Roth IRA conversions and Roth IRA transfers are two methods of moving money from one type of retirement account to another, but they are not exactly the same thing.
What is the difference between a Roth IRA conversion and a Roth IRA transfer?
In many ways, a Roth IRA conversion and a Roth IRA transfer are similar. Technically, a conversion is a type of transfer. However, practically, there are some distinctive differences. In the table below, you will find more information about some of the key similarities and differences.
Eligibility
To initiate a Roth IRA conversion, you first need to have an account that contains post-tax retirement funds, such as a Roth 401(k). From there, you can roll over assets from a Roth 401(k) to a Roth IRA without being subject to the income restrictions that would apply if you were to contribute directly to a Roth IRA.
A Roth IRA conversion is considered a “backdoor” method of funding a Roth IRA, as it is not subject to any income restrictions that apply to direct contributions.
Taxes
The most significant difference between a Roth IRA conversion and a Roth IRA transfer is the tax implications.
With a Roth IRA conversion, you are moving money from one type of Roth account to another. This does not trigger any immediate tax implications, as you have already used post-tax money to fund the employer-sponsored Roth account, and you are simply rolling that money into a Roth IRA that also involves post-tax contributions.
Roth money can grow tax-free and can be withdrawn tax-free, provided you meet conditions such as having the account for at least five years and being 59 and a half years old or older.
In contrast, Roth IRA conversions are taxable events. This occurs because the conversion often involves moving money from a tax-exempt account to an account that takes in taxable income.
Distributions from a tax-exempt account, such as a 401(k) or traditional IRA, are taxable. However, Roth IRAs allow for tax-free withdrawals in retirement.
A Roth IRA conversion requires individuals to pay ordinary income taxes for the tax year in which the conversion occurs, based on the amount of money being converted. This can lead to larger tax bills, but in the long run, depending on your investment horizon, a Roth IRA can lead to tax savings.
Required Minimum Distributions
Both Roth IRA conversions and Roth IRA transfers can help individuals avoid required minimum distributions (RMDs), but there are some important aspects.
Employer-sponsored accounts like 401(k)s, including Roth 401(k)s, typically require account holders to start taking distributions once they reach a certain age (usually 72). However, some plans allow employees to avoid RMDs if they are still working past that age.
Regardless, moving money into a Roth IRA means account holders can enjoy the absence of RMDs.
To completely avoid required minimum distributions, you will need to make the conversion before you reach the age at which you are required to start taking those distributions. If you have already reached RMD age, you will need to take your RMD for the year before rolling over the remaining funds.
The same concept applies to Roth IRA conversions. This may mean you need to do the conversion earlier if you wish to avoid required minimum distributions altogether. Once you start taking RMDs, the amount of RMD for the year you perform the conversion cannot be included when moving the money.
Rule
The Five Years
Both Roth IRA conversions and Roth IRA rollovers share the fact that they must be open for at least five years to make the distributed or converted amounts tax-free, starting from January 1 of the year the first contribution was made.
Each conversion or rollover resets the clock to make the distributed amounts tax-free, except for earnings. For earnings, the five-year rule begins on January 1 of the year your Roth IRA started, even if you make new contributions.
Summary
Both a Roth IRA conversion and a Roth IRA rollover involve moving money from one retirement account to a Roth IRA account. This can help individuals save money in the long term if they can grow their Roth IRA assets without paying taxes and withdraw earnings tax-free.
However, you don’t always have the option to perform a Roth IRA conversion or a Roth IRA rollover. This will depend on what type of retirement account you currently have. If you already have after-tax money like a Roth 401(k), you will be eligible for a rollover. If you have a pre-tax account like a traditional 401(k), you can make a conversion.
Roth IRA conversions tend to be more tax-oriented. If you believe you will save on taxes in the long run by making the change and can bear the initial tax implications at the time of conversion, it may be an option worth exploring.
Frequently Asked Questions
Are Roth IRA conversions and Roth IRA rollovers the same thing?
Technically, a conversion is a type of rollover. But in practice, it’s best to distinguish between them when determining tax implications. You can think of a rollover as involving the transfer of after-tax money, such as from a Roth 401(k) to a Roth IRA, while a conversion involves transferring pre-tax money, such as from a traditional 401(k) to a Roth IRA after taxes.
What are the tax implications of a Roth IRA conversion and a Roth IRA rollover?
Since a Roth IRA conversion involves switching from one type of Roth account to another, there are no immediate tax implications. However, a conversion changes the account structure. Therefore, the conversion incurs income tax for the tax year in which the conversion takes place, based on the amount converted.
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Sources:
IRS. “Publication 590-A.”
IRS. “RMD Comparison Chart (IRAs vs. Defined Contribution Plans).”
Schwab. “What Is a Roth IRA?”
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