How to Convert to a Roth IRA

Converting your traditional individual retirement account (IRA) to a Roth IRA is a strategic financial move that could lead to long-term tax savings. A Roth IRA conversion involves transferring funds from a tax-deferred traditional IRA into a Roth IRA, where future growth and withdrawals during retirement are tax-free if you follow certain rules. While you’ll pay income tax on the amount converted, the benefits can be significant, especially for those expecting to be in a higher tax rate in the future, probably once they’re retired. We’ll examine the steps required to make the switch and the factors you must consider before moving your money.

Understanding Roth IRA Conversions

A Roth IRA conversion involves moving money from a tax-deferred retirement account into a Roth IRA, which invests after-tax money and provides the benefit of tax-free growth when done right. When you convert, the amount moved is treated as taxable income for the year of the conversion, so it’s important to plan for the tax impact. However, once the funds are in the Roth IRA, they grow tax-free if done correctly and aren’t subject to required minimum distributions (RMDs).

Types of accounts eligible for conversion:

• Traditional IRA
• 401(k), qualified pension, profit-sharing, or stock bonus plan
• Annuity in a traditional IRA
• 403(b)
• 457 b
• SEP IRA
• SIMPLE IRA (after two years of participation)

Considerations of a Roth IRA Conversion

A Roth IRA conversion can be especially beneficial if you expect to be in a higher tax bracket in the future. By paying taxes now, you can lock in tax-free growth, which means you will not pay tax when or if you make withdrawals from the account if you meet certain conditions, potentially saving money over the long term. It’s also a smart strategy for high-income earners who aren’t eligible to contribute directly to a Roth IRA. This method, known as the “backdoor” Roth IRA, allows them to contribute to a traditional IRA and then convert it to a Roth IRA.

There are factors to consider when converting to a Roth IRA. The converted amount counts as taxable income in the year of the conversion, which could bump you into a higher tax bracket or affect other financial factors. Timing matters as well. If the market is down, converting investments at a lower value can reduce the tax burden, but if it’s up, the tax bill might be high. It is advisable to consult with a financial advisor or a tax professional prior to making this type of financial change.

How to Convert Your Retirement Account to a Roth IRA

A Roth IRA conversion moves funds from a traditional IRA or other eligible retirement account into a Roth IRA. As a result, you owe taxes on the amount transferred, but you gain future tax-free growth for assets in the Roth IRA if certain conditions are met. It’s not the same as a direct rollover, which typically transfers funds between similar account types without any tax consequence. A conversion to a Roth IRA changes the tax treatment of your retirement account.

Converting From a Traditional IRA to a Roth IRA

There are three steps to convert from a traditional IRA to a Roth IRA.

• Review financial impact: On your own or by talking with a financial advisor or tax professional, determine the effect a conversion would have on your tax situation.
• Open a Roth IRA: You need an active Roth IRA to receive the transferred funds.
• Directly transfer funds: Request the account to be transferred directly between trustees. Do not take it in cash, as that may result in penalties or withholdings.

Converting From an Employee-Sponsored Plan to a Roth IRA

Many people save for retirement through employer-sponsored plans like 401(k)s and 403(b)s, which offer tax-deferred investment growth. While these are the most common, there are several types of workplace retirement plans, each with their own rules. If you’re considering converting part or all of one of these plans to a Roth IRA, it’s important to understand the plan’s rules regarding conversions. You may also want to consult a financial advisor to help navigate the process and avoid costly mistakes.

These are the steps to convert from an employer-sponsored plan to a Roth IRA.

• Check eligibility: Make sure your current account is eligible for a conversion to a Roth IRA.
• Review financial impact: Ask a financial advisor or tax professional what effect a conversion would have on your individual tax situation.
• Open a Roth IRA: You need a Roth IRA to receive the transferred funds.
• Directly transfer funds: Request the assets to be transferred directly from your workplace retirement account to a Roth IRA. Do not take it in cash, as that may result in penalties or withholdings.

The Bottom Line

Converting your tax-deferred retirement account to a Roth IRA can be beneficial in several ways. A Roth IRA allows your invested funds to grow tax-free when done properly. Also, you are not required to take minimum distributions from a Roth IRA. That leeway allows you to pass the Roth assets along to your heirs tax-free (although your heirs would have to follow RMD rules). Converting a traditional IRA to a Roth IRA is also a unique tool for contributing to a Roth even if your income is too high for a direct contribution. Regardless of which type of tax-deferred retirement account you are converting to a Roth IRA, you must be aware of the tax ramifications on your specific financial situation.