A Roth conversion is a transfer from an eligible pre-tax retirement account to a Roth Individual Retirement Account (IRA). Converting retirement plans to a Roth IRA offers many benefits. Taxes may be due on the converted amount, however, once the funds are in the Roth IRA, they grow tax-free and can be withdrawn tax-free during retirement. Roth IRAs do not have required minimum distributions (RMDs) which allows the money to continue to grow tax-free for an extended period. Roth IRA accounts can also be passed to beneficiaries tax-free. A Roth conversion can be a beneficial tax tool, however, it is important to consider current and future financial implications before implementing this strategy.
Anyone with an eligible plan can do a Roth conversion, regardless of income level. Eligible accounts include traditional IRAs; qualified plans like 401(k), 403(b) or 457 plans; SEP IRAs and SIMPLE IRAs; and 529 college savings plans (with restrictions discussed later). Transfers from a qualified plan usually require that the employee has left their job or be of retirement age. The most common route to convert to a Roth is a trustee-to-trustee transfer, meaning that the money is transferred between trustees without the owner ever receiving a distribution. If the owner does receive a distribution, it can be rolled into a Roth within 60 days. It is important to document each step of this transaction in case the IRS questions it.
If certain conditions are met, 529 plan assets can be moved into a Roth IRA. The 529 plan must be in existence for at least 15 years. Any converted funds and associated earnings must be in the account for at least 5 years before they can be moved. The beneficiary of the 529 plan must also be the beneficiary of the IRA. The conversion amount counts towards the annual limit for Roth IRA contributions and there is a lifetime cap per beneficiary of $35,000.
There are several rules pertaining to Roth Conversions. The distribution amount is included in taxable income in the year of the conversion, except for any part of the distribution that is attributable to basis. If the account owner is age 73 and required to take an RMD for the year, the RMD cannot be avoided by converting the eligible retirement plan to a Roth.
Roth accounts must be funded for 5 years before any earnings are withdrawn. Converted amounts are treated the same as regular Roth IRA contributions once this 5-year rule is met. Each conversion amount has its own 5-year waiting period that starts on the first day of the tax year in which the conversion was made.
Consider converting to a Roth IRA in the following situations:
- If taxpayers’ expected tax bracket will be higher in retirement than during working years. If income and/or tax rates are lower now, it may be preferable to pay tax on the conversion at a lower rate than taking ordinary retirement distributions that will be taxed at a higher rate once taxpayer stops working. Situations where this may apply include taxpayers that have not yet achieved their highest earning years; significant savings have been accumulated in taxable retirement accounts or federal tax rates are expected to increase.
- Taxpayers want to maximize their estate for their heirs. This applies if the IRA funds are not needed during taxpayers’ lifetime. A Roth conversion allows the savings to grow with RMDs, potentially leaving more for heirs who can withdraw amounts tax free (following the IRA distribution rules).
- Taxpayers have irregular income streams (such as commission-based pay), and the current year income is lower than usual.
- Accounts are not diversified by tax treatment. Money in a tax deferred account will likely incur a tax liability when it is withdrawn. When amounts are withdrawn from a Roth IRA, there is not a tax liability. During retirement, having amounts in both types of plans allows for better management of tax brackets and more personalized tax planning.
It may not be advantageous to convert to a Roth IRA in the following situations:
- Taxpayers expect lower income and lower tax bracket in retirement.
- Taxpayers are close to or in retirement and need income stream from traditional retirement plans to cover living expenses.
- Do not have additional funds to pay the tax on the conversion or must sell assets which could lead to additional tax liability
- Plan to give substantial amount of IRA to charity with Qualified Charitable Distributions or the ultimate beneficiary is charity
- Heirs will be in a lower tax bracket
- Considering a move to a lower-tax state
Planning around Roth conversions is complex. Our experienced team at Waverly Advisors is here to help! If you have questions about tax strategies and planning for Roth conversions, please contact your Waverly Advisors representative.
