Roth Conversion Facts

Pros of Roth Conversion:

  • With a Roth IRA, you can have completely tax-free distributions on both your contributions and related earnings.
  • There are no required minimum distributions (RMD) to the original owner of the Roth IRA.
  • You can withdraw contributions at any time, tax-free.
  • Beneficiaries will inherit your Roth IRA tax-free. RMD rules do apply to beneficiaries, but all distributions are tax-free. Depending on the beneficiary, they may be able to have 10 years of tax-free growth before being required to fully distribute the account. Spousal beneficiaries have the option to treat the inherited Roth IRA as their own.

All of the above are subject to the “5-Year Rule” for Roth IRAs. See below for rules.

Cons of Roth Conversion:

  • Converting funds from a Traditional IRA to a Roth IRA is a taxable event with no cash to you.
  • A Roth conversion will increase taxable income in the year of the conversion. This can reduce other tax credits or deductions, trigger Net Investment Income Tax (NIIT), increase your Medicare premiums, and increase the taxable amount of your Social Security as well as reduce your benefit in some cases.
  • There is a separate 5-year waiting period for each conversion (see below for details).
  • Roth conversion is subject to Pro-rata rules (see below for details).
  • You may not benefit if you are in a lower tax bracket after reaching RMD age.

5-Year Rule

There are actually two different 5-Year Rules. One is for Roth IRA withdrawals and one is for Roth IRA conversions.

For Roth IRA withdrawals prior to age 59 ½:

  • Your contributions can be withdrawn tax-free.
  • Your earnings will be subject to income tax and the 10% penalty for early withdrawal.
  • See below for Distribution Ordering Rules.

For Roth IRA withdrawals after the age of 59 ½:

  • Your contributions can be withdrawn tax-free.
  • If you have owned any Roth IRA account for at least 5 years, all distributions are tax-free.
  • If you have not owned any Roth IRA for at least 5 years, your earnings will be taxed at your marginal income tax rate, but there will be no 10% penalty.
  • See below for Distribution Ordering Rules.

For Roth IRA Conversions:

  • Each conversion has its own 5-Year period and the Distribution Ordering Rules apply (see below)
    • If you are under 59 ½ and you take a distribution within 5 years of the conversion, you will pay a 10% penalty on the entire distribution in most cases. See exceptions noted below.
    • If you have not had any Roth IRA open for more than 5 years, your earnings will be subject to income tax regardless of your age. If you are over 59 ½, you will not be subject to the 10% penalty.
    • Conversions use a calendar year. If you complete a conversion in August 2021, the 5-year period begins January 1, 2021.

The 5-Year Rule applies to beneficiaries. If you inherit a Roth IRA that has not been held for 5 years, earnings distributed will be subject to income tax. The ordering rules apply, so the 5-year period may lapse before you withdraw any earnings and you will not owe any taxes.

Exceptions to the 5-Year Rule:

  • Common exceptions to the 10% penalty include up to $10,000 for first time homebuyers, funds used to pay for higher education, funds used to pay for health insurance premiums if you become unemployed or reimbursing yourself for medical expenses that exceed 7.5% of your adjusted gross income.

Distribution Ordering Rules

When you take a distribution from your Roth IRA, the IRS will view your distribution in this order:

  1. Contributions
  2. Conversions (if both pre-tax and after-tax amounts were converted, pre-tax are distributed first).
  3. Earnings

Pro Rata Rule for Roth Conversions

If you have after-tax (non-deductible) IRA contributions as well as pre-tax IRA contributions, you are subject to the Pro Rata Rule. Even if you have kept your after-tax IRA account completely separate from your pre-tax IRA account, you must take all IRA accounts into consideration.

Here is how you determine the taxable portion of your distribution/conversion:

  1. Total all of your IRAs as of 12/31 of the distribution year and add back all distributions taken during the year. This total should include all traditional, SEP and SIMPLE IRA accounts. Do not include your Roth IRA or your company plan (401(k), 403(b), etc.).
  2. Total all of your after-tax (non-deductible) balances in all of your IRAs. This information should be on your Form 8606 from your most recent tax return. If you have not been filing a Form 8606, you will need to go back through your accounts to calculate the totals. You will also want to be sure to give that information to your tax preparer so they can file the Form 8606 on your next tax return.
  3. Calculate your after-tax percentage. Divide your after-tax IRA contributions by your total IRA balance. For example:
    • $10,000 of after-tax contributions and your total balance of all IRAs is $100,000. Your after-tax percentage is 10% ($10,000/$100,000 = 10%).
  4. Calculate the taxable portion of your distribution/conversion. Take your distribution amount and multiply it by the after-tax percentage you calculated in Step 3 above. For example:
    • You converted $20,000 to a Roth IRA. The tax-free portion of this distribution is $2,000 (10% x $20,000 = $2,000). The remaining $18,000 is a taxable distribution that will be taxed at your marginal income tax rates.

If you have an employer plan, you may be able to rollover your pre-tax dollar IRA into your plan. If your employer plan allows this, you can disregard the pro-rata rule completely.

Examples:

Jane is 58 and has a Roth IRA totaling $50,000. She has had the Roth account for more than five years. She has contributed $20,000 and converted $20,000 from her pre-tax traditional IRA. The remaining $10,000 is from earnings. Jane takes a distribution of $15,000. Because she has contributed $20,000, her distribution is tax-free and penalty-free.

Using the same details, but assuming Jane’s Roth conversion was completed more than 5 years ago, Jane takes a distribution of $45,000. Jane will pay ordinary income tax on $5,000 and early distribution penalties on $25,000.

If Jane waits until she is 59 ½, there would be no tax implication on this transaction.

Ben inherited his father’s (James) Roth IRA. At the time of his death, James had owned the Roth IRA for 3 years. He had contributed $50,000 and the account has earnings of $6,000. Due to the Secure Act, Ben has 10 years to fully distribute the account. Ben can withdraw up to $50,000 tax-free now. If he waits 2 years, he can withdraw the remaining balance of the account tax-free.

Additional Considerations for Roth Conversion Planning

Do you have a Net Operating Loss (NOL) carrying forward from prior tax years? A Roth conversion can be a great way to utilize those losses.

Do you expect your RMD to affect your Medicare premiums? RMDs from your traditional IRA and 401(k) plans are included in the threshold calculation. Roth distributions are not.

If your retirement income is solely comprised of Social Security and IRA distributions, Roth conversions could help shelter more of your Social Security from taxation.

Have you recently retired? Or are you nearing retirement and have several years before you reach age 72? Often people find themselves in lower tax brackets during the years between retirement and RMD age. These years may be a great opportunity for Roth conversions.