Before converting Traditional IRAs to Roth IRAs, it’s essential to determine whether it’s a wise retirement investment decision by learning more about it. Here are the Roth IRA conversion rules every investor needs to know about.
In this article:
- Will Everyone Benefit from a Roth IRA Conversion?
- The (Tax) Case for Converting Traditional IRA to Roth IRA
- Roth Conversion Rules
- Converting Traditional IRA to Roth IRA Tax Implications
- Roth IRA Conversion: The Pro-Rata Rule
Roth IRA Conversion Rules Every IRA Owner Should Know
Will Everyone Benefit from a Roth IRA Conversion?
Roth IRAs can be an excellent way to ramp up one’s retirement investing campaign. However, it’s not a retirement-investing magic bullet that can perfectly answer all related concerns.
In some instances, converting Traditional IRAs to Roth IRAs, i.e., backdoor Roth IRAs, isn’t a wise investment decision. By being familiar with Roth IRA conversion rules, investors can make sound retirement-investing decisions to ramp up their retirement finances.
The (Tax) Case for Converting Traditional IRA to Roth IRA
The main reason why investors convert their Traditional IRAs to Roth IRAs is immunity from taxes upon withdrawals. The IRS neither taxes nor penalizes qualified withdrawals from Roth IRAs, unlike all forms of withdrawals from Traditional IRAs.
Traditional IRA Tax Rules
Traditional IRAs in retirement plans sponsored by employers, like 401(k) plans, operate mostly on a tax-deferred basis. Investors can use their direct contributions to such Traditional IRA plans to reduce their income tax liabilities on the years they made those contributions.
Contributions to Traditional IRAs accumulate or grow without paying taxes. The IRS will only tax both contributions and income upon withdrawals from Traditional IRAs.
Roth IRA Tax Rules
On the other hand, IRA owners can’t use contributions to Roth IRAs as tax deductions. They pay taxes on the income that funds Roth IRA contributions.
While the IRS taxes the income that funds Roth IRA contributions, it doesn’t tax qualified distributions or withdrawals from this type of IRA. Because investors already paid taxes on the income that funded the Roth IRA contributions, the IRS will no longer tax qualified withdrawals of contributions and the income they generate.
A qualified Roth IRA distribution is one that:
- Happens 5 years after the Roth IRA was opened and the first contribution was made; and
- Meets one of the following distribution conditions:
- The IRA owner is 59 ½ years old
- Death or disability of the owner caused the distribution
- The distribution will finance a qualified first-time purchase of a home
For investors who want their taxes over and done with, Roth IRA tax rules can make conversion a good option. It’s also a great option for IRA owners who are certain they’ll move up the tax bracket ladder upon retirement.
Roth Conversion Rules
While the IRS imposes income limits when it comes to direct Roth IRA contributions, it doesn’t impose income limits on Roth IRA conversions. This is one of the reasons why Roth IRA conversions (a.k.a. backdoor Roth IRAs) are very popular.
Investors can convert their Traditional IRAs to Roth IRAs in three ways: through a 60-day rollover, a trustee-to-trustee transfer, and same trustee transfer.
The Sixty-Day Rollover
IRA owners withdraw from their Traditional IRAs and roll over the funds to a Roth IRA. The IRS’ rule is that the withdrawn funds must be rolled over within 60 days from when the withdrawals or distributions are made.
If investors don’t roll-over the distributed funds to a Roth IRA within 60 days, the IRS will do the following:
- Tax the net amount distributed, which is the distribution amount less non-deductible contributions
- Impose an early distribution penalty of 10%
This is a very easy way for investors to convert a Traditional IRA to a Roth IRA. Here, investors merely instruct the Traditional IRA trustee to transfer funds to the Roth IRA trustee to trigger the conversion.
Same Trustee Transfer
This is the easiest way to do a Roth IRA conversion. It’s because the funds will be moved from a Traditional account to a Roth account with the same trustee.
According to the IRS, it doesn’t apply the one-IRA annual rollover rule to Roth conversions. The IRS said there is no limit to the number of annual rollovers from Traditional IRAs to Roth IRAs.
However, the IRS prohibits Traditional IRA owners from converting a specific kind of distribution or withdrawal to a Roth IRA. In particular, IRA owners can’t convert required minimum distributions (RMDs) from most tax-sheltered retirement accounts.
Converting Traditional IRA to Roth IRA Tax Implications
Here are some of the implications of converting a Traditional IRA into a Roth IRA that can help investors evaluate.
- Income Taxes — Investors will pay regular income taxes on deductible Traditional IRA funds that were converted into Roth IRA. Because investors have already paid income taxes on non-deductible Traditional IRA contributions, they no longer need to pay taxes on withdrawals or conversions of such contributions.
- Early Withdrawal Penalty and Taxes — As mentioned earlier, the IRS will not impose a 10% early distribution or withdrawal penalty on investors who rollover Traditional IRA distributions within 60 days.
- Traditional IRA owners who’ve already started receiving substantially equal regular payments from their accounts can also convert these payments. While the IRS will tax the Traditional IRA payments for conversion, it will not impose the 10% early withdrawal penalty.
Roth IRA Conversion: The Pro-Rata Rule
Many IRA owners think they can avoid income taxes when they roll over their Traditional IRAs to their Roth IRAs. They think they can do it by rolling over portions of their Traditional IRA that were funded by non-deductible contributions.
- A person has $100,000 in a Traditional IRA comprised of $50,000 in investment earnings, $20,000 in non-deductible contributions, and $30,000 in tax-deductible contributions.
- This investor may think that the IRS will not impose income taxes if the conversion is limited to the $20,000 non-deductible contributions only.
However, this won’t be the case because the IRS applies the pro-rata rule to all Roth IRA conversions.
What is the Pro-Rata Rule? By the pro-rata rule, the IRS won’t consider the entire amount of any non-deductible contribution distribution as tax-exempt. The specific portion of the distribution that will be tax-exempt shall be determined by the pro-rata share of total non-deductible contributions of the entire Traditional IRA portfolio.
Going back to our example, the pro-rata shares in the Traditional IRA portfolio are as follows:
- Traditional IRA investment earnings: $50,000 ÷ $100,000 = 50%
- Non-deductible contributions: $20,000 ÷ $100,000 = 20%
- Tax-deductible contributions: $30,000 ÷ $100,000 = 20%
Since non-deductible contributions comprise only 20% of the entire Traditional IRA portfolio, the IRS will consider only 20% of this person’s planned conversion of $20,000 as tax-exempt. This person will need to pay regular income taxes on 80%, or $16,000, of the total conversion of $20,000.
A Roth IRA conversion can provide opportunities to minimize one’s tax liabilities upon retirement and make more funds available for retirement. However, before making any decisions, it’s essential for an investor considering a Roth conversion to learn the rules.
Understanding the rules can help empower investors to use Roth IRA conversions to their advantage. Not knowing may lead them to miss out on Roth IRA benefits or suffer unnecessary taxes and penalties as a result of erroneously converting.
Based on the tax-related advantages of Roth IRAs and the applicable conversion rules, would you consider converting some or all of your Traditional IRAs to a Roth IRA? Let us know what you think in the comments section below.