Is a Roth Conversion for you?
Imagine having a retirement account where the proceeds are entirely tax-free! You can “convert” funds from a pre-tax account (Traditional, SEP, SIMPLE Solo(k)) into a Roth.
How do I convert my traditional IRA to a Roth IRA?
You can complete a Roth Conversion from your traditional IRA to a Roth IRA by:
Same trustee transfer – If your traditional and Roth IRAs are maintained at the same financial institution, you can tell the trustee to transfer an amount from your traditional IRA to your Roth IRA.
With a pre-tax retirement account, the Contributions have not been taxed and the profits grow tax deferred. You pay personal income taxes when you take Distributions from those accounts.
A Roth IRA, on the other hand, is a retirement account holding after-tax funds. The taxes have already been paid on the Contributions, and the profits from those funds grow tax-exempt.
The IRS allows you to change the funds from pre-tax account to after-tax. This is referred to as a “Roth Conversion”. You do pay taxes on the amount you convert. You change the tax status to after-tax funds as the result of the conversion. It is a great idea to reach out to your tax advisor and see how a conversion works with your overall tax strategy.
Some people make too much money to be eligible to make a Roth Contribution directly. You can find information on Roth Contribution income limits by linking HERE. While there are income limits to contributing, there are no income limits when doing a Roth Conversion. In fact, many people take advantage of this by making pre-tax Contributions and then converting them to an after-tax account. That is referred to as the “Back-Door Roth”.
Simple and SEP IRA’s allow for higher Contributions than a Traditional or Roth IRA and you can take advantage of those accounts if you are self-employed. You will find information on the different types of IRA’s by linking HERE. You might want the advantage of the higher Contribution limit in a SEP account, for example, and then convert those funds to Roth.
Since the amount of taxes you pay is based on your tax bracket, if there is a year where your income is lower than others, you might consider to a Conversion during that tax year. We have also seen the value of assets in retirement account decrease for some people. Converting the funds before the rebound in the market occurs means you are paying taxes on a smaller amount now. Please understand that if you are converting an asset that is not a publicly traded stock or bond, you probably will need to get a current market appraisal of that asset.
When you cash-out your retirement account later in life, the distributions can be taxable or tax-free. The Roth IRA gives you the tax-free advantage. Again, please consult with your tax advisor to see if the Roth Conversion would be beneficial for you.
A conversion to a Roth IRA results in taxation of any untaxed amounts in the traditional IRA. The conversion is reported on Form 8606, Nondeductible IRAs. See Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), for more information..