Many investors find the allure of tax-free growth and withdrawals too attractive in a retirement account. Roth IRA and 401(k) accounts are a great way to lower your expenses in retirement. IRS-imposed income limits, though, can keep investors from setting them up right away. Fortunately, by converting a traditional IRA account into a Roth account, investors can sidestep these requirements.
A conversion has an impact on your tax liability. Because traditional accounts are funded with pre-tax dollars, funds converted from a traditional account to a Roth account are subject to income tax during the year in which the conversion takes place. This can lead to some super-sized tax bills, so it’s important to proceed with caution.
As with many other money moves, when you take them matters. Converting early in the year can provide additional flexibility. Converting later in the year might give you access to your money sooner.
If you convert early in the year, taxes won’t come due until the following April (provided you don’t make estimated quarterly tax payments). This can ensure you have time to save incrementally for the larger tax bill. You can even increase your withholding from each paycheck to cover the tax bill automatically.
You’ll also have more time to change your mind if you convert early in the year. Essentially, until you file your next year’s taxes, you can undo a conversion and avoid paying taxes on the converted amount. You might do so if you experience an unexpected windfall, like a bonus or commission, which would put you in a higher tax bracket. Conversely, an unexpected home repair or medical expense might make a high tax bill an unbearable hardship. Filing early gives you the flexibility to change your mind.
Filing late can give you access to the money in your Roth IRA sooner if you don’t already have a Roth account. IRS rules require a 5-year waiting period between initial deposit and withdrawal in a Roth account. The 5-year waiting period ends on January 1 of the 5th year, so deposits made in December will be available for withdrawal 12 months earlier than deposits made in January. Note that in order to make a withdrawal from a Roth account, you must meet one of these conditions: turning 59 ½ years old, becoming disabled, dying, or making a qualifying first home purchase.
Beyond the timing, you can also choose how much of your traditional IRA to convert to a Roth account. Generally, investors aim to minimize tax liability, so converting just enough to put you up against the upper limit of a given tax bracket is prudent. Calculating what portion of your withdrawal will add to your taxable income can be slightly tricky.
If you’ve never contributed after-tax dollars to a traditional IRA account, then 100% of your conversion is taxable. If you’ve made contributions to a traditional IRA account and not taken a tax break for it, the math gets a little harder. You take the percentage of the traditional account funded with post-tax dollars, multiply that by the amount of the conversion, and add the resulting number to your taxable income. For example, an account of $100,000, of which $70,000 is pre-tax, $15,000 is post-tax, and $15,000 is earnings would require its owner to pay taxes on 85% of any conversion.
It’s not just traditional IRA accounts that can be converted. Traditional 401(k) accounts from former employers can also be converted into Roth IRA’s. The same rules about timing and taxable percentage still apply.
If you’re subject to minimum required distribution (MRD) rules, a conversion can’t satisfy that requirement. You must still take your MRD amount, and that amount isn’t eligible for conversion to a Roth account. Generally, in order to minimize tax liabilities, it makes most sense to take MRD’s from traditional accounts, and then make any necessary conversion decisions.
The tax-free growth benefits of a Roth IRA make them a valuable addition to a retirement plan. Funding them with existing retirement accounts can make good tax sense for many investors. If you’re considering such a move, talk to a professional who can assess how it would affect your unique tax situation.