The complete guide to Roth IRA and Roth 401(k) conversions

Roth conversions are often simple to complete and may offer significant tax benefits. But don’t rush into a Roth conversion without first understanding all the nuances and implications.

Both Roth individual retirement accounts (IRAs) and Roth 401(k) accounts allow you to pay taxes on contributions now in exchange for vast tax savings in the future. However, while this trade-off may be an easy yes in some scenarios, it could actually backfire in others.

Keep reading to learn more about what Roth conversions are, how to do one and when this approach might make sense for you.

What is a Roth conversion?

A Roth conversion is the process of moving existing assets from a traditional IRA or qualified employer-sponsored retirement plan (QRP) — such as a 401(k), 403(b) or 457(b) — to either a Roth 401(k) or a Roth IRA. Simplified employee pensions (SEP) and SIMPLE IRAs may also be converted to Roth IRAs.

• If you don’t want to take required distributions from a Roth 401(k), converting the funds to a Roth IRA can give you that freedom.
• Repositioning your assets from a traditional 401(k) to a Roth 401(k) is also called an in-plan Roth rollover.

What is the main difference between Roth and traditional retirement accounts?

The essential difference between Roth and traditional accounts is that Roth accounts are funded with after-tax dollars, while traditional IRA and 401(k) accounts are funded with pre-tax dollars. Each approach has distinct tax advantages:

• Traditional accounts reduce your adjusted gross income (AGI) and tax bill during the contribution year.
• However, for those who can wait for their tax benefits to be realized later, Roth IRAs and Roth 401(k)s offer tax-free withdrawals during retirement.

How do Roth conversions work?

Roth conversions can deliver non-taxable retirement income by converting your traditional IRA or 401(k) into a Roth IRA or 401(k). This involves transferring retirement assets to a Roth account, completing any necessary filing paperwork and paying applicable taxes. Any returns delivered by the assets now held in the Roth account become non-taxable upon reaching retirement age.

Types of Roth conversions

There are three types of Roth conversions. These include:

• Converting a traditional IRA into a Roth IRA.
• Converting a traditional 401(k) into a Roth 401(k).
• Converting a 401(k) into a Roth IRA.

Keep reading to learn more about each.

Converting an IRA into a Roth IRA

Converting a traditional IRA into a Roth IRA makes investment income from that IRA tax-free upon retirement. This can be done with minimal hassle, although you should discuss the process with your tax advisor first to weigh the pros and cons.

What should you know about traditional and Roth IRAs?

What do IRAs and Roth IRAs have in common?

IRAs are set up by individuals rather than employers and can be created in both traditional and Roth forms. Key details include:

• Contributions for the prior year can be made through Tax Day (April 15) of the current year.
• The standard contribution limit is $6,000 for taxpayers under 50, or $7,000 for taxpayers 50 and older.
• IRA investments can be made at any age if the individual making the contribution has earned income equal to or higher than the contribution amount.
• Anyone can fund an IRA on behalf of an individual when the collective amount doesn’t exceed that individual’s earned income. As a result, it can be an effective way to gift money to children and grandchildren who have reached working age.

Key required minimum distribution rules

While Roth IRA owners don’t need to take required minimum distributions (RMDs), those who inherit Roth IRAs follow the same provisions as traditional IRAs. If the original owner had started their distributions and the spouse is the sole beneficiary, they are required to take their distributions within five years or over their lifetime.

Typically, spouse and non-spouse heirs of IRAs must withdraw all the funds within 10 years of the original owner’s death, although there are some exceptions. For example, minors who inherit IRAs must withdraw all funds within 10 years of their 18th birthday.

The differences between IRAs and Roth IRAs

Generally, IRAs are taxed for contributions and earnings upon withdrawal. In the contribution year, deposits are deducted from the AGI on income tax returns. Roth IRAs are not deductible.

• Considerable attention should be paid to the effect of an increased AGI with Roth conversions and contributions. AGI is used by several government programs such as Medicare, the Affordable Care Act and college financial aid.
• Having a higher AGI may affect your eligibility with these programs or their healthcare premium amounts. Medicare has a two-year “look back” period in determining premiums.
• Completing your Roth conversion at least two years prior to your Medicare enrollment may be beneficial.

Contribution limits

Both IRAs and Roth IRAs have contribution limits:

• IRA contribution limits are equal to earned income, with the deduction phasing out at $68,000 and eliminated at $78,000 for single filers ($109,000 and $129,000, respectively, for joint filers). Nondeductible contributions above these amounts are reported on IRS Form 8606.
• Roth IRA contribution limits are imposed based on modified AGI. They are phased out at $129,000 and eliminated at $144,000 for single filers, and at $204,000 and $214,000, respectively, for joint filers.

