Converting an IRA to a Roth IRA
When you withdraw funds from an IRA, distributions are taxable as ordinary income. But would you prefer to pay taxes now so you don’t have to pay taxes on distributions in your retirement years? If so, consider converting part or all of your IRA to a Roth IRA. The following are a few reasons why people convert – or choose not to convert – their IRAs.
Reasons to Convert to a Roth IRA
- You don’t plan to withdraw your funds for a number of years.
- You have money available to pay taxes on the conversion.
- You think that your ordinary income tax rate may be higher in retirement than it is today.
- You prefer not to take Required Minimum Distributions (RMDs) each year after turning a certain age.
- You would like to take tax-free withdrawals in retirement.
- In the event of your death, you would like to provide a tax-free inheritance to your loved ones.
Reasons Not to Convert to a Roth IRA
- You plan to withdraw your funds within a few years or so.
- You can’t afford to pay taxes on the conversion now.
- You think that your ordinary income tax rate may be lower in retirement than it is today.
- You won’t mind taking Required Minimum Distributions (RMDs) each year after turning a certain age.
- You suspect the government may change how Roth IRAs are taxed in the future.
Important Change About Recharacterizations
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the ability to reverse (“recharacterize”) a conversion. Therefore, if you convert an IRA to a Roth IRA, you will be required to pay any taxes owed as a result of the conversion.
Roth IRA Restrictions
- You cannot convert a Required Minimum Distribution (RMD) to a Roth IRA.
- You cannot convert a SIMPLE IRA to a Roth IRA if the SIMPLE IRA has been open for less than 2 years.
- You cannot convert an inherited IRA to a Roth IRA.
Roth IRA Conversion Tax Consequences
- The amount of the Roth IRA conversion is taxable and is treated as ordinary income.
- The 10% early distribution penalty tax does not apply.
- If you made non-deductible IRA contributions and have more than one IRA, you must aggregate all of your IRAs (e.g. Traditional, Rollover, SEP and SIMPLE) to calculate the taxable portion of your distribution. In other words, the IRS views you as having one big IRA, regardless of how many IRAs you own.
Many years ago, Jenny made a $2,000 non-deductible contribution to an IRA. Her other contributions were deductible. Today, she has three IRAs that total $10,000.
Jenny converts $1,000 to a Roth IRA. Since her non-deductible contribution makes up 20% of her total IRA balance ($2,000 divided by $10,000), 20% of her $1,000 conversion (i.e. $200) is not taxable regardless of which IRA is converted.
NOTE: This is a simplified example. Be sure to complete and attach IRS Form 8606 with your taxes.