Basics of Roth Conversions

Converting money from a tax-deferred retirement account to a Roth account is often discussed as a way to reduce future income taxes, to take advantage of years in which you have lower income and are therefore in a lower tax bracket, or to avoid required minimum distributions. Today’s post will explain how a conversion works while also pointing out differences between Roth and tax-deferred accounts, and differences between Roth IRAs and Designated Roth Accounts. In upcoming posts, we’ll look at the factors that may determine whether a conversion is a good idea, and how converted amounts are handled when you eventually take distributions from the Roth account.

Tax-deferred Accounts vs Roth accounts

Tax-deferred retirement accounts, commonly referred to as a traditional retirement accounts, allow you to defer taxes on income that you contribute to the account. You don’t pay any tax until you take the money out. At that time, all of the distributions will be taxable income. For a Roth account, the tax treatment is just the opposite: there is no tax benefit when you make contributions to the account. The tax benefit comes when you take distributions from the Roth account and receive the earnings tax-free (if you follow 2 simple rules, below).

Just as we have both tax-deferred IRAs and tax-deferred employer retirement plans (401(k), 403(b), 456, etc.), we also have two categories of Roth accounts: Roth IRAs and Designated Roth Accounts which may be offered as an option inside those same employer retirement plans.

What is a Qualified Distribution?

Distribution of earnings and conversions from a Roth account will be tax- and penalty-free as long as they are Qualified Distributions. Contributions won’t be subject to taxes or penalties even if they aren’t qualified distributions.

Qualified distributions must meet a two-pronged test, which differs slightly for Roth IRAs and Designated Roth Accounts:

• The 5-year rule
  • Roth IRAs: For contributions and earnings, the five years begin on January 1 of the year you first made a contribution to any Roth IRA – not necessarily the one from which you are taking the distribution.
    • Each conversion has its own 5-year clock, which starts at the beginning of the tax year (January 1) in which that particular conversion was made.
  • Designated Roth Accounts: The five-year period is calculated separately for each Roth account and begins on January 1 of the year contributions were made to that account. If one Roth account is rolled into another, the earlier start date applies.
    • If money is rolled from one Designated Roth account into another, the earlier start date between the two accounts applies.
• The distribution is made
  • On or after the date you reach age 59½.
  • Because you are disabled.
  • To a beneficiary or to your estate after your death.
  • Roth IRAs only: For first-time home-buyer expenses, up to a $10,000 lifetime limit.

What is a conversion?

A conversion is a specific type of distribution from a tax-deferred account, in which you move some or all the money in the tax-deferred account to a Roth account. Because money deposited into a Roth account must be money on which you have already paid income tax, any previously un-taxed money will be taxable income when converted. In most cases, that means you will pay tax on the entire amount.

There are situations where you might have money in a tax-deferred account on which you have already paid taxes.

• In an IRA, these are called non-deductible contributions. That can happen when you also have an employer plan and your income is too high to allow deductible contributions to a tax-deferred IRA. In that case, you can choose to make non-deductible contributions.
• Some 401(k) plans allow participants to make after-tax contributions to the tax-deferred account. In both cases, these monies have already been taxed and they will be converted tax-free when moved to a Roth account.

If you have after-tax money in your tax-deferred account, you cannot choose to convert just that portion and leave the tax-deferred money. Any conversion will be considered a proportional mix of tax-deferred and after-tax money. For IRAs, you must go a step further and add together the balances in all of your traditional IRA accounts (including SEP and SIMPLE IRAs), and calculate the proportion of that total that is from nondeductible contributions.

The IRS does offer one work-around for 401(k) and other defined contribution retirement plans that contain both pre- and after-tax dollars.  But the strategy apparently does not apply to IRAs.  The IRS page titled Rollovers of After-Tax Contributions in Retirement Plans begins the explanation with this statement: “Distributions sent to multiple destinations at the same time are treated as a single distribution for allocating pre-tax and after-tax amounts (Notice 2014-54). This means you can roll over all your pretax amounts to a traditional IRA or retirement plan and all your after-tax amounts to a different destination, such as a Roth IRA.”

What accounts can I move from/to?

The IRS Rollover Chart lays out very clearly the accounts between which transfers can be made and any special rules that apply, for example, to transfers involving SIMPLE IRAs. Money from any type of retirement account can be moved to a Roth IRA, including money from tax-deferred employer plans – to the extent that the plans allow distributions. Another way to convert tax-deferred money from an employer plan is by doing an in-plan conversion, to a Designated Roth Account option offered within that same plan.  

Things to Know about Conversions

Roth conversions are treated as ordinary income. You owe tax on the amount converted, at your marginal tax rate. You may need to make estimated tax payments or increase your withholding to avoid penalties for underpaying your taxes.

You do not have to convert the entire balance in an account at the same time. You can do multiple conversions, choosing the amount you want to convert each year. This is a common strategy to spread the income over several years.

As of Jan. 1, 2018, Roth conversions can no longer be undone or recharacterized. It is irreversible, so if the value of the converted assets drops, you are stuck with having paid tax on the higher value.

You can do a conversion at any age, and there are no early distribution penalties even if you are not yet age 59½.

If you have a required minimum distribution for the year of the conversion, you must take that RMD. An RMD cannot be converted (or rolled over) to another retirement. You must take your RMD first. Then you can do a conversion of additional funds from the account.  

A conversion can be done by

• Having the money moved directly from one account to the other.
  • This is called either a trustee-to-trustee transfer (for transfers from an IRA) or direct rollover (for transfers from an employer plan). Although the official wording is different, the effect is the same: money moves directly from one financial institution or custodian to the other. You will never have control of the money.  
• Converting with the same trustee with an in-plan conversion.
• A rollover, meaning that you receive the funds and are responsible for depositing them in the new account within 60 days. With a rollover, the original custodian will be required to withhold 20% for taxes. If you want to convert the full balance of the traditional IRA, you will have to make up the difference with other funds.
  • If you miss the 60-day deadline, you may not be able to complete the conversion. In addition to the tax that you were already expecting to pay, you may also owe a 10% early distribution penalty. Perhaps more importantly, you pay tax on all future earnings instead of receiving them tax-free.
  • See IRS FAQs about waivers and other ways to request to make a late rollover.

Conclusion

Understanding how a conversion works is the first step. Next is figuring out whether it makes sense in your situation. My next post will discuss numerous factors that could help determine whether a conversion will offer a financial benefit or not. The last step will be learning how converted amounts in a Roth account affect future distributions. I’ll cover that in a third post.