Roth Individual Retirement Accounts (IRAs) are retirement accounts that allow for tax-free growth of investments until retirement. Unlike other types of IRAs that are taxed on distributions, you must pay taxes on contributions to Roth IRAs in the year you make the contribution (or conversion). Other types of retirement accounts can be converted into a Roth IRA so that distributions are not taxed when taken after retirement.
Types of accounts that can be converted to a Roth IRA
All major types of retirement accounts can be converted to a Roth IRA or transferred to one. For the purposes of this article, “retirement account” refers to an account that shields investments from taxes until distributions are made during retirement. The government refers to these accounts as “qualified retirement plans.”
Traditional IRA
In a traditional IRA, the investor contributes pre-tax amounts to the account, then pays taxes upon distribution of the funds during retirement. In 2023, the annual contribution limit for a traditional IRA is $6,500, or $7,500 for those over age 50.
Converting a traditional IRA to a Roth IRA should be straightforward. Often, you can simply fill out a form with your financial institution to convert the account type if you are converting with the same financial intermediary. Otherwise, you will convert the account by receiving a check for the full amount and then depositing it into a Roth IRA within 60 days. If you are changing financial intermediaries, you can choose to transfer from one custodian to another to move the funds from your current account to a Roth at the new financial intermediary.
401(k)
A 401(k) is a type of defined contribution plan sponsored by an employer. Typically, an employee contributes a percentage of their pre-tax income to the plan, and the employer may match this amount or part of it.
If you have a Roth 401(k), the conversion process is simple when filling out forms with the 401(k) provider and the financial institution that will host your new Roth IRA. The funds can be transferred electronically or by check. This transfer allows you to manage the funds as you wish, rather than being restricted by the 401(k) provider. You will not need to pay any taxes on the amount you converted.
If you have a traditional 401(k), you will go through the same process to convert and transfer it to a Roth IRA. However, you will need to pay taxes on the amount you converted at your current marginal income tax rate.
Note: Similar to 401(k)s, 403(b) and 457(b) retirement plans can typically also be converted to a Roth IRA.
SEP IRA
Simplified Employee Pension (SEP IRAs) allow businesses to contribute directly to an employee’s retirement account. SEP IRAs are often used by small businesses and self-employed professionals and are known for their low administrative costs.
Like a 401(k) conversion, a SEP IRA can be converted once you leave the employer sponsoring the plan. The conversion amount is received in a check and must be deposited into a Roth IRA within 60 days. You will report and pay taxes on the amount at the end of the year.
SIMPLE IRA
The Savings Incentive Match Plan for Employees (SIMPLE IRA) is another retirement plan option for small businesses with fewer than 100 employees. The employer must make matching contributions of 3% of compensation for each eligible employee and 2% of compensation for employees who do not choose to participate.
SIMPLE IRA accounts can be converted like other account balances, with one key difference: you must have invested the money for two years before it can be converted.
Note:
The U.S. IRS imposes a single annual limit on certain types of IRA rollovers, including those from SEP and SIMPLE IRAs. Traditional individual account rollovers to a Roth IRA are exempt, as are direct transfers from custodian to custodian from a 401(k) to a Roth IRA.
Should You Convert Your Retirement Accounts to a Roth IRA?
If you’re considering converting your retirement account to a Roth IRA, ask yourself the following questions to help determine if it’s worth it:
What are the tax implications of the conversion?
The amount rolled over to a Roth IRA must be reported as taxable income in the year the conversion takes place. This means you’ll pay tax on the amount you converted based on your current marginal tax rate.
It’s advisable to set aside some money outside of your retirement account to cover the tax bill. This strategy helps you maximize the benefits of converting to a Roth IRA. Additionally, using funds from your retirement account may incur taxes on the financial returns and a 10% penalty fee if you’re under age 59.5.
What is the opportunity cost of paying the tax?
It can be helpful to think of paying the tax on a Roth IRA conversion as an investment. You’re paying it now so you won’t have to pay it later.
What is the opportunity cost of paying the tax now? You’re likely to pay with cash from outside your retirement account, so you should consider how much you could potentially earn by investing that money elsewhere. What if you pay a large tax bill now, and then the market rises above average over the next few years?
You should also consider tax brackets. What tax bracket are you in now, and where do you expect to be during retirement? If you’re currently earning a high salary and expect to have lower income in retirement, converting now may mean paying a much higher tax rate on the funds compared to what you’d pay if you waited.
Frequently Asked Questions (FAQs)
What is a Backdoor Roth Conversion?
A Backdoor Roth Conversion is when you contribute to a traditional retirement account with the intention of eventually converting it to a Roth IRA. Using this method, you can create a Roth IRA through a “back door” even if your income is too high to establish a Roth IRA directly.
When is tax paid on a Roth IRA conversion?
Tax on the amount converted to a Roth IRA must be reported as income on your tax return for the year in which the conversion occurs. Some people spread out the conversion of accounts to a Roth IRA over several years to distribute the tax burden.
Sources
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Source: IRS. “Rollover Chart.” IRS. “Traditional and Roth IRAs.” IRS. “IRA FAQs,” see “How long do I have to complete a rollover from a retirement plan to an IRA?” IRS. “SIMPLE IRA Plan.” IRS. “Retirement Plan Distributions and IRA Rollovers,” see “One rollover limit per year for IRAs.” IRS. “What if I withdraw money from my IRA?” Charles Schwab. “Why you should consider a Roth IRA conversion and how to do it,” see “How can you convert to a Roth IRA?”
Source:
https://www.thebalancemoney.com/which-account-types-can-you-convert-to-a-roth-ira-5222577
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