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, or you can roll over funds from your traditional IRA to a Roth IRA.
In the case of a conversion, you 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. In the case of a rollover, 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 that you need to consider.
Caution: 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 it be used?
You have a traditional IRA
It probably goes without saying, but you can't convert or roll over funds from a traditional IRA to a Roth IRA unless you already have a traditional IRA.
Tip: In addition to traditional IRAs, 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
As mentioned, one of the two ways to transfer funds from a traditional IRA to a Roth IRA is to withdraw the funds from your traditional IRA, and then roll those funds over into a Roth IRA in your name. If you choose this 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.
Tip: The 60-day deadline can be waived in certain circumstances. You may be eligible for an automatic waiver if you sent your rollover assets to a financial institution within the 60-day period, but the financial institution makes an error and fails to complete your rollover before the deadline. However, to be eligible to use this automatic waiver, your rollover must be completed within one year from the beginning of the 60-day period. The IRS also has the discretion to grant a waiver of the 60-day deadline "where failure to do so would be against equity or good conscience," such as a casualty, disaster, or other event beyond your reasonable control. However, you'll need to request a private letter ruling from the IRS, an expensive proposition — the filing fee alone is currently $10,000. There is also a third way to seek a waiver of the 60-day requirement: self-certification. Under the new procedure, if you've missed the 60-day rollover deadline, you can simply send a letter to the IRA trustee/custodian certifying that you missed the 60-day deadline due to one of 11 specified reasons. To qualify, you must generally make your rollover contribution to the employer plan or IRA within 30 days after you're no longer prevented from doing so. Also, there is no IRS fee. The downside of self-certification is that if you're subsequently audited, the IRS can still review whether your contribution met the requirements for a waiver. For this reason, some taxpayers may still prefer the certainty of a private letter ruling from the IRS.
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 death
Tip: 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.
If these conditions aren't met, your distribution is "nonqualified" and only the portion of a Roth IRA withdrawal that represents investment earnings 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 never taxable, since those dollars were already taxed. Roth IRA withdrawals are treated as coming from your nontaxable contributions first and from investment earnings last.
Caution: 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). See "Tax considerations," below.
Roth IRAs are not subject to the lifetime required minimum distribution (RMD) rules
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 72 (if you reach age 72 before July 1, 2021, you will need to take an RMD by December 31, 2021). These withdrawals are calculated to dispose of all of the money in the traditional IRA over a given period of time. Because Roth IRAs are not subject to the lifetime RMD rules, 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.
Converting or rolling over 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 that results from converting or rolling over funds from a traditional IRA to a Roth IRA, the funds that you use to pay the tax are removed from your taxable estate, potentially reducing your future estate tax liability. Also, the funds that you use to pay the tax are no longer part of your countable assets for purposes of 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 portion of your Social Security benefits that is taxable (if any) depends on your 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.
A conversion can be used to overcome the income limit on annual Roth IRA contributions
Annual Roth contributions may be limited, or eliminated, depending on your income and filing status. If your ability to make annual Roth contributions is restricted because of these limits, and you want to make annual Roth contributions, a conversion may be the answer. You can simply make your annual contribution first to a traditional IRA, and then convert that traditional IRA to a Roth IRA. (You can make nondeductible contributions to a traditional IRA if you have taxable compensation.) There are no limits to the number of Roth conversions you can make. (Note: you'll need to aggregate all traditional IRAs and SEP/SIMPLE IRAs you own — other than IRAs you've inherited — when you calculate the taxable portion of your conversion.) This is often called a "back door" Roth IRA.
You have to pay tax now on the funds that you convert or roll over
When you convert or roll over funds from a traditional IRA to a Roth IRA, the funds that you transfer are subject to federal income tax (to the extent that those funds represent investment earnings and tax-deductible contributions made to the traditional IRA). Even if it makes overall financial sense to convert funds from a traditional IRA to a Roth IRA, paying tax on your IRA funds now may not be desirable.
Using IRA funds to pay conversion tax has significant drawbacks
If using other IRA dollars is the only way that you can pay the conversion tax that results from converting or rolling over funds from a traditional IRA to a Roth IRA, the benefits of converting or rolling over funds are substantially reduced. Using IRA dollars to pay the tax reduces the amount of funds in your IRAs, potentially jeopardizing your retirement goals. In addition, the IRA funds used to pay the tax may themselves 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.
Special penalty provisions may apply to withdrawals from Roth IRAs that contain funds converted from traditional IRAs
If you're under age 59½ and take a nonqualified distribution from a Roth IRA, the 10% premature distribution tax generally applies only to that portion of the distribution that represents investment earnings. However, if you convert or roll over funds from a traditional IRA to a Roth IRA and then take a premature distribution from that Roth IRA within five years, the 10% premature distribution tax will apply to the entire amount of the distribution (to the extent that the distribution consists of funds that were taxed at the time of conversion).
Tip: The five-year holding period begins on January 1 of the tax year in which you converted or rolled over the funds from the traditional IRA to the Roth IRA. When applying this special rule, a separate five-year holding period applies each time you convert or roll over funds from a traditional IRA to a Roth IRA.
Taxable income resulting from conversion can increase taxable portion of Social Security benefits being received
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, those funds are generally considered taxable income to you 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. This means that converting funds to a Roth IRA 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 qualified distributions from Roth IRAs are completely tax free. Under current law, this is the federal tax treatment given to Roth IRAs. Some experts, however, 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.
States may differ in their treatment of 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.
Federal law provides protection for up to $1,362,800 of your aggregate Roth and traditional IRA assets if you declare bankruptcy (Note: This amount is scheduled for adjustment in April 2022). (SEP IRAs, SIMPLE IRAs, and amounts rolled over to the IRA from an employer qualified plan or 403(b) plan, plus any earnings on the rollover, aren't subject to this dollar cap and are fully protected if you declare bankruptcy.) The laws of your particular state may provide additional bankruptcy protection, and may provide protection from the claims of your creditors in cases outside of bankruptcy. (Inherited IRAs may be afforded less protection from creditors under federal and state law — seek professional guidance.)
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
William DiCristofaro is a registered representative of and offers securities through MML Investors Services, LLC. Member SIPC. Integrity Benefit Partners is not a subsidiary or affiliate of MML Investors Services, LLC, or its affiliated companies. 200 Clarendon Street, 19th & 25th Floors. Boston, MA 02116. 617-585-4500. CRN202406-291916