You still have the option to convert some or all of your standard IRA retirement savings to a Roth IRA. Depending on a number of variables, you may or may not want to consider a Roth.
IRA Roth Basics
There are no tax breaks for savings contributions made to a Roth IRA, unlike standard IRAs. In contrast, Roth earnings are normally tax-free at the time of withdrawal in exchange for a lack of upfront tax deductions.
By making an investment in a Roth IRA, you essentially consent to paying taxes now in exchange for future withdrawals of the money being tax-free. To reach this totally tax-free status, an investor using a Roth IRA must postpone taking any distributions until they are at least 59 1/2 years old. The assets must also stay invested for a minimum of five years, unless a unique situation allows for a shorter period of time.
Absent unusual circumstances, early withdrawals from a Roth IRA result in taxes on the earnings as well as a 10% penalty.
The early withdrawal penalty tax can be avoided if the money is used to pay for a first-time home purchase or to cover health insurance payments while unemployed.
Conventional IRAs
Contributions to traditional IRAs may be tax deductible or not. You can claim a tax deduction for your savings contributions made to a regular IRA in the year you choose to make them. When the money is eventually taken, taxes are due on both your initial investment and the returns on those contributions.
There can be restrictions on how much of your contributions you can deduct if your workplace sponsors a retirement plan (or your spouse’s employer if you’re married and filing jointly).
For savings contributions made to a nondeductible conventional IRA, you can either claim a full deduction or none at all. The portion of the earnings that represents your nondeductible basis is returned to you tax-free, and the earnings are tax-deferred until they are withdrawn.
Transitioning to a Roth
When you “convert to a Roth,” you effectively change the tax treatment of the fund where your retirement funds are held.
Roth IRAs are post-tax contributions, as opposed to a standard IRA’s tax deferral option. To reverse this deferral, convert to a Roth. Both the cumulative profits and any savings contributions that you previously deducted from your taxes must be taxed. The money is now in post-tax form as a result.
How to Change Money
Simply inform your bank or other financial institution that you want to convert your investments from a deductible or nondeductible IRA to a Roth IRA. You can continue to keep your money at the same bank. Even better, you can continue to invest in the same ones. Simply altering the type of account that holds them is all you’re doing.
Calculating the tax expense of converting to a Roth is the difficult part.
Two things happen when you switch from a standard IRA to a Roth IRA. The money you convert becomes your basis in a Roth, and the government taxes its current value.
How to Determine “Income” for a Roth Conversion
As a first step, you should determine your Roth conversion revenue. If you are converting deductible IRA funds, you must report the funds’ present value on the conversion day as income. Due to the fact that you were given a tax deduction for your savings contributions, your basis in a deductible IRA is zero.
Report as income the current value of the funds on the day of conversion, less your basis, if you are converting nondeductible IRA funds. Your basis in those funds would be $5,000 if you made a $5,000 contribution to a traditional IRA in 2016 but did not receive a deduction for that contribution (i.e., $5,000 of income less $5,000 for the deduction).
Let’s imagine that in 2018, two years from now, you decide to convert that IRA into a Roth. It is currently worth $5,500. If you deduct $5,000 from the current value of $5,500, you would have $500 in income to report on your tax return.
When You Have Traditional IRAs That Are Both Deductible and Nondeductible,
Even if your traditional IRA funds are stored in separate accounts at several financial institutions, tax law requires that your basis in the nondeductible funds be distributed over all of your traditional IRA funds if you possess both deductible and nondeductible IRAs. Since there would appear to be a smaller tax impact, it makes sense that you would want to convert nondeductible IRA assets first, but that is not how the tax calculation works.
Let’s imagine you made a $5,000 contribution to a deductible IRA in 2016, which implies your basis in those assets is now nil. Your basis is now $5,000 because you made a $5,000 nondeductible IRA contribution in 2018. You have contributed $10,000 to a traditional IRA with a basis of $5,000.
If all of your conventional IRAs were converted to Roth IRAs and the value of your IRA account was $11,000, you would report $11,000 as income and $5,000 as your basis, for a total of $6,000 in income.
Even if a person with mixed traditional IRAs decides to convert solely to the nondeductible IRA, their basis will still be divided proportionally among all of their accounts. The calculations remain the same even if the current value of each IRA fund is $5,500 and the individual only converts $5,500 from the nondeductible account: $5,500 (current value) minus $2,500 (basis prorated). This would result in $3,000 in revenue being reported.
Some Unique Techniques
By rolling over money from your traditional IRAs to a qualifying plan like a 401(k) or 403(b), you can “isolate” your nondeductible IRA funds. If you do this, you can also choose to roll over only your deductible traditional IRAs. You can transfer all of them to a 401(k) or comparable plan by conducting such a rollover, leaving just nondeductible funds in your IRA. Your nondeductible funds can then be rolled over to a Roth IRA.
Your nondeductible IRA basis is preserved in this way. Less income is recognized on the Roth conversion as a result.
No matter how many IRAs you own, you are only permitted to make one rollover from the same IRA account and one rollover from one IRA to another or the same IRA per year.
Transfers from a qualified retirement plan, such as a 401(k) or 403(b) account, made directly from trustee to trustee to an IRA do not count. Otherwise, any further rollovers made after the first during a 12-month period are treated as distributions that are fully taxable and may be subject to an early distribution penalty.
