How to Convert an IRA to a Roth IRA

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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.