What You Need to Know about Roth IRA Conversions

While it’s important to start planning for retirement as early as possible, it’s never too late to start saving and building a nest egg. There are several types of retirement accounts that offer growth via compound interest and various tax advantages. Employer-sponsored 401(k) plans and individual retirement accounts (IRAs) are the two most common retirement-saving vehicles in the United States.

An IRA is an individual retirement account that may offer greater investment variety and have lower contribution limits than 401(k)s. Both IRAs and 401(k)s are further separated into two categories: traditional or Roth. Funds can be transferred between Roth and 401(k) accounts under certain circumstances. However, there are tax considerations to consider prior to making a transfer, or “conversion”.

Below is a breakdown of Roth IRAs, why you may decide to transfer or convert money to these accounts, and the rules associated with doing so.

What Is a Roth IRA?

Roth IRAs are different from traditional IRAs. You can open and contribute to both accounts at any age, and both have IRS-imposed contribution limits. Those limits are $7,000 and $8,000 for people younger than and older than 50, respectively, for the 2024 tax year.

Withdrawals from traditional IRAs are subject to income tax penalties, while Roth IRA account holders can withdraw contributions tax-free at any time, although there are restrictions and penalties associated with withdrawing gains pre-retirement. Traditional IRA contributions are tax-deductible, but you cannot deduct Roth IRA contributions.

Why Make Roth IRA Conversions?

Because qualifying withdrawals are tax-free, many people choose to transfer funds from traditional IRAs or other accounts into Roth IRAs as they approach retirement. Roth IRAs also don’t have minimum distribution requirements, offering the account holder greater savings flexibility.

While they provide future tax free benefits, Roth IRA conversions are subject to tax in the year that the conversion occurs. The account holder is responsible for paying the required taxes, not only on the amount of money withdrawn from the traditional IRA, but also the tax-deductible contributions and tax-deferred earnings over the years, in the IRA or 401k or 403B. Consider your current financial situation and how it might change before effectuating a Roth IRA conversion.

If you expect to be in a higher tax bracket when you retire, you might decide to shift the bulk of your savings to a Roth IRA over time, so you can make tax-free withdrawals, or enjoy guaranteed tax free income for life from a ROTH IRA annuity. Conversions are also a powerful part of estate planning because beneficiaries will also be able to take advantage of tax-free withdrawals, although in that case the Roth IRA must be completely liquidated within a 10-year period. Non-spouse beneficiaries used to be able to make withdrawals as long as they lived, but Congress changed this as part of the SECURE Act in 2019, and now they must empty out these accounts within 10 years.

Because there are also no limits on the amount and size of Roth conversions, making conversions over multiple years, as opposed to a large one-time conversion can also be helpful from a tax perspective. Speaking to a tax professional may clarify whether this is something you could benefit from. If you believe tax rates may be higher in the future ( a good bet given the country’s terrible financial condition and rapidly aging population), converting large amounts of tax deferred 401k, 403B, or IRA funds to ROTH status would insulate all that money from all future tax increases.

Types of Transfers

There are three ways to perform Roth IRA conversions. A rollover is a common method for transferring funds from a 401(k) or other employer-sponsored plan, especially when leaving a company. In this case, the employer or plan administrator will either deposit the money directly into your new Roth IRA or send a check to the designated account representative. If you are performing a direct rollover conversion, make sure to the check is deposited within 60 days. Otherwise, you may owe taxes on the rollover amount in addition to a 10 percent penalty, if you are under age 59 and a half when you do the conversion rollover.

Trustee-to-trustee and same-trustee transfers are the other two Roth IRA conversions allowed by the IRS. For trustee-to-trustee transfers, the account holder directs the financial institution that holds their traditional IRA to transfer a specified amount to their Roth account at a different financial institution. Same-trustee transfers can be made when both of the conversion-facilitator’s accounts are held by the same institution. You can have taxes withheld from the conversion amount, but if you can pay the taxes from your ongoing cash flow, or a non-IRA source, that is better, as more ( or all) of the converted funds will go to the forever tax free world of the ROTH IRA.

The 5-Year Rule

Although Roth IRA contribution or conversion withdrawals can be made tax-free at any age, there are restrictions for withdrawing gains. The growth on the converted or contributed funds must stay in the Roth account for up to five years, depending on when the account holder effectuated the conversion, or made the contribution.

The five-year wait period begins on January 1 of the year that the person made the conversion. Someone who makes a Roth IRA conversion on December 20, 2024, then, would only have to wait until January 1, 2029, to perform a penalty-free withdrawal on the growth on the conversion.

Backdoor Roth IRAs

Roth IRA contributions are capped at $8,000 for people 50 years old or older in 2024. Additionally, high-income earners can’t open or contribute to Roth IRAs. As of 2024, married couples filing taxes jointly who made more than $240,000 in combined income were not eligible to contribute to Roth IRAs. However, there are no income limits on conversions, so anyone can convert funds from other retirement accounts into Roth IRAs. This is known as a “backdoor Roth IRA.”

Single people or married couples whose income exceeds the contribution limit for Roth IRAs can also contribute to a 401(k) or traditional IRA on a non-deductible basis, then and convert those funds to an existing Roth IRA to take advantage of tax-free withdrawals in the future.