How to do a Roth conversion

Roth conversion is what it sounds like: a way to convert money from a traditional IRA (individual retirement account) into a Roth IRA. A Roth IRA is a powerful retirement savings tool, as your money grows tax-free and you can roll your money into a fund.

To help you figure out if it’s a good money move for your situation, CNBC Make It spoke with Fred Egler, a certified financial planner at Betterment, about the difference. Distinguish between the two types of IRAs, the pros and cons of doing a Roth conversion, and exactly how to do one.

With a Traditional IRA, you contribute dollars before taxes and let that money be tax-deferred over time.

You will have to pay tax on your contributions and any investment gains only when you withdraw, you can do this starting from 59½. If you withdraw before that time, you may be charged a 10% fee on early withdrawals, unless you qualify for an exception.

With this type of IRA, there is a minimum distribution requirement, which means that you must begin withdrawing by April 1 after the year you turn 72 and by December 31 of the following years.

In 2020, you can contribute up to $6,000 to this account, or $7,000 if you’re 50 or older.

With a Roth IRA, contributions are taxed as they are made, so you can withdraw your contributions and income tax-free when you hit 59½.

There is an income limit on a Roth IRA, which the IRS sets annually based on modified adjusted gross income (MAGI): In 2020, a single person earning $139,000 or more and a married couple Earning $206,000 or more cannot directly contribute to Roth.

Like a traditional IRA, there’s also a contribution limit: For 2020, it’s $6,000 a year, or $7,000 for those 50 and older. If you’re contributing to both accounts, keep in mind that your total contributions to all of your Traditional and Roth IRAs can’t be more than $6,000 a year or $7,000 if you’re over 50.

A Roth Conversion turns a Traditional IRA into a Roth IRA. If you have funds in a traditional account, but like the idea of ​​tax-free future withdrawals, converting to Roth will allow you to do so.

Anyone is eligible to perform a Roth conversion, regardless of their income.

“This is a great way for high-income individuals to get money into a Roth IRA without contributing directly to a fund because of income limits,” says Egler. You may have heard of the limit crossing process known as the “Roth backdoor IRA.”

The biggest benefit is that you will be able to keep the money in the Roth IRA, where it will grow tax-free and qualified withdrawals in retirement will be tax-free.

If you think your tax rate will be lower now than when you started withdrawing, converting to Roth is especially appealing as you will have to pay tax on the amount while you are in a low tax bracket. than.

It’s also a way to avoid the required minimum distribution, which is the minimum amount you must withdraw from your account each year. With a Traditional IRA, you must start withdrawing at 72. Roth IRAs don’t require withdrawals at a certain age, so your money can continue to grow there until you’re ready to withdraw.

“In most cases, when you convert money, it is considered a taxable event, which means you owe tax on some or all of the money you convert to Roths,” Egler explains. Basically, that amount will be added to your income for that tax year.”

If you are converting a ton of money, the tax consequences will be high, and the process can be more of a burden than an advantage. “Let’s say someone has $500,000 in their traditional IRA,” says Egler. “It probably wouldn’t make sense to convert that to Roth because you would add $500,000 to your taxable income for the year.”

Also, if you think your tax rate is higher now than it was when you started withdrawing, a conversion could cost you more tax now than you would have saved with the withdrawal. tax exemption later on, says Egler. You can use a Roth conversion calculator to estimate how this might work out for you, but it’s hard to predict future tax rates, especially if you won’t be withdrawing for 10 to 10 days. 30 years.

While everyone’s circumstances are different, a transition may not make sense if you’re nearing retirement. “The shorter the time period, the less advantageous the Roth transition, because tax-free growth has less time to merge and develop,” Egler said.

Also, there’s a “five-year rule” that says you must wait five years from conversion to get the most out of tax-free distributions from a Roth IRA. “For people who plan to use that money sooner rather than later, it might not make sense,” Egler said.

“Once you do a Roth conversion, it can’t be changed,” Egler adds. “If you’re going to make one, you should definitely make sure it’s for you.”

If you’ve considered the tax consequences and decided that a conversion makes sense for you, the first step is to move the money into a traditional IRA account if you haven’t already. Next, you will open a Roth account if you don’t already have one.

“You pay tax on a Roth conversion when you file your taxes, usually in April,” says Egler. “Your investment custodian will provide you with a tax form regarding the Roth conversion.” It’s smart to plan ahead and make sure you have money set aside to pay taxes when you file, rather than using the money from your IRA withdrawal. “Those funds will sit in a retirement account and grow over time,” says Egler.

There is no limit to the amount you can convert. Here are three ways to transfer your funds from a traditional account to a Roth account:

1. Indirect conversion. You will receive a distribution check from your Traditional IRA and then contribute to your Roth IRA within 60 days.
2. Transfer of trustee to trustee. You ask the financial institution holding your traditional IRA funds to transfer an amount directly to your Roth IRA at another institution.
3. Joint entrustment transfer. If your IRA is held at the same institution, you ask the trustee to transfer some money from your traditional to your Roth.

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