step process.

First, you’d roll your 401(k) over into a traditional IRA. This way, your new IRA will match the tax status of your old 401(k).

You’d then initiate a separate Roth conversion process through your IRA provider. Again, however, doing so means you’ll have to pay taxes on the tax-deferred contributions you convert.

Here are some key rules to be aware of when you convert a traditional IRA to a Roth:

  • You don’t have to convert the full balance of your traditional IRA to a Roth IRA, but you can — even if your income exceeds the limits set by the IRS regarding who’s allowed to contribute to a Roth. This process is also sometimes known as a “backdoor Roth.”
  • You will be responsible for paying taxes on untaxed traditional IRA funds in the year they are converted to Roth investments.
  • Finally, keep in mind that if you choose to initiate an indirect rollover — that is, if you take the funds from your traditional IRA in the form of a check in order to deposit them into a new account — you must complete the manual conversion within 60 days and contribute the full amount to your new Roth account. Otherwise, you’ll be responsible not only for the regular taxes due, but also a 10% early withdrawal penalty if you’re under the age of 59.5.

A Roth IRA conversion can be a great way to help your retirement funds grow tax-free and allows you to enjoy the other benefits Roth accounts offer. You just have to plan it right to make sure you can cover the taxes you’ll incur in the process. Timing your Roth conversion to occur on a lower-income year or while your traditional IRA balance is still relatively low can help decrease your total tax burden. As always, we suggest enlisting the help of a qualified financial advisor, like a CFP, about major financial decisions.

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