If you want to isolate nondeductible money in your IRA using this strategy, you can do so in the same year by using the two-step process outlined below:
Transfer your deductible IRAs directly from trustee to trustee into a qualifying plan. These transfers do not count toward the annual cap of one rollover.
Then, in order to avoid the mandatory 20% withholding, convert your nondeductible IRAs to Roth IRAs via another trustee-to-trustee direct transfer.
Taxable Earnings Do Not Always Equal Expenses.
It’s not always the case that income declared on a conversion to a Roth IRA will be subject to taxation. Through various tax deductions or tax credits, the tax implications of reported income can be minimized.
Let’s assume that in 2016, someone converts a $5,500 fully deductible traditional IRA to a Roth IRA. These funds would be reported as an additional $5,500 in income on his 2016 tax return because they were totally deductible. They are still qualified to claim a variety of tax deductions and credits, just like any other taxpayer.
Therefore, they could use any applicable deductions to offset the additional $5,500 in income. For instance, they may use a $5,500 charitable deduction or a $5,500 business loss to offset the income from the Roth conversion. As a result of the $5,500 in deductions canceling out the $5,500 in conversion income, their taxable income in this situation would remain the same.
Calculating the Impact of Taxes
However, because income reported on a Roth conversion raises income before credits or deductions, it is possible for it to raise taxable income and result in different phaseouts.
It is relatively simple to calculate an increase in taxable income. Review the marginal tax rates for the year you plan to convert. You will pay about your marginal tax rate plus the conversion value for an increase in taxable income.
The analysis of different phaseouts is a little more difficult. More Social Security benefits may be taxed as a result of higher income, and/or different tax deductions and credits may be phased out or eliminated as a result.
Run a projection in your tax software to examine the tax rise brought on by a Roth conversion in order to determine the impact of a conversion to a Roth in these distinct situations.
Conversion Timing
It usually makes sense to convert to a Roth IRA under the following circumstances:
- You have money that isn’t in a retirement account that you could use to pay the conversion tax in full.
- Your traditional IRAs’ value has decreased, making conversion now more reasonable.
- You anticipate that in retirement, your tax bracket will either be similar to or greater than it is now.
- To lessen the tax implications of a Roth conversion, you can employ losses, deductions, or tax credits.
When to Avoid Conversion
In the following circumstances, converting to a Roth IRA would not be prudent:
You don’t have enough cash on hand to cover the whole cost of the Roth conversion tax.
After comparison to your current tax bracket, you anticipate having a lower one in retirement.
You could need to access your IRA money within the next five years, and you won’t be 59 and a half yet.
If you reasonably anticipate being in a lower tax band in retirement, it makes no sense to pay taxes now at a higher tax rate. Additionally, it makes little sense to pay taxes now if you might need to use that cash in the next five years. In this scenario, you will essentially pay tax twice: once on the conversion and again on the withdrawal, plus any penalties that may be applicable.
The Roth Conversion Report
If you go from a regular IRA to a Roth IRA, you’ll need to declare the conversion twice on your tax return and receive two pieces of tax paperwork.
Your financial institution will send you a Form 1099-R detailing the Roth conversion. A rollover to a Roth IRA will be the designation. The data from that form will be used to report your Roth conversion income on Form 8606, with the conversion income’s taxable component reported on your Form 1040. Typically, Forms 1099-R are distributed by the end of January of the succeeding year
The financial institution that received the Roth IRA funds should also have sent you Form 5498. The value of the cash received and the account’s worth at the end of the year are both reported on this form. Generally speaking, this form is mainly for informational purposes. Your tax return does not need to include the information in any way. By May 31, Form 5468 is often mailed out.
Advancing With Caution
Before you take any action, think about speaking with a tax expert because the Tax Cuts and Jobs Act, which was enacted into law in December 2017, makes it impossible for you to undo any conversions you make.
When converting to a Roth account, you no longer qualify for this treatment. Previously, trustee-to-trustee transactions could be effectively “undone” if you recategorized the conversion before your tax deadline, including any extensions. 529: Rollovers from regular, SEP, and SIMPLE IRAs as well as 401(k) and 403(b) accounts are also covered by the new rule.
Questions and Answers (FAQs)
How much is allowed for a Roth IRA contribution?
For 2021 and 2022, you may contribute a total of $6,000 per year to all of your regular and Roth IRAs. Nevertheless, based on your salary, you might not be able to give the full amount or anything at all. If your modified adjusted gross income is less than $198,000 ($204,000 in 2022) and you’re married filing jointly or a qualified widow (er), you can, for instance, pay the full amount. If your income is between $198,000 and $207,999 ($204,000 and $213,999 in 2022), you can donate less; if it’s $208,000 or more ($214,000 in 2022), you can’t contribute at all.
Who is eligible to contribute to a traditional IRA with full deductions?
You can deduct your conventional IRA payments entirely if you and your spouse (if applicable) don’t participate in an employer-sponsored retirement plan. You may be able to deduct your entire contribution, a portion of it, or nothing at all if you or your spouse participate in a workplace retirement plan. For example, if your modified adjusted gross income for 2021 is $66,000 or less ($68,000 or less for 2022), and you file as single or head of household, you are eligible for the full deduction. If it is more than $68,000 and less than $78,000 for 2021 (more than $68,000 and less than $78,000 for 2022), you can deduct a portion of it. You cannot deduct your contribution if it is $76,000 or higher for 2021 (or $78,000 or higher for 2022).