Withdrawal distributions

This is a significant win for Roth IRAs:

• IRAs have RMDs mandating that the account owner begin the distributions at age 72, whether they are needed or not. If not taken or an insufficient amount is distributed, a 50% excise tax may be imposed on the amount not distributed as required.
• Roth IRAs have no RMD until after the death of the owner, so the money can compound longer if it is not needed.
• Money in an IRA grows tax-deferred, and withdrawals are taxed as ordinary income when withdrawn after age 59 and a half. Roth IRA monies grow tax-free. Tax- and penalty-free withdrawals can be made after 59 and a half.

• Early withdrawals (before 59 and a half) are permitted from principal without penalty from Roth IRA accounts, while IRA withdrawals are subject to both tax and a 10% penalty. Early withdrawals of investment income from a Roth IRA are also taxed and carry a 10% penalty.

Converting a 401(k) into a Roth 401(k)

Employer-sponsored Roth 401(k) plans are a hybrid of Roth IRAs and traditional 401(k) plans, borrowing features from each. Converting your traditional 401(k) allows you to continue participating in your employer-sponsored retirement plan while also enjoying the tax benefits of a Roth account.

Contribution limits

There is no income limitation to participate in a Roth 401(k):

• Currently, the maximum amount of income that can be considered when computing a contribution to a 401(k) plan is $305,000. Employees may contribute to the plan until the annual deferral limit is reached.
• Employer matching contributions must follow the plan formula (e.g., a 5% match) with the combined total employee and employer contributions not exceeding the match limit correlating to $305,000.
• Total employer and employer contributions are capped at the lesser of $61,000 or 100% of the employee’s compensation.
• Employers who match employee contributions in 401(k) plans are required to provide the same benefit for Roth 401(k) plans.
• Contributions must be processed by December 31.
• In 2022, the maximum contribution across all 401(k) and Roth 401(k) accounts is $20,500 for individuals under 50. Those 50 and over are eligible for catch-up contributions up to $27,000.

Withdrawal distributions

For a Roth 401(k), employer contributions from matching programs are technically held in a traditional 401(k). It would then be taxed upon conversion.

• Rolling a Roth 401(k) into a Roth IRA doesn’t require withholding. If it is moved directly into the new account, it can be completed without any tax liability.
• Roth 401(k) and 401(k) accounts both have RMDs. You must start taking money out at 72 unless you are still working or are not a 5% owner in the company sponsoring the plan.
• If you have reached age 72, some plans may still require that you begin distributions even if you have not retired. Read the fine print.
• The penalty for not taking an RMD is a 50% excise tax imposed on the amount not distributed as required. The excise may also apply if an insufficient amount is distributed.
• When funds are withdrawn from a Roth 401(k) before the age of 59 and a half — whether leaving the company or taking an in-service distribution — you must take out the proportional growth, which may be subject to tax and withdrawal penalties.

Converting a 401(k) into a Roth IRA

In addition to converting a traditional IRA into a Roth IRA or a traditional 401(k) into a Roth 401(k), you can also convert a 401(k) into a Roth IRA. This can be useful in certain situations, like if you are leaving your employer. In this situation, your account will be subject to any transfer requirements as well as the rules that govern Roth IRAs.

Why Roth conversions matter for high-net-worth individuals

In some situations, Roth conversions can offer significant tax benefits to high-net-worth individuals. A Roth conversion can be especially useful if you expect your tax bracket to go up in the future or if you can afford to pay an upfront tax bill now in order to give yourself non-taxable income upon retirement.

When should you consider a Roth conversion?

Understanding the IRS rules, legislative requirements, and the timing and thresholds associated with IRAs and 401(k)s is necessary to make educated Roth conversion decisions. And like everything else in life, these guidelines are subject to change.

Consider factors like:

Tax liability now versus in retirement

Would you rather pay a large tax bill now and enjoy tax-free retirement income — or lower your tax bill today but face taxes on future withdrawals from your retirement account? This question is a good starting place for considering whether a Roth conversion might make sense.

Five-year withdrawal prohibition

When made before the age of 59 and a half, withdrawals are prohibited for five years following a Roth conversion. If a withdrawal is made within that time frame, it is subject to a 50% excise tax penalty and the withdrawn earnings are taxed. Penalty exceptions are made for first-time home buyers, those who become disabled, or when the original account owner dies.

