Understanding Roth IRA conversions
Key Points
- A Roth IRA may offer tax-free growth on earnings and tax-free withdrawals in retirement.
- Converting your retirement savings to a Roth IRA may be a good idea if you are in a low tax bracket and can pay the taxes, ideally with funds outside of your traditional IRA or employer retirement account.
- If you need the money within five years, a conversion is not for you.
If you are focusing on saving and investing, you may want to consider converting assets in a traditional IRA or eligible workplace plan, such as a 401(k), to a Roth IRA.
In some circumstances, a Roth IRA conversion may have a positive impact on your financial future and the future of your beneficiaries.
What is a Roth IRA conversion?
Converting to a Roth IRA involves moving assets from your traditional IRA or employer-based retirement plan to a Roth IRA. While you'll pay taxes on the pretax retirement assets in the year you convert, future earnings on your money will be tax-free in a Roth IRA — and withdrawals will be tax-free as well, when you have met certain requirements.
Should I convert pretax assets to a Roth IRA?
Benefits: Reasons a conversion may make the most sense
• You have a long timeframe (typically 10-15 years or more) before you need the money, you may be able to accumulate a significant amount of earnings that may eventually be withdrawn tax-free.
• Assets with lower values will not create as large of a tax bill.
• Assets in a Roth IRA are not subject to required minimum distributions (RMDs). So, if you don't need the money at age 73, you can let it keep working on a tax-free basis.1
• Qualifying distributions (withdrawals) are income tax-free to you and your beneficiaries, allowing you the potential to pass on more financial assets to future generations.
• Tax-free Roth IRA distributions do not count towards the income threshold that determines the taxation of Social Security benefits, Medicare Parts B or D premiums or the 3.8% Medicare surtax on investment income.
Considerations: Reasons a conversion may not make sense
• You don’t have enough money outside your retirement accounts to pay the conversion-related taxes.
• You need the money within 5-10 years.
• You are in a higher tax bracket now than you (or your beneficiaries) will be when the money is accessed.
Tax-free Roth IRA distributions
Qualified distributions (withdrawals) from a Roth IRA are free from income tax. For a distribution of earnings to be considered qualified, it must:
- Take place at least five years after the first day of the year you first made a Roth IRA contribution or converted to a Roth IRA; and,
- Is taken:
- On or after the date that the Roth IRA owner reaches age 59½
- Due to disability
- By a beneficiary after the owner's death; or,
- For a first home purchase up to $10,000.
Distributions of converted assets (excluding earnings) are tax- and penalty-free for any reason five years from the first day of the year you converted.2
401(k) conversion to a Roth IRA
Participants in a 401(k) plan need a distributable event (typically separation from service or attainment of age 59½) to convert pretax money from a 401(k) plan to a Roth IRA. However, in-plan conversions to a Roth 401(k) are allowed without a distributable event. It is important to remember the plan sponsor of the 401(k) must allow for the transaction and there are some significant differences between converting to a Roth IRA and a Roth 401(k), most notably:
- Purchasing of a first home is not a triggering event for a tax-free distribution from a Roth 401(k) like it is from a Roth IRA.
- Distribution ordering rules are not as favorable for a Roth 401(k) non-qualified (potentially taxable) distribution. Roth IRAs allow you to access non-taxable assets first.
Roth IRA conversions during market declines
Completing a Roth IRA conversion during a market decline may save you money on the taxes due upon conversion. You'll pay taxes on the current value of the pretax assets being converted and then enjoy tax-free growth potential and tax-free withdrawal of the assets, if applicable requirements are satisfied.
This method usually works well, but not always. Since no one knows how to choose the "bottom" of the market, the value of an IRA that is converted to a Roth IRA may continue to decline. Therefore, it may be worth less than the market value that was reported — and taxed — when the conversion was done. Taxpayers can't recharacterize or “undo” the conversion once it has been completed.
After-tax Roth IRA conversions
You may have an opportunity to make after-tax contributions to your 401(k) plan if the plan allows it. After-tax money in a 401(k) can present a special opportunity for a tax-free Roth IRA conversion. After-tax contributions are not subject to income tax when converted to a Roth IRA, and if any related pretax amount is directly rolled to a traditional IRA, the conversion is tax-free.
Talk to your financial advisor about Roth IRA conversions
An Ameriprise financial advisor can give you the information you need to determine if Roth conversions and contributions are right for you.