A faster way to get money into a ROTH IRA is to move some of your Traditional IRA money to your ROTH IRA. It is called a ROTH Conversion. This can be an effective strategy to build a tax free account for later in life, but it comes with a caveat. When you move money from your Traditional IRA to your ROTH IRA, taxes are due. This requires the need to have the facts so you can make an informed decision. Because of the tax impact, it is important to consult a knowledgeable tax professional before undertaking a ROTH Conversion.
The biggest benefit to moving money from a Traditional IRA to a ROTH IRA is that you are building an account which can provide Tax Free income in the future. See “How Does a ROTH IRA Work?” for more benefits of a ROTH IRA.
When you convert a Traditional IRA to your ROTH IRA you must pay the tax in the current tax year. So you need to know how much tax you will owe based on your current tax bracket, eligible tax deductions this year, and other taxable income. Your CPA or Financial Advisor can help you gather this information. The best time to do a ROTH Conversion is in a year when you will be in a low tax bracket. This could be due to lower income or higher tax deductions which offset income.
Here is how it works:
- The Conversion must be completed by December 31 of the tax year. There is no provision to complete a ROTH conversion after the close of the tax year. Annual contributions can be made retroactively until you file your return, but not so for the ROTH Conversion.
- There is no restriction on how much you can convert. This will be driven strictly by your tax bracket and how much tax you are willing to pay in return for tax free future growth.
- You can do a partial conversion. You do not have to convert the entire Traditional IRA at one time, and converting in stages over several tax years can reduce the tax hit.
- You can’t be too old or too young! There is no age restriction on a ROTH conversion, so you may decide to do conversions in retirement when your taxable income may be lower.
- You can be working or you can be retired.
- There is no income cap on the eligibility for a ROTH Conversion. However, your income does determine how much tax you pay.
- You can move shares of stocks or mutual funds from your Traditional IRA to your ROTH IRA so you don’t have to sell shares to do a ROTH Conversion.
- You need to complete some paperwork for your IRA custodian in order to make the Conversion happen. Your Advisor can help with this.
- It is best to pay the tax due from money outside of the conversion. We do not recommend reducing the conversion amount by withholding the tax that will be due. It reduces what will be available to grow tax free, and if you are under 59 ½ when you do the conversion, and you withhold the tax, you will owe a 10% penalty on the amount withdrawn for the tax. You can increase your withholding on other income early in the year to prepare for the extra tax hit, or you can file an estimated tax payment to cover the tax liability. If you normally receive a large refund, you may not need to add extra withholding. Your refund may cover some or most of the tax due. Again, this should be discussed with a tax professional.
- The conversion amount will be added to your taxable income for the year in which you complete the conversion. This is reported on Form 1099 from the custodian to you and to the IRS. The additional income will be taxed at your marginal tax rate for the year. That is your highest tax bracket after adding this income to any other income that year.
- The question is pay it now or pay it later, so you should strategize to pay the lowest tax. If you believe you are in a lower tax bracket now than you may be in the future, now is a good time to consider this strategy.
- One strategy is to be alert to your tax bracket for any given year and if you have not filled the 15% bracket as the year draws to a close, then convert enough of your Traditional IRA to fill that bracket.
- Another strategy is to pick out stocks or funds to transfer which have declined in price, and transfer those to move more shares at a lower price and keep the tax down.
- Do a ROTH Conversion in a tax year when the market is down. This will minimize the taxable event.
The good news is there is an escape hatch! If you get to tax time and find for any reason you regret your decision to convert, you can undo all or part of the conversion and put the money back into the Traditional IRA. This is called recharacterize. You have until October 15 of the year following the year of the conversion to do this.
Why might you decide to recharacterize a ROTH Conversion?
- One reason could be the tax turned out to be more than expected when you prepared your return. Overlapping into the next tax bracket could cause higher taxes in other ways.
- Another could be that the stock market declined and your converted amount is worth less at tax time than when you converted. The tax is determined by the value on the day you converted the account so the taxable amount will be inflated.
You have to wait until the tax year following the conversion year or a minimum of 30 days before you convert again at the lower amount.
The benefits of the ROTH IRA are many (link again to the How Does a ROTH IRA work article) and converting some of your Traditional IRA money is a faster way to build the account than just annual contributions. Be sure to consult your tax advisor before deciding to convert so you are not surprised by a tax bill. It can make good sense to pay the tax now in return for tax free growth going forward. It changes the future growth on your investment from tax-deferred to Tax Free!
Written by Connie C. Guelich, CFP, AEP, CLU, ChFC. This represents our views at the time of this writing, and it is subject to change. It is not intended to be personal investment advice. If you would like to discuss your own account, please don’t hesitate to call us. We are here to help and welcome your call.