How to Convert an IRA to a Roth IRA

Is a Roth conversion right for you?

Moving your money from a traditional IRA or 401k and into a Roth IRA can be a smart choice for your future finances. But, while the mechanics of a Roth conversion are simple, it’s important to get the full picture to find out if it will benefit you in the long term.

In this post, we share everything you need to know about doing a Roth conversion, including what a Roth conversion is, why you may choose to do one, and the process of moving your money between these two different types of accounts.

You can watch the video on this topic above. To listen to the podcast episode, hit play below, or read on for more…

The differences between a traditional IRA and a Roth IRA

A traditional IRA or 401k is considered pre-tax money. It gives you an immediate tax benefit. So, for example, you may be using salary deferrals to contribute to a 401k which automatically comes off your income for the year. When you withdraw from a traditional IRA, then the money becomes taxable, similar to a paycheck.

A Roth IRA contains after-tax dollars, but it grows tax-free, and you won’t be taxed when you withdraw it. Say you contribute $50,000 to a Roth IRA that’s invested in the market, and it grows to $100,000 or even $200,000. You can withdraw this without being taxed.

So, these are the two key differences:

  • Traditional IRAs and 401ks are pre-tax (but you’ll pay tax on withdrawal)
  • Roth IRAs use after-tax money (but you get a tax benefit later)

One thing that is the same between the two accounts is how you invest. You can invest both a traditional IRA and Roth IRA exactly the same.

How much of a traditional IRA can you convert to a Roth IRA?

Broadly speaking, you can convert 100% of your traditional IRA or 401k into a Roth IRA. There are no conversion limits. So, if you have $1 million in your traditional IRA, you can convert the entire $1 million into a Roth IRA.

But don’t get conversion and contributions mixed up. There are contribution limitations. However, these depend on your age and income.

How to convert your traditional IRA into a Roth IRA

Converting your traditional IRA into a Roth IRA is a simple process, similar to switching any account. The easiest way to do a Roth conversion is when both IRAs are held at the same institution.

For example, if you had a traditional IRA at Charles Schwab and wanted to do a Roth conversion, the easiest option is to open a Roth IRA also at Charles Schwab. Then it’s a straightforward transfer to move your money from your traditional account into your Roth account. You just have to know how much you want to convert, then sign the document and the custodian (in this case Charles Schwab) will take care of the rest.

If your traditional IRA and Roth IRA accounts aren’t held at the same institution, the process is almost the same, but with a few extra steps. It’s best to check with your traditional IRA or 401k account holder to find out what their exact process is, and they’ll help you through it.

Taxes: what to look out for when converting

When you do a Roth conversion, you have to pay taxes as you’re moving money out of a pre-tax account and into an account for after-tax dollars only.

You might consider holding back some money to cover these taxes. However, we believe this isn’t the best option. You may not be able to make contributions to your Roth IRA, so a conversion is the only way to put as much money as you can in this tax-free account. So, we advise converting 100% of your traditional IRA into a Roth IRA and paying the taxes from another account, such as savings or a brokerage account.

Say you want to convert $30,000 from your traditional IRA into a Roth IRA. First, you should make sure you have enough money outside of your traditional IRA to cover the taxes. On $30,000, these taxes may equate to around $6,000. If you decide to take that $6,000 from your IRA money, you’re putting yourself at a long-term disadvantage. The tax-free growth of a Roth IRA means you should put as much money in as possible to reap the future benefits.

Depending on your tax situation, you may need to think strategically about how much you can convert. You don’t want to end up in a higher tax bracket because you converted too many extra dollars. If you’re unsure about how much you can convert without changing your tax bracket, speak to your financial planner or advisor who can help you play with the numbers.

Why you need to consider future tax

The number one reason to do a Roth conversion is to protect against higher tax rates in future. The idea is to pay lower tax rates now and avoid rising ones later down the line. So, if you believe that your taxes will be lower in future, a Roth IRA will not make sense for you.

If you currently have a high-income rate, say $250,000, but are expecting this to drop to $60,000 in 15-20 years, then you could be paying less tax in future. However, if tax rates rise, you may pay a higher percentage, even though you’re earning a lower amount. So, the question is, would you still convert?

