A Roth conversion is the process of turning a traditional IRA into a Roth IRA. There are many reasons to move all or part of the balance of an existing IRA to another retirement account. A Roth IRA is a powerful savings tool for retirement that allows a person’s money to grow tax-free. Under a Roth IRA, contributions are taxed when they are made, allowing the account holder to withdraw their earnings and contributions tax-free once they reach 59½ years old.
Many people interested in Roth conversions worry about the tax implications. Learn how Roth conversions are taxed and how to reduce this tax burden.
Why May You Consider Performing a Roth Conversion?
Anyone can invest in a Roth IRA if their modified gross income (MAGI) falls below a specified limit. In 2021, single and head of household filers can invest if they make up to $140,000 and married filing jointly filers can earn up to $208,000 a year. However, there are no income limits for Roth conversions.
One of the top reasons to perform a Roth conversion is to lower taxes in the future. Although a Roth IRA does not offer an upfront tax break, earnings and contributions do grow tax-free. This makes Roth IRAs a good option for people who expect to be in a higher tax bracket in retirement. With a Roth IRA, many people will pay less in taxes in the long-term than what they would pay with a traditional IRA.
Another major benefit of performing a Roth conversion is the convenience. With a Roth IRA, the account holder can withdraw their contributions (not earnings) for any reason and at any time, tax-free. Moving a traditional IRA to a Roth IRA also means that account holders will not have to take required minimum distributions (RMDs) on the account until they reach age 72. If the account holder’s money is not needed, the funds can remain intact and be passed down to the person’s heirs.
How Roth Conversions are Taxed
Roth conversions can be a useful tool for reducing taxes on withdrawals during retirement. Converting money in a traditional retirement account, such as an IRA or 401k, into a Roth IRA, triggers income tax on the converted amount. If a person converts $500,000, they would add $500,000 to their taxable income when they file their income tax return for that year.
The tax rate on the conversion is based on the person’s unique marginal income tax rate that is based on their taxable income. Where the money comes from to pay these taxes can also vary. The funds may come from the new Roth account that the money was converted into, separate “taxable” funds outside the account or any balance in the original traditional retirement account.
Ways To Pay Roth Conversion Taxes
The IRS collects federal tax from Roth IRA conversions with other income taxes due on a person’s tax return filed during the year of the conversion. Ordinary income generated by a Roth IRA conversion may be offset by deductions and losses reported on the same tax return.
Account holders are discouraged from using the money being converted within the Roth account to pay the taxes on a conversion as this leaves less money in the account to grow tax-free. Roth IRA conversion amounts as distributions should be reported on Form 1099-R and any contributions to the Roth IRA for that tax year on Form 5498.
How To Perform A Roth IRA Conversion
If a person has money in a traditional IRA account but likes the concept of making future withdrawals tax-free, then undergoing a Roth conversion may be a good option. There are several ways to convert money from a traditional IRA to a Roth IRA, including the following methods:
- Indirect Rollover – With an indirect rollover, the account holder receives a distribution from a traditional IRA and then contributes it to the Roth IRA within a 60-day period.
- Trustee-to-Trustee – Under the trustee-to-trustee process, the account holder requests that the institution holding the traditional IRA assets transfer an amount directly to the trustee of the Roth IRA at a different financial institution.
- Same Trustee Transfer – If the account holder’s traditional and Roth IRA accounts are at the same financial institution, the account holder can request that the trustee transfer an amount from the traditional IRA to the Roth IRA.
Speak With An Experienced Wealth Manager
A Roth conversion may be the right solution if a person likes the idea of their investment earnings growing tax-free, if they want the ability to potentially lower their taxable income in retirement or if they believe that their tax rate in retirement may be higher than it is now. To learn more about how Roth conversions are taxed, speak with a knowledgeable wealth manager at Campbell Wealth Management.
This is intended for informational purposes only and should not be construed as tax advice. Consult your tax advisor regarding your situation.