Roth Conversions (revisited)
11/01/2024Blog Categories
Many of you have executed (or at least heard about) a “Roth conversion.” This refers to moving all or part of a traditional IRA balance into a Roth IRA.
As many also know, Roth IRAs are generally not taxable when we take money out of them. We often advise people to add to Roth, and one way to do that is by doing Roth conversions.
The questions many people have are: why would I want to do one? How do I do one? What steps do I need to take? Are there forms involved? Amongst other questions…
Without question though, is why most people want their money in a Roth to begin with. The number one reason why people love Roth IRAs is because the money can grow inside of the account and be taken out tax-free in retirement (as long as certain requirements are met).
People also like knowing their funds can grow tax-free, and for LONGER. Unlike traditional IRAs, there are no required distributions forced upon you at any age. Want to leave a tax-free inheritance to your heirs? A Roth IRA is one of the best ways to do so. I previously wrote (March 2020) about WHY the timing was great for Roth conversions.
Should everyone have a Roth (or make a conversion into one)? It’s not always cut and dry, but in general, I think most people would benefit from a Roth. But deciding on this could involve estimating your tax rate now versus in the future, how you would pay for this tax now, and future plans for your estate. I won’t delve into these topics today, but I will say it’s best to talk through these things with a professional.
Next, let’s address how we do one.
Step 1. Open a Roth IRA at the financial institution. I generally use Charles Schwab for this, but it could be Schwab, Fidelity, E-trade, Vanguard, etc.
Step 2. Contact the institution (if different) of where the IRA current is, and ask them what they require in order to execute a Roth conversion. This is much easier if the two accounts are in the same place.
Step 3. You will need to specify which assets you want to convert, whether it’s cash or securities, and how many shares.
This should all be completed within a week or so, depending on the firm and time of year. I would encourage not waiting til late in the year since many firms get backlogged and have a large number of requests at that time. I’d personally recommend doing it before December. If they don’t get to it by 12/31, the absolute deadline, the window to execute it for that calendar year closes.
When is the best time to do a Roth conversion? Ideally during low-income years, although this is not a hard-and-fast rule. We do like to “fill up” the lower brackets with converted funds if the scenario presents itself.
Other circumstances certainly come into play as well besides that year’s income bracket. In general, most experts think it’s always a good time as long as the tax rate you are in today is the same (or lower) than what you expect to be in future years. No one has a crystal ball, and we’re likely to see many rate changes in the next 10, 20, 50 years!
Moving on to the forms you will need to submit to IRS…
Let’s say you converted $100k in 2024, you will get a 1099-R form in 2025 stating this conversion amount. You will then need to apply this to your tax return and report on tax form 8606. Here you will indicate what percentage of that conversion is “taxable”.
But wait – you might be asking “Isn’t 100% of my conversion considered taxable?”
Not always.
Some of your IRA may consist of after-tax contributions that you don’t want to be required to pay tax on. Perhaps your income was too high in a prior year, and you were NOT able to get a full deduction at that time on the IRA contribution, for example.
Truth is, you probably have some mix that is taxable and some is not being converted. Form 8606 is where we indicate those amounts.
To use actual numbers, let’s assume that you have an existing pre-tax IRA valued at $50,000. And in 2024 you made too much money to get a deduction but you added your $8k contribution. So your $8,000 contribution is now considered an after-tax (non-ded) contribution. Now the account value is $58,000 and you wish to convert it all to a ROTH IRA.
This is where something called the pro-rata rule comes into play. Only a certain percentage of the Roth IRA conversion is taxable. We calculate this by dividing $8k (after-tax contribution) by $58k (amount of the total account), or 13.8% of the conversion is tax-free. Said differently, since you already paid taxes on the $8k (ie never got a deduction) then you will NOT need to pay taxes again when converting to a Roth.
One caveat regarding form 8606. We should be using this form EACH year we have a non-deductible IRA contribution to establish basis in your IRA. In other words, keep track of which dollars in your IRA have already been taxed versus which have not. If not, many years from now…you may pay unnecessary taxes on dollars that you should not be.
A double tax is something that you should be looking to avoid at all costs. That would be no beuno.
One last thought: a conversion is permanent. You cannot revert the money back to a traditional IRA. It’s probably best to wait until later in the year once some of your variables (income and otherwise) are known. Just don’t wait until the last minute/day/week.
