The end of the year can be a good time to review current investments and consider potential changes. One common topic is converting or rolling over a Traditional IRA to a Roth IRA. An experienced professional can be especially helpful when exploring these types of decisions and understanding the potential implications. An Arvest Wealth Management client advisor can work in collaboration with your tax and legal advisors to identify if any changes may be needed to support your holistic financial goals. Here are some key points to consider regarding IRA conversions and rollovers.
What is it?
In general, you can transfer all or a portion of your traditional IRA funds to a Roth IRA. This can be accomplished in one of two ways:
- You can convert your traditional IRA to a Roth IRA – For this option, notify the trustee or custodian of your traditional IRA that you wish to convert your traditional IRA to a Roth IRA. The account is then renamed as a Roth IRA, and your funds never actually leave the account.
- You can roll over funds from your traditional IRA to a Roth IRA – In this case, you actually transfer the funds from your traditional IRA to a Roth IRA. The income tax consequences of the two methods are identical.
However, the fact that you can convert or roll over funds from your traditional IRA to a Roth IRA doesn’t necessarily mean that you should. There are a number of factors you need to consider.
Note: If you’ve inherited a traditional IRA (or SEP/SIMPLE IRA) from someone other than your spouse, you cannot convert that traditional IRA to a Roth IRA.
When can this change be used?
It probably goes without saying, but you must already have a traditional IRA in order to convert or roll over funds to a Roth IRA. Additionally, SEP-IRAs, SAR-SEP IRAs, and SIMPLE IRAs (those that have existed for at least two years) are eligible to be converted to a Roth IRA. The rules that apply to conversions from traditional IRAs, as discussed in this article, also apply to SEP, SAR-SEP, and SIMPLE conversions.
Rollovers must follow IRA rollover rules
If you choose the rollover method to transfer funds, you must comply with federal rules governing IRA rollovers. For example, if you roll over funds from a traditional IRA to a Roth IRA, the funds must be deposited in the Roth IRA within 60 days after you receive the distribution from the traditional IRA. If you do not meet the 60-day deadline, you may be subject to tax consequences and a penalty. There is no limit on the number of rollovers from traditional IRAs to Roth IRAs that you can do in a year. The 60-day deadline can be waived in certain circumstances. Contact your tax advisor and an Arvest Wealth Management client advisor, if you have questions about the deadline.
Benefits
Qualified distributions from Roth IRAs are tax free
A withdrawal from a Roth IRA (including both contributions and investment earnings) is completely tax free (and penalty free) if made at least five years* after you first establish any Roth IRA, and if one of the following applies:
- You have reached age 59½ at the time of the withdrawal
- The withdrawal was made due to qualifying disability
- The withdrawal was made to pay for first-time homebuyer expenses ($10,000 lifetime limit)
- The withdrawal is made by your beneficiary or estate after your passing
If the above conditions aren’t met, your distribution is “nonqualified” and only the investment earnings portion of a Roth IRA withdrawal will be subject to federal income tax (and a potential 10% early distribution penalty, unless an exception applies). The portion of a Roth IRA withdrawal that represents your contributions (including amounts converted to or rolled over from a traditional IRA) is not taxable, since those dollars were already taxed. Withdrawals are treated as coming from your nontaxable contributions first and from investment earnings last.
If you convert or roll over funds from a traditional IRA to a Roth IRA, special penalty provisions may apply if you subsequently withdraw funds from the Roth IRA within five years of the conversion (and prior to age 59½). Discuss this with your tax advisor.
Roth IRAs are not subject to required minimum distributions (RMDs)
Federal law requires you to take annual minimum withdrawals (required minimum distributions, or RMDs) from your traditional IRAs beginning no later than April 1 of the year following the year in which you reach age 73 (75 for those who reach age 73 after December 31, 2032). Roth IRAs are not subject to the lifetime RMD rules, so you are not required to make any withdrawals from your Roth IRAs during your life. This can be a significant advantage in terms of your estate planning and may be a good reason to consider converting funds.
May reduce your taxable estate and your countable assets for federal financial aid purposes
If you use non-IRA funds to pay the conversion tax, the funds you use are removed from your taxable estate, potentially reducing your future estate tax liability. Also, the funds you use to pay the tax are no longer considered when determining your children’s eligibility for federal financial aid. In contrast, if you use IRA funds to pay the conversion tax, there generally is no effect on financial aid eligibility, because the federal aid formula does not count retirement accounts when determining aid eligibility.