In this situation, one solution is to do smaller conversions and split your money into both pre-tax and after-tax assets. Ultimately, we don’t know what might happen in the future, so you will need to think carefully about whether a conversion is really right for you and put a strategy in place.

How to avoid required minimum distributions with a Roth conversion

Any pre-tax account, including traditional IRAs, 401ks, and 403bs, are subject to required minimum distributions (RMDs). These are to make sure that you do eventually pay tax on this money. At age 72, you’ll be required to take withdrawals from your pre-tax account based on your life expectancy.

Another reason many people choose to do a Roth conversion is to avoid these RMDs. You may prefer to pay your taxes now rather than on RMDs at age 72. If you’re already at this age, it becomes more challenging to do a Roth conversion as the IRS requires you to take the RMDs every year.

Say you have $1 million in a traditional IRA and your RMD for that year is $50,000. If you want to do a Roth conversion, you have to take the $50,000, put it in your bank, pay the taxes on it, and only then can you proceed with the Roth conversion. So, if you wanted to convert $20,000 from your traditional IRA into a Roth IRA, you could do this after you’ve taken and paid tax on your RMD. It’s important to note that this means you’ll have to pay tax on both amounts, so $70,000 in total that’s been added to your income for the year.

Our advice is, if you’re planning to do a Roth conversion, don’t wait until you’re RMD age.

It’s important to look at the whole picture when deciding whether to do a Roth conversion. Tax numbers can be confusing, so it’s best to find out what solution suits your specific situation. If you want to get more insight on converting your traditional IRA into a Roth IRA, you can book a complimentary 15-minute call with us and we’ll discuss what option is right for you.

How to Rollover Your IRA and 401k

How do IRA and 401k rollovers work?

Retirement accounts are a great way of saving for the future, but they’re not preferable for everyone. If you want to move your money out of your 401k, 403b, 457, or IRA, the best way is to do a rollover.

If done correctly, rollovers are tax-free and a straightforward solution to moving money between retirement accounts. But there can be rules, limitations, and risks involved. In this post, we explain the process of doing a 401k or IRA rollover, when you’ll be eligible, and the reasons why you should consider one.

[You can watch the video on this topic above or, to listen to the podcast episode, hit play below, or read on for more…]

 

 

How to rollover your IRA and 401k

A rollover is a term meaning the action of moving money from one account into another account.

You’ve likely accumulated money in several retirement vehicles throughout your career. You might have 401ks, 403bs, 457s, IRAs. If you decide to move your money from where it is currently to a new institution, this is a rollover.

You can do a rollover between any employer plan, even if they’re the same. For example, you can move your money from one 401k into another 401k, or you can go from a 401k to an IRA account.

There are two main types of rollover. One is a direct rollover, which is a straightforward, trustee-to-trustee transfer. The other is a 60-day rollover, which can be riskier.

 

How to rollover your IRA and 401k using a trustee-to-trustee transfer

A trustee-to-trustee transfer moves your money from one institution directly to another institution. To do this, your existing account holder has to make out a check to your new account holder, with your name listed as “FBO” (for the benefit of).

Let’s use an example. If you have a 401k or an IRA held with Fidelity, but you want to move it to Charles Schwab, Fidelity has to write a check addressed to Charles Schwab followed by FBO and your name.

 

Key things to know about a trustee-to-trustee transfer:

  • The check is not made out to you, so you cannot put it into your account
  • The government have not put a limit on how many trustee-to-trustee transfers you can do so you can do this as many times as you like
  • This is a simple, straightforward, and risk-free way to do a rollover
  • If you are moving money into an IRA, you should set this up before you instruct your institution ­– you do not have to put money into an IRA to open one

 

How to do a 60-rollover for your IRA and 401k 

With a 60-day rollover, your institution writes the check directly out to your name. From this date, you have just 60 days to put it into an IRA, otherwise, it will be taxable. If you’re under the age of 59 and a half and you go over the 60-day limit, you’ll owe a 10% penalty as well as tax.

For 401ks, there is one additional caveat. 401ks are required by law to withhold 20% of your money, even if you get them to write a check out to you. This can be an issue.

