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CONVERTING OR ROLLING OVER TRADITIONAL IRAS TO ROTH IRAS Part II

CONVERTING OR ROLLING OVER TRADITIONAL IRAS TO ROTH IRAS Part II

July 26, 2021
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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.

Click here for more information on the strengths and tradeoffs of each approach.

How to do it

Calculate the tax that will result from converting or rolling over funds from your traditional IRAs to Roth IRAs

All or a portion of the funds that you convert or roll over from your traditional IRA to a Roth IRA will be subject to federal income tax in the year that you shift the funds. Consult a tax professional for an accurate calculation of the income tax liability that will result. This will 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 conversion tax that will result from converting or rolling over funds, and make sure that you understand the tax consequences of either choice. For example, if you plan to sell stock to pay the tax, realize that your sale of stock will have tax consequences of its own. If you plan to use IRA funds to pay the tax, be aware that 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 have decided to transfer funds from your traditional IRA to a Roth IRA, your next step is to decide whether to convert your traditional IRA to a Roth IRA, or to 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 of your traditional IRA

The custodian/trustee of your traditional IRA will provide you the paperwork you need to convert your traditional IRA to a Roth IRA with that same institution.

If rolling over, establish a Roth IRA and roll over your traditional IRA

First, 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 paperwork that you need to do this. 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.

Tax considerations

You include funds that are converted or rolled over from a traditional IRA to a Roth IRA in income

When you convert or roll over funds from a traditional IRA to a Roth IRA, those funds are subject to federal income tax in the year that you transfer them (to the extent that the funds consist of deductible contributions and investment earnings). If you have made only deductible contributions to your traditional IRAs, then the entire amount of any funds that you convert or roll over to a Roth IRA will be taxable.

If, however, you have ever made nondeductible (after-tax) contributions to your traditional IRAs, then those contribution amounts will not be taxable when converted or rolled over to a Roth IRA (since they have already been taxed). In effect, the income tax consequences of converting funds are the same as those that apply when you make a withdrawal from a traditional IRA. Each distribution you convert or roll over to a Roth IRA will contain a pro-rata amount of pre-tax and after-tax dollars.

Caution: You 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.

The IRS has provided the following formulas to determine the pre-tax and after-tax portions of each conversion:

After-tax amount = (after-tax amounts in all IRAs/Value of all IRAs) x amount distributed

Pre-tax amount = amount distributed - after-tax amount

Caution: You must make these calculations as of year-end (December 31 of the year of the distribution) and not on the date of the distribution.

Application of the 10% premature distribution tax

The 10% premature distribution tax does not apply at the time that you convert or roll over funds from a traditional IRA to a Roth IRA, even if you convert the funds before reaching age 59½. However, if you convert or roll over funds from a traditional IRA to a Roth IRA and withdraw any portion of those funds from the Roth IRA within five years (and prior to age 59½), the withdrawal will be subject to the 10% premature distribution tax (to the extent those funds were taxed at the time of the conversion).

Tip: Remember that withdrawals from Roth IRAs are treated as coming from contributions first and investment earnings second. Contributions are considered to consist first of regular contributions (i.e., contributions other than rollover contributions), and then of amounts converted or rolled over from a traditional IRA (on a first in, first out basis).

Tip: All of your Roth IRAs (other than Roth IRAs you've inherited) are aggregated for this purpose.

Example(s): John is age 40. John contributed $3,000 to his Roth IRA in 2018. In 2019, John converted $10,000 from his traditional IRA to his Roth IRA, and included this $10,000 in his 2019 gross income. He made no further contributions to his Roth IRA. In 2021, his Roth IRA has grown to $14,000, of which John withdraws $4,000. None of the exceptions to the 10% premature distribution tax apply to John. John's $4,000 withdrawal is considered to consist first of his $3,000 regular contribution made in 2018. John owes no premature distribution tax on this $3,000. The remaining $1,000 of John's $4,000 withdrawal is considered to consist of funds he converted from his traditional IRA, and is subject to the 10% premature distribution tax.

You can't convert or roll over RMDs into a Roth IRA

After age 72, you are required to begin taking annual minimum withdrawals from your traditional IRAs (RMDs). You cannot roll over or convert these RMD amounts to a Roth IRA.

Questions & Answers

Should you convert or roll over funds from your traditional IRA to a Roth IRA?

Before you even begin to think about converting or rolling over funds from a traditional IRA to a Roth IRA, be sure that you understand what the Roth IRA is and how it works. If the Roth IRA seems like an appropriate retirement savings vehicle, be sure to consider the income tax consequences of converting funds, and how you will pay the resulting tax. Think about the following scenarios and factors before you act.

Scenario 1: You'll pay the resulting "conversion" tax with non-IRA funds, you have 10 years or more before you will be taking distributions from the Roth IRA, and you will be in the same or a higher tax bracket when you start taking those distributions. Converting funds probably makes overall sense.

Scenario 2: You'll pay the conversion tax with IRA funds, you need to take substantial distributions from the Roth IRA within a few years (5 years or less), and you will be under age 59½, or in a lower tax bracket when you begin taking distributions. You probably shouldn't convert funds to a Roth IRA.

Can you convert or roll over only a portion of the funds in your traditional IRAs to Roth IRAs?

Yes, you can convert or roll over whatever amount you want from your traditional IRAs to a Roth IRA. All or a portion of the funds that you convert or roll over to the Roth IRA will be subject to federal income tax. If you have ever made nondeductible (after-tax) contributions to your traditional IRAs, you have to calculate what portion of the funds that you convert represents nondeductible contributions. Because those amounts were already taxed, they will not be taxed again when converted to a Roth IRA.

How do you calculate the portion of your conversion that represents nondeductible contributions?

If you have made only deductible contributions to your traditional IRAs, the full amount that you convert or roll over from your traditional IRAs to a Roth IRA will be subject to federal income tax, since no portion of the funds represents nondeductible contributions. If you have ever made nondeductible contributions to your traditional IRAs, you calculate and report the taxable and nontaxable portions of the funds that you convert or roll over using IRS Form 8606. Basically, you calculate the ratio of all of your nondeductible contributions to the total balance of all of your traditional IRAs, including simplified employee pension plan (SEP) IRAs and savings incentive match plan for employees (SIMPLE) IRAs. That ratio is then applied to any withdrawal that you make from any of your traditional IRAs, including a conversion or rollover to a Roth IRA. So, if 50% of the total balance of all of your traditional IRAs represents nondeductible contributions, half of the funds that you convert to a Roth IRA would be taxable, and half would not.

Can you convert or roll over funds from your traditional IRAs to a Roth IRA if you're already receiving RMDs from your traditional IRAs?

The fact that you're receiving RMDs from your traditional IRAs doesn't by itself disqualify you from converting funds to a Roth IRA. You cannot, however, convert or roll over an RMD itself into a Roth IRA.

When you withdraw funds from a Roth IRA, in what order are the funds considered withdrawn?

Withdrawals from Roth IRAs are considered made in the following order:

  • Regular Roth IRA contributions (i.e., contributions other than rollover or conversion contributions).
  • Rollover or conversion contributions, in the order made (i.e., first in, first out). If any rollover or conversion included nondeductible contributions, the withdrawal is considered made first from funds that were subject to federal income tax at the time of the rollover or conversion.
  • Any investment earnings.

All Roth IRAs you maintain (other than Roth IRAs you've inherited) are aggregated (i.e., treated as a single Roth IRA) for purposes of classifying withdrawals.

IMPORTANT DISCLOSURES

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