Qualified distributions from Roth IRAs are not included when determining the taxable portion of Social Security benefits
Converting or rolling over your funds from a traditional IRA to a Roth IRA could be beneficial when it comes time to begin receiving your Social Security benefits. The taxable portion of your Social Security benefits (if any) depends on your modified adjusted gross income (MAGI) and federal income tax filing status in a given year. Under current law, qualified distributions from Roth IRAs are not included when determining the taxable portion of an individual’s Social Security benefits.
Tradeoffs
You have to pay tax now on the funds you convert or roll over
When you convert or roll over funds from a traditional IRA to a Roth IRA, the funds you transfer are subject to federal income tax (on the funds that represent investment earnings and tax-deductible contributions made to the traditional IRA).
Using IRA funds to pay conversion tax has significant drawbacks
If you use IRA dollars to pay the resulting conversion tax, the benefits of converting or rolling over funds are substantially reduced. Using IRA dollars to pay the tax reduces your IRA funds, potentially jeopardizing your retirement goals. Additionally, the IRA funds used to pay the tax may be subject to federal income tax and a premature distribution tax. If possible, paying the conversion tax with non-IRA funds is generally more advisable.
Taxable income from conversion can increase taxable portion of Social Security benefits
If you’re currently receiving Social Security benefits, or soon will be, consider the possible tax consequences of converting or rolling over funds from a traditional IRA to a Roth IRA. When you convert or roll over funds, they are generally considered taxable income for the year in which you transfer them. Remember that the portion of your Social Security benefits that is taxable (if any) depends on your income and tax filing status for the year, so a Roth IRA conversion may increase the taxable portion of your Social Security benefits for that year.
Risk of future change in the law
One of the main reasons to consider converting or rolling over funds from a traditional IRA to a Roth IRA is that, under current federal law, qualified distributions from Roth IRAs are tax free. However, some experts are skeptical that this will always remain the case, given the uncertain status of Social Security and the projected lost federal revenue attributable to Roth IRAs.Although most states follow the federal tax treatment of Roth IRAs, you should check with a tax professional regarding the tax treatment of Roth IRAs in your particular state.
How to do it
Calculate the taxes resulting from a conversion or rollover
All or a portion of the funds you convert or roll over from your traditional IRA to a Roth IRA will be subject to federal income tax in the year you shift the funds. Consult a tax professional for an accurate calculation of the resulting income tax liability to help you decide if converting funds makes sense for you.
Decide where the dollars will come from to pay the resulting tax
Decide if you will use IRA funds or non-IRA funds to pay the resulting conversion tax, and make sure you understand the tax consequences. For example, if you plan to sell stock to pay the tax, your sale of stock will have tax consequences of its own. If you plan to use IRA funds to pay the tax, this may trigger additional income tax liability (and possibly a penalty). Again, consult a tax professional.
Decide whether to convert or roll over
If you decide to transfer funds from your traditional IRA to a Roth IRA, your next step is to decide whether to convert or roll over your traditional IRA funds to a Roth IRA. The income tax consequences are the same either way, so the question is: Do you want your IRA to stay at the same institution with the same custodian/trustee, or would you prefer to move your IRA dollars to another institution and have a different custodian/trustee?
If converting, contact the custodian/trustee of your traditional IRA. They will provide you the paperwork you need to convert your traditional IRA to a Roth IRA with that same institution.
If rolling over, you need to establish a Roth IRA in your name, if you don’t already have one. Once you have a Roth IRA, you can have the funds in your traditional IRA transferred directly to your Roth IRA. The custodian of your Roth IRA can give you the necessary paperwork. If you prefer, you can instead contact the custodian of your traditional IRA, have the funds in your traditional IRA distributed to you, and then roll those funds over into your Roth IRA within 60 days of the distribution.
There are a variety of tax implications to consider for both a conversion and rollover and other benefits and drawbacks apply. Contact your trusted tax and legal advisors to help identify potential impacts to your financial plan.
*The five-year holding period begins on January 1 of the tax year for which you make your first contribution to any Roth IRA. Each taxpayer has only one five-year holding period for this purpose.
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Arvest and its associates do not provide tax or legal advice.