If you have $100,000 in your 401k, for example, and the institution withholds $20,000 in taxes, you only have $80,000. You will get that $20,000 back, but only when you next file your taxes. To complete the rollover in the meantime, you’ll need to find an additional $20,000 to roll over the full amount.

 

Key things to know about a 60-day rollover:

  • You have to complete your rollover within 60 days, or you will be taxed
  • If you’re under the age requirement, you will also face a penalty
  • You can only do one 60-day rollover in a calendar year

We prefer using a trustee-to-trustee transfer. This way, you do not run the risk of having to pay income tax on your money, and it’s a more straightforward solution.

 

Why you shouldn’t use a 60-day rollover as a personal loan

Some people choose to use a 60-day rollover as a personal loan, but we advise against it. You may do this to loan yourself money in an interest-free way.

This is a high-risk strategy as you’re bound by the 60-day rule to get your money back into that account. This is a fixed rule and if you miss your 60-day deadline for any reason, whether you didn’t manage your time well, or you didn’t have enough money to put it back in to your account in time, then you’re faced with an irreversible problem, and bigger tax bill, and potentially a penalty too.

It’s a very risky strategy and not one that the IRS likes, so we urge you to be cautious if this is something you’ve heard or read about.

 

What makes you eligible to rollover your IRA and 401k

If you’re under age 59 and a half and you try to take money out of any retirement account, such as 401ks and IRAs, you will be penalized for it.

However, if you’re over age 59 and a half, the government now considers you eligible to use that money. Most 401k, 403b, and 457 plans allow you to do rollovers whenever you want. So, if you meet the age requirement, you can do a rollover without any penalties or tax concerns, providing you do it correctly.

One other way you become eligible for a 401k rollover is following a separation of service. This is when you leave your company for one of the following reasons:

  • Transitioning into a new company
  • If you get laid off
  • If you retire before 59 and a half

If you’re leaving your company, you may want to consider doing a rollover as you may not be eligible again for some time.

 

Why should you rollover your IRA and 401k

Your company might match your 401k contributions and offer you investment choices, so why would you choose to rollover your 401k into an IRA?

Firstly, 401ks have lots of hidden fees. You may not be aware of just how much you’re losing in fees for your 401k. Sometimes your employer will pay these, but they can also be passed along to you, the participant, without you knowing.

With an IRA, there’s a far higher level of transparency. You own every aspect of your IRA, so you can know each fee that gets charged to your account – if any. There are no admin fees with an IRA, so the only possible charges will be mutual fund or ETF fees if you use your IRA to buy those.

Secondly, it’s a myth that you get better rates if you have a 401k with a big company. It is not true that you get better rates based on what company you’re with. It’s also worth noting that your investment options are very limited in a 401k. An IRA has far more investment opportunities available.

Thirdly, 401k plans limit how much activity your account can have within a given year. Some plans may only allow you to make a change once every quarter or biannually. If you like to manage your money actively, then an IRA might be more suited to you.

It’s also challenging to manage your funds in a 401k. If you want a financial planner to help you handle your 401k, there’s very little that they can do. With an IRA, a financial planner can manage and monitor your money much more closely.

Finally, if you have multiple retirement accounts, you may want to make them easier to manage by consolidating them all into a singular, traditional IRA.

So, those are the reasons why you might want to rollover your 401k into an IRA. But why might you not want to?

There’s one time when you might not want to do a rollover, and that’s if you’re aged between 55 and 59 and a half and you’re no longer employed with the company your 401k is with. The IRS allows people above the age of 55 to take distributions of their 401k without penalties. If it’s in an IRA, you have to be 59 and a half to avoid the penalty. If you’re within this window and want access to your 401k money, we advise you to take distributions instead of doing a rollover.

 

How to execute a rollover

To do a trustee-to-trustee transfer or 60-day rollover, call your institution directly. They will have specialists available to help you do a transfer, but they are not there to give you advice, so make sure you’ve researched your options beforehand.

If you’re continuing to work at your company, this is called an in-service rollover. In this case, you stay in-service at your company, keep the 401k account, but roll out the balance into a traditional or Roth IRA account. Your 401k will stay the same, you will still make contributions and get the match, but your previous balance will now be in an IRA.