With careful planning and execution, converting to a Roth IRA can unlock a world of tax advantages and greatly enhance your retirement outlook.
Brandon
As many also know, Roth IRAs are generally not taxable when we take money out of them. We often advise people to add to Roth, and one way to do that is by doing Roth conversions.
The questions many people have are: why would I want to do one? How do I do one? What steps do I need to take? Are there forms involved? Amongst other questions…
Without question though, is why most people want their money in a Roth to begin with. The number one reason why people love Roth IRAs is because the money can grow inside of the account and be taken out tax-free in retirement (as long as certain requirements are met).
People also like knowing their funds can grow tax-free, and for LONGER. Unlike traditional IRAs, there are no required distributions forced upon you at any age. Want to leave a tax-free inheritance to your heirs? A Roth IRA is one of the best ways to do so. I previously wrote (March 2020) about WHY the timing was great for Roth conversions.
Should everyone have a Roth (or make a conversion into one)? It’s not always cut and dry, but in general, I think most people would benefit from a Roth. But deciding on this could involve estimating your tax rate now versus in the future, how you would pay for this tax now, and future plans for your estate. I won’t delve into these topics today, but I will say it’s best to talk through these things with a professional.
Next, let’s address how we do one.
Step 1. Open a Roth IRA at the financial institution. I generally use Charles Schwab for this, but it could be Schwab, Fidelity, E-trade, Vanguard, etc.
Step 2. Contact the institution (if different) of where the IRA current is, and ask them what they require in order to execute a Roth conversion. This is much easier if the two accounts are in the same place.
Step 3. You will need to specify which assets you want to convert, whether it’s cash or securities, and how many shares.
This should all be completed within a week or so, depending on the firm and time of year. I would encourage not waiting til late in the year since many firms get backlogged and have a large number of requests at that time. I’d personally recommend doing it before December. If they don’t get to it by 12/31, the absolute deadline, the window to execute it for that calendar year closes.
When is the best time to do a Roth conversion? Ideally during low-income years, although this is not a hard-and-fast rule. We do like to “fill up” the lower brackets with converted funds if the scenario presents itself.
Other circumstances certainly come into play as well besides that year’s income bracket. In general, most experts think it’s always a good time as long as the tax rate you are in today is the same (or lower) than what you expect to be in future years. No one has a crystal ball, and we’re likely to see many rate changes in the next 10, 20, 50 years!
Moving on to the forms you will need to submit to IRS…
Let’s say you converted $100k in 2024, you will get a 1099-R form in 2025 stating this conversion amount. You will then need to apply this to your tax return and report on tax form 8606. Here you will indicate what percentage of that conversion is “taxable”.
But wait – you might be asking “Isn’t 100% of my conversion considered taxable?”
Not always.
Some of your IRA may consist of after-tax contributions that you don’t want to be required to pay tax on. Perhaps your income was too high in a prior year, and you were NOT able to get a full deduction at that time on the IRA contribution, for example.
Truth is, you probably have some mix that is taxable and some is not being converted. Form 8606 is where we indicate those amounts.
To use actual numbers, let’s assume that you have an existing pre-tax IRA valued at $50,000. And in 2024 you made too much money to get a deduction but you added your $8k contribution. So your $8,000 contribution is now considered an after-tax (non-ded) contribution. Now the account value is $58,000 and you wish to convert it all to a ROTH IRA.
This is where something called the pro-rata rule comes into play. Only a certain percentage of the Roth IRA conversion is taxable. We calculate this by dividing $8k (after-tax contribution) by $58k (amount of the total account), or 13.8% of the conversion is tax-free. Said differently, since you already paid taxes on the $8k (ie never got a deduction) then you will NOT need to pay taxes again when converting to a Roth.
One caveat regarding form 8606. We should be using this form EACH year we have a non-deductible IRA contribution to establish basis in your IRA. In other words, keep track of which dollars in your IRA have already been taxed versus which have not. If not, many years from now…you may pay unnecessary taxes on dollars that you should not be.
A double tax is something that you should be looking to avoid at all costs. That would be no beuno.
One last thought: a conversion is permanent. You cannot revert the money back to a traditional IRA. It’s probably best to wait until later in the year once some of your variables (income and otherwise) are known. Just don’t wait until the last minute/day/week.
With careful planning and execution, converting to a Roth IRA can unlock a world of tax advantages and greatly enhance your retirement outlook.
Brandon