The five-year withdrawal rule applies if IRA account funds are used to pay taxes that are owed at the time of a Roth conversion. When possible, use outside funds to pay for taxes to avoid incurring the penalty.

Tax deadlines

You need to complete Roth conversions by December 31 to use them for the following tax year. Contact your investment advisor early since paperwork can get backlogged in November and December. Remember that estimated tax payments may be required, and late payment penalties can be assessed if the payment isn’t timely.

Financial institutions issue IRS information return Form 1099-R for Roth conversions. Contributions to Roth accounts are also reported on Form 5498 by the financial institution holding the account.

How to execute a Roth conversion

The process of completing a Roth conversion is simple. The four steps are so simple that it’s easy for a misstep to occur if you don’t consider all the nuances of the transaction.

To complete a Roth conversion:

1. Open a Roth IRA or use an existing Roth IRA account.
2. Contact the plan administrators for both the old and new financial institutions to find out what is needed.
3. Submit the completed paperwork to indicate which assets are being converted. Processing the request may take a few weeks.
4. Once complete, file IRS Form 8606 to report the conversion of an IRA to a Roth IRA and make any necessary tax payments.

Converting from a traditional 401(k) to a Roth 401(k) may be restricted to an employer’s open enrollment period unless a qualified life event has occurred.

Roth conversion strategies for high-net-worth individuals

Certain high-net-worth individuals may earn too much to qualify for a Roth IRA. However, in this situation, you may be able to lean on a process called a backdoor Roth IRA conversion, in which a contribution is made to a traditional IRA first, then transferred to a Roth IRA. This accomplishes the goal of having tax-free income while complying with IRS regulations.

• The dollar amount converted is taxed as ordinary income, which could push you into a higher marginal federal income tax bracket. Financial modeling can be done to plan for converting the funds to your Roth account over a few years to minimize the tax liability, potentially saving you the marginal difference.
• A Roth conversion can offset other losses or deductions that can reduce the amount of tax due on conversion.
• Converting from a Roth 401(k) to a Roth IRA relieves the burden of having to take distributions at age 72 if they aren’t needed or desired.

Pros and cons of Roth conversions

Depending on your specific circumstances, a Roth conversion could help you increase your available retirement income or gain additional flexibility around tax strategy. However, you also face an immediate tax bill after you make the conversion, as well as the possibility that you end up paying a higher tax rate now than you would in the future.

What situations benefit from Roth conversions?

Every situation should be evaluated individually. The “right” thing to do could vary based on the individuals involved, their ability to pay the tax at conversion, and various withdrawal rules. In the following scenarios, a Roth conversion is often beneficial:

• If you expect to be in a higher tax bracket in the future or at retirement due to increased earnings, paying the taxes for a Roth conversion now can make sense.
• If you feel the value of your IRA investments is hitting a low point, the timing may be optimal for converting to a Roth IRA.
• If you live in a low- or no-income-tax state and plan to move to a state with much higher income taxes, completing a Roth conversion before the move can provide substantial savings. When optimally timed, you could avoid paying taxes on conversion in your original state and avoid income taxes on withdrawal in your new state.
• If your income is temporarily lower due to reduced work hours or a sabbatical, you may slide into a lower income tax bracket than normal. It could be a good time to convert to a Roth account while your tax rate is lower.
• If you’re nearing retirement with a substantial 401(k) or Roth 401(k) balance and won’t need the mandatory withdrawals at age 72, consider converting to a Roth IRA, where withdrawals aren’t mandated.
• If you have funds in a traditional IRA and would like to leave non-spouse heirs tax-free income, converting to a Roth IRA can offer them more flexibility. Under the SECURE Act of 2019, traditional IRAs require heirs to withdraw all funds within 10 years.
• When budgets permit, an earner in their early years can greatly increase their total gain by converting to a Roth IRA as soon as possible to allow the greatest amount of time for compounding.

Conversely, if you think that your tax bracket may go down in the future, a Roth conversion could actually end up exposing you to a higher tax liability than if you stick with your existing IRA or 401(k).

Common mistakes to avoid

Sophisticated financial modeling and expertise are often necessary to understand the impact of tax regulations, market volatility and trade-offs on your specific situation. You should also consider contribution amounts, withdrawals and most importantly timing alongside tax implications.

To avoid making an ill-considered Roth conversion, talk to your tax advisor before moving forward. Your tax advisor can help you evaluate different scenarios and decide what makes the most sense for your specific needs.

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