When you speak to your institution, they’ll ask you to verify your identity and address and then ask where you’re sending the money. Make sure you already have your IRA in place so that you can send the money over smoothly.

Your institution will then write the check out to the new institution if it’s a trustee-to-trustee transfer or directly to you if it’s a 60-day rollover.

You will rarely need to do any paperwork, and if you do, your institution can walk you through any documents that they need. Your institution may also ask you to review a tax notice, which explains the tax-risk of a 60-day rollover, much like we have in this post.

Ultimately, a rollover should be a simple, smooth process, resulting in putting your money in an account that you’re happy with.

If you’re considering doing a rollover or have any questions about IRAs, 401ks, 403bs, or 457s, our team can answer them. We work with these accounts every day and can offer you tailored advice and information based on your situation. Do consider booking a complimentary 15-minute call with us to find out how we can help you.

How Are You Going to Stay on Top of Your Finances in 2021?

How are you going to stay on top of your finances in 2021?

Financially planning for retirement can feel like a lot of work, especially if you have multiple moving parts to your money. Dealing with 401Ks, IRAs, Social Security, and RMDs can become overwhelming as the year gets busier, so we recommend taking stock of your finances early and planning ahead.

The beginning of the year is a great time to review your finances but knowing where to start is challenging. So, we’ve created our retirement and financial planning checklist.

Read on to discover the nine key areas you should consider for the upcoming year. We also point out some key changes and information for 2021, so you can start this year as securely as possible.

1. Review your 401K, traditional IRA, Roth IRA, and HSA contributions

If you’re earning income, you should review your accounts and plan how much you want to contribute to each one this year. Do you have a goal for each? How much will you need to contribute to get you there?

Bear in mind that contributions may be limited, so you might need to adjust your plans and payroll accordingly. For example, the contribution limit for 401Ks in 2021 is $19,500. However, if you’re over 50 years of age, you can qualify for the ‘catch-up contribution’, increasing the $19,500 limit by an additional $6,500. This also applies to 403Bs and 457 plans.

Roth IRA accounts have a much lower contribution limit of $6,000, with an additional $1,000 for those over 50.

We’ve detailed the difference between Roth IRAs and traditional IRAs before, but to recap, the main differences are:

  • A Roth IRA is tax-free assets: contributed to after you’ve paid tax on the money – these have income limitations, so if you earn over a certain amount, you will not be able to contribute
  • A traditional IRA is pre-tax assets: contributed to before you’ve paid tax on the money – no income limitations

To learn more about the pros and cons of Roth IRAs vs traditional IRAs, read this post.

Once you are aware of your accounts’ limitations, we advise you plan your contributions for the year. This way, you can ensure you’re on track to achieving your long-term money goals without having to continually review your accounts’ statuses.

2. Update your beneficiaries

Life sometimes moves so fast that it can be hard to keep up. New grandchildren, marriages, or other life changes may affect who you want as a beneficiary.

It’s important to stay on top of your different accounts and which beneficiaries are associated with them. Your accounts and associated beneficiaries should align with your overall estate plan and life insurance to avoid confusion.

Updating beneficiaries can be easily done online or with a signature on a form. It should only take a few minutes and is something we highly recommend putting in order while you have the time.

3. Consolidate your accounts

If you’ve previously changed employment, you may well have more than one 401K plan open. We often speak to clients who have two, three, or four 401Ks with past employers, that they’ve completely forgotten about – and that have substantial balances in them!

Moving existing 401Ks into a traditional IRA is a fantastic way to consolidate your accounts. It’s completely tax-free, with no risk, penalties, and typically no fees. If you hold multiple traditional IRAs, we also advise consolidating these into just one account.

By reducing the number of unnecessary accounts, managing your money will become more straightforward and less stressful.

4. Assess your mortgage rate

It’s very unlikely that mortgage rates will reduce further, so we recommend taking advantage of them while you can. Now is a great time to refinance your house or any investment properties you have a loan on. An advantageous rate could lower your payments, giving you greater monthly cash flow, or help you pay off the loan faster.

