What is a Roth Conversion: From a Financial Advisor

Converting funds from a traditional 401(k) or IRA to a Roth 401(k) or Roth IRA offers several potential benefits. While you’ll need to pay taxes on the amount you convert, the long-term advantages can outweigh the upfront cost. Once your money is in a Roth account, you can take tax-free withdrawals in retirement. This gives you flexibility to manage your taxes and boosts your after-tax income.

A key advantage of Roth accounts is that they’re not subject to required minimum distributions (RMDs). While this has always been true for Roth IRAs, as of 2024, Roth 401(k)s are also exempt from RMDs, making them a valuable tool for estate planning.

One compelling reason to consider a Roth conversion soon is the potential for higher tax rates. Unless Congress acts, the current tax rates under the 2017 Tax Cuts and Jobs Act will expire at the end of 2025, potentially leading to higher taxes. Although some lawmakers support extending the lower rates, rising national debt and deficits could complicate these efforts. By converting at today’s lower rates, you may reduce the tax impact now and enjoy tax-free withdrawals in retirement.

Interested? Here are answers to some common questions about Roth conversions. Be sure to consult a tax advisor to understand how this strategy fits your specific situation.

Can I Convert Funds from a Traditional 401(k) to a Roth 401(k)?

Yes, if your employer’s retirement plan offers a Roth 401(k) option and allows in-plan conversions, you can convert your traditional 401(k) to a Roth 401(k). Keep in mind that the conversion may trigger taxes, depending on the source of the funds being converted.

Tip: If you’ve made after-tax contributions to your 401(k), you may want to explore strategies for maximizing their potential.

Can I Convert Funds from a Traditional 401(k) to a Roth IRA?

Yes, you can convert a traditional 401(k) to a Roth IRA under certain conditions:

●      After Retirement: You can roll over funds directly from your 401(k) to a Roth IRA.

●      While Still Working: If your plan allows in-service withdrawals, you can roll over funds to a Roth IRA even before you retire.

This can be done either through a direct rollover from the 401(k) to a Roth IRA or by transferring funds first to a traditional IRA, then converting to a Roth IRA.

Tip: For step-by-step guidance, consider using tools and resources designed to simplify Roth conversions.

Can I Convert to a Roth IRA If I Earn Too Much to Contribute Directly?

Yes, income limits don’t apply to Roth IRA conversions. If your income exceeds the threshold for contributing directly to a Roth IRA, you can still take advantage of a backdoor Roth IRA strategy:

1.     Open a traditional IRA and make a nondeductible contribution.

2.     Convert those funds to a Roth IRA.

This allows high-income earners to access the benefits of Roth accounts, even if they aren’t eligible for direct contributions.

How Can I Estimate My Tax Liability on a Roth Conversion?

Your tax liability for a Roth conversion depends on two key factors:

1.     The taxable income generated by the conversion.

2.     Your applicable tax rate.

When calculating taxes, the IRS treats all of your traditional IRAs as a single account, regardless of how many you have. To estimate your tax liability, you need to understand the types of contributions made to your traditional IRAs:

●      Pre-Tax (Deductible) Contributions: Contributions for which you received a tax deduction.

●      After-Tax (Nondeductible) Contributions: Contributions made without a tax deduction, which establish a "basis" in your IRA.

If you’ve never made nondeductible contributions, the entire conversion amount will be taxable. However, if your traditional IRA includes both deductible and nondeductible contributions, you’ll need to calculate the proportion of your IRA balance that is nondeductible. This percentage will determine the portion of the conversion that is tax-free.

Important: You can’t selectively convert only the nondeductible portion of your IRA to avoid taxes. Instead, the IRS requires you to use a pro-rata rule, which considers the ratio of nondeductible contributions to the total balance of all your traditional IRAs (excluding inherited IRAs).

This hypothetical example is for illustrative purposes only. It shows how to figure out what part of an IRA conversion is taxable income.

Don’t Forget State Taxes

A Roth IRA conversion is not only a federal tax event. State taxes may also apply if you live in a state with income tax. The conversion amount is typically treated as taxable income at both the federal and state levels.

Tip: If you and your spouse have IRAs with different contribution types—such as one spouse with mostly nondeductible contributions and the other with primarily deductible — you might reduce your tax burden by converting the nondeductible IRAs first. The IRS views your IRA accounts separately from your spouse's when calculating taxes.

Strategies to Manage Taxes on a Roth Conversion

There are several ways to offset the tax liability of a Roth IRA conversion, including utilizing tax deductions.

●      Charitable Contributions:

●      Donations to qualified charities can help reduce your taxable income.

●      Cash donations typically allow a deduction of up to 60% of your adjusted gross income (AGI).

●      Noncash donations, such as appreciated securities, or contributions to certain private foundations, generally allow a deduction of up to 30% of AGI.

If your total itemized deductions are less than the standard deduction, you won’t gain from these charitable deductions. Work with a tax advisor to develop a strategy that maximizes both your giving and your tax savings.

Does Timing Matter for a Roth Conversion?

Yes, the timing of your conversion can have a significant impact. Here’s how:

●      Early-Year Conversions: Converting early in the year gives you more time to plan for taxes. You can pay them later, as they are due by the next year's tax deadline. This could give you up to 15 months to manage your tax payments. Keep in mind that if you pay estimated taxes, you may need to make some payments before the deadline.

●      Late-Year Conversions: Waiting until later in the year has its own benefits:

●      The 5-Year Rule: The IRS requires a 5-year waiting period before you can withdraw converted funds penalty-free. The clock starts on January 1 of the year you make the conversion, regardless of when the conversion actually takes place during that year.

●      Better Income Clarity: By converting later, you’ll have a clearer picture of your total income for the year. This can help you strategically convert only enough to stay within your current tax bracket, minimizing the tax hit.

Remember, conversions must be completed by December 31 to count for that year’s taxes.

Can I Convert Specific Investments to a Roth IRA?

Yes, you can convert specific assets, such as stocks or other investments, from a traditional IRA to a Roth IRA without selling them first. This is known as an in-kind conversion and allows you to retain ownership of those assets while moving them into the Roth IRA.

For tax purposes, it doesn’t matter whether you transfer the actual investment or sell it and transfer the cash—both scenarios will be taxed based on the fair market value of the assets at the time of conversion.

Sources:

https://www.fidelity.com/learning-center/personal-finance/retirement/answers-to-roth-conversion-questions

Disclosures:

This information is an overview and should not be considered as specific guidance or recommendations for any individual or business.

This material is provided as a courtesy and for educational purposes only.

These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information