Is it Helpful to Make a Roth IRA Conversion?

Introduction to Roth conversions

In previous posts, we looked at Roth retirement accounts and also compared them to their Traditional counterparts. While Roth accounts can provide tax benefits, there are income limits for who can make Roth IRA contributions. For those above the income limits, Roth IRA conversions provide one way to get money into a Roth account. In this post, we’ll summarize what a Roth IRA conversion is, how it works, and why it could make sense.

How does a Roth conversion work?

A Roth IRA conversion allows you to transfer funds from a Traditional IRA or a 401(k) into a Roth IRA. This conversion process may allow those who are ineligible to for Roth contributions to still get funds inside of a Roth IRA account and enjoy benefits like potential tax-free withdrawals and the ability to pass on tax-free assets to heirs.

Here’s a step-by-step breakdown on how a Roth conversion typically works.

1. Understand Your Situation. As of 2023, there are no income limits on performing a Roth IRA conversion. However, there could be other restrictions and considerations. For example, retirement assets inside of a 401(k) plan may be ineligible for conversion or rollover until distribution conditions are met. In other cases, some assets (like some insurance products) may have special considerations that make a conversion unattractive. Whatever the case, you should be clear about the rules and issues relevant to your individual circumstances.
2. Choose Conversion Amount. Typically, Roth conversions do not have to be all or nothing. In other words, you should be able to choose how much of your Traditional IRA or 401(k) you want to convert. What amount to convert depends on a number of factors including the expected tax costs, the expected tax benefits, and the underlying reasons for performing the conversion (retirement income, reducing taxes, estate planning, etc.).
3. Pay Taxes. One important thing to understand is that the amount you convert is considered taxable income in the year of the conversion. This means you may owe income tax on the converted amount. The tax rate will depend on your overall income. In addition, if you only convert a portion of your outstanding Traditional IRA assets, you may be subject to pro-rata tax and accounting rules. You should consult with a qualified tax advisor to fully evaluate the implications of a conversion.
4. Complete Conversion. Contact your financial institution or IRA custodian to initiate and execute the Roth IRA conversion. This typically involves completing and signing conversion documentation. They should provide you with the necessary materials and guide you through the process. Note, when filing your income taxes for the year, you may need to file IRS Form 8606 to offset the 1099-R that generates from your IRA distribution. You may also need to complete additional filings, depending on your situation. Again, consult a qualified tax advisor to be sure.
5. Enjoy Benefits. After the conversion is complete, you may enjoy the various benefits of a Roth IRA such as tax-deferred treatment on gains and income, tax-free treatment on qualified withdrawals, avoidance of required minimum distributions, and potential tax-free treatment of Roth assets passed down to heirs.

Should you convert?

The many benefits of a Roth IRA may make a conversion seem like a no-brainer. So, if it’s so helpful, should you just convert all your retirement accounts into Roth IRAs? As with most financial decisions, it depends on the circumstnaces.

As we noted in previous posts, Roth IRAs may not necessarily be better than their Traditional counterparts. In addition, a Roth conversion has one big caveat, the upfront tax bill. Simply put, the upfront cost should be weighted against the be the expected benefits over time.

It all boils down to carefully understanding your needs, goals, and circumstances. If you’re unsure, consult with a qualified tax and financial advisor to consider all the relevant information and to determine how or if a Roth conversion will be helpful for your specific situation.*

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HWL

*Nothing in this post represents tax or financial advice. You should consult with professional tax and financial advisors for personal advice.