We spoke to a Loan Officer with 15 years’ experience about the benefits of refinancing in our podcast episode ‘Tammi Rowe – Planning Your Mortgage and Retirement’. To find out more about what refinancing could do for you, listen to the episode.

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5. Plan for emergencies

You might be faced with a financial opportunity, for example, paying off your mortgage, but it’ll leave you with less cash in the bank than you’d like. Should you do it? Or should you build up your ‘emergency fund’ first?

Having cash reserves in case of emergencies is necessary. But you don’t always have to choose between keeping lots of cash in the bank or paying off a substantial loan.

One tip we give our clients is to open an equity line of credit. There can be a minimal fee to open it, but there’s no interest if you don’t have any balance. This means that if you spend your cash reserves on something like paying off a mortgage, you have easy access to cash, as an equity line of credit comes with either a debit card, a checkbook, or both.

An equity line of credit is only available to those still working, so if you want an emergency fund for the future, we urge you to set one up while you still qualify. You won’t need to make any payments, and it won’t gain any interest, so long as the balance is zero.

6. Consider how and when you’ll take your RMDs

If you’re turning 72 in 2021, pay close attention. RMDs or Required Minimum Distributions were optional in 2020, however, the rules are changing for 2021, and if you turn 72 this year, you will have to take your RMDs this year and every year going forward.

Your individual RMDs are based on your IRAs’ combined balance, so there isn’t one set figure for everyone. You can spend your RMDs, or you can reinvest them into another brokerage account, but they must leave your IRA and cannot go into another IRA.

Bear in mind that money in a traditional IRA is pre-tax. So, when it leaves the IRA as an RMD, it’s treated as income and will be taxed.

There is no rule when you should take your RMDs, but you must start taking them before December 31st from the year you turn 72. Some people choose to take it monthly, like a paycheck, and others take it as a lump sum at the beginning or end of the year.

If you don’t need to take your RMD and don’t want to pay tax on the money you don’t need, you can make a qualified charitable deduction once you’re aged 70 and a half. This is where you direct your RMD straight from your IRA to a charity of your choice. This way, your RMD leaves the IRA but isn’t claimed as income, making it tax-free.

You can also do this with a portion of your RMD. For example, if your RMD is $10,000, and you want to instruct $5,000 to a charity and keep $5,000 for yourself, you only have to pay tax on the $5,000 you keep.

7. Apply for Social Security

If you’re planning on taking Social Security in 2021, it can be a long process. Right now, there are thousands of people applying every single day, so we advise applying two to three months ahead of when you want to start receiving your Social Security benefits.

You can apply as early as three months before the date that you want to start receiving them, so if you’ve already decided it’s part of your financial plan for 2021, don’t wait. Plan ahead, make the phone calls, and fill out the paperwork as soon as you can so that you can receive your benefits when you need them.

8. Research your Medicare options

Health insurance has never been more vital, so putting a plan in place as soon as possible is recommended. There’s a lot to think about with Medicare, from how your income affects your premiums to when the open enrollment periods are. If you’re turning 65 or going to be receiving Medicare, we encourage you to research your options.

We spoke to Medicare Specialist, Lorraine Bowen, on our podcast, and she answered all of our Medicare questions, including what it covers and how to find out if you’re entitled to it. To learn more about Medicare, listen to this episode.

9. Understand your income plan

When you stop working, you might find it more challenging to keep track of your income. There can be many moving parts in retirement with different income streams and RMDs, and it could leave you with an unnecessarily high tax bill or with fewer cash reserves than you’d like.

Now is the perfect time to adjust your income to ensure that you’re not taking too much or too little. We use a couple of different software programs that help us automatically track income on a month-by-month basis to find a monthly income figure that’s best suited to you. If you want to learn more about how we do this, reach out to us.

Those are our nine key points for preparing your finances for retirement in 2021. By completing this checklist, you’ll be giving yourself peace of mind that you’re on track to achieving your financial goals throughout the year.

We’re going to delve deeper into more of these topics as the year progresses, but if you have any urgent questions about any of the subjects we discussed in this post, please get in touch. You can contact us, or if you want to discuss your retirement goals with a member of our team, we invite you to schedule a 15-minute complimentary call with us.