How to Convert Your Traditional IRA to a Roth IRA

If you don’t have a Roth IRA now, but like the benefits of one, you can convert your traditional IRA (and sometimes 401K) to a Roth account. There are certain steps you must follow to avoid unnecessary taxes and/or penalties.

Here’s how to change over your account to enjoy the benefits of a Roth retirement account.

Why Consider a Roth IRA?

A Roth IRA isn’t for everyone, but it certainly has its benefits. First, you should know that Roth IRAs have income limits – if you make more than $208,000 as married filing jointly or $140,000 as a single-filer, you aren’t eligible for a Roth account, but anyone can convert to one no matter their income.

So, why would you want to change to a Roth account? Here are the benefits:

  • Enjoy a tax-free retirement on contributions and earnings.
  • Your heirs will enjoy tax benefits if you pass your account down.
  • There aren’t any required minimum distributions during retirement.
  • You can withdraw contributions (not earnings) any time even before retirement age.

How to Convert to a Roth IRA

If you already have a traditional retirement account, here’s how to switch over to a Roth account for more benefits.

  1. Open a traditional IRA account

Before you can convert to a Roth account, you need a traditional retirement account. Open and fund your account. You can open one with a robo-advisor, discount broker, or full-service broker. Robo-advisors are for hands-off investors and full-service or discount brokers are for investors who want more of a say in where they invest their funds.

  1. Withdraw funds from your retirement account

This step is tricky, and you have a few options.

Direct Rollover

The direct rollover is the least risky. You tell your current IRA administrator to withdraw your funds and deposit them directly into your new Roth account. You never receive the money in hand, so you don’t have to worry about penalties for early withdrawal.

Indirect Rollover

With an indirect rollover, you are the middleman. You receive the funds from your traditional retirement account and have 60 days to deposit them in your Roth account. If you miss the deadline, you’ll pay a 10% early withdrawal penalty.

  1. Pay the taxes on the contributions and earnings

A traditional retirement account gives you tax advantages in the year you contribute. All funds are pre-tax. A Roth IRA, however, is post-tax. When you convert from a traditional to a Roth account, you must pay the taxes on the money you convert.

You must claim the income on your tax returns and pay the applicable tax rate. It’s best to find out what you’d owe at the time to make sure it makes sense to convert the accounts.

Can you Convert an Employer-Sponsored 401k or 403b?

If you have an employer-sponsored 401k or 403b, you can usually convert to a Roth IRA once you leave the employer. Most businesses don’t allow ‘in-service’ rollovers, but there are exceptions to the rule.

When you leave your job, you can ask to roll the funds over to a Roth account, but we said previously, you must do a direct rollover or make sure you deposit the funds within 60 days of withdrawing them.

However, if you are planning on rolling over funds from a 401k or 403b into an IRA, I highly recommend you check out my friends over at Capitalize. Capitalize provides a completely free service where they will handle all paperwork and phone calls necessary to rollover your old 401k into an IRA. They handle the paperwork, phone calls, moving your money, and all that hassle completely for free.

Should you Consider a Roth Conversion?

Like any personal finance decision, there are certain factors to consider before you convert to a Roth IRA.

1. Do you have the money to cover the taxes?

Work with a tax advisor to find out how much you’d owe in taxes converting your retirement accounts. You can’t use funds from the retirement account to cover them unless you’re over the retirement age of 59 ½. This can leave you with a large liability, so know the amount first.

2. Will the conversion put you in a higher tax bracket?

You will add the amount from your retirement accounts to your current taxable income. If it bumps you up to the next tax bracket, you could owe more than you anticipated because the amount that you are converting will get taxed at a tax higher rate than you normally pay. Do the math or talk to your tax advisor to see how it would affect you.

If the entire amount bumps you into a much higher tax bracket, you can consider converting only a part of the account. You don’t have to convert your full account to get the tax benefits of a Roth IRA.

3. Are you in a Lower Tax Bracket This Year?

If you find yourself in a lower tax bracket because of life circumstances in a particular year, it’s a great time to convert. You’ll pay fewer taxes on the conversion, leaving you with more money to invest in your retirement.

4. Do you think you’ll be in a higher tax bracket during retirement? 

If you anticipate being in a higher tax bracket when you retire, paying the taxes now when you’re in a lower tax bracket makes sense. You’ll save money on taxes and your contributions and earnings will continue to grow tax-free until you withdraw them in retirement.

Final Thoughts

Converting a traditional IRA to a Roth IRA is a great way to set yourself up for retirement. If you think you’ll be in a higher tax bracket during retirement, you don’t want to worry about required minimum distributions, or you want every dollar in retirement and don’t want to worry about taxes, converting at least a portion of your accounts may be a good idea.

Before you convert, make sure you understand the tax liabilities you’ll incur this year and determine if you can afford it. Work with your tax advisor to determine if you should roll over the entire account to a Roth IRA or just a portion to limit the tax liability and the potential of bumping you up into the next tax bracket.

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