If you’ve been saving for retirement in a traditional individual retirement account, you may have been advised somewhere along your journey to consider the benefits of converting to a Roth IRA. There are several advantages to consider that might compel you to covert — namely, the ability to make tax-free withdrawals, the absence of required minimum distributions and the ability to pass on your Roth IRA to a beneficiary as a tax-free inheritance. It doesn’t hurt that the conversion process is not as difficult or daunting as you might suspect.
Where to start if you don’t have an IRA
It’s important to note that you most likely can’t convert your 401(k) into a Roth IRA without first rolling over into a traditional IRA. According to the Internal Revenue Service, you can roll over all or any distributions from your retirement plan. However, there are some exceptions, including required minimum distributions, distributions as part of substantially equal payments or distributions made to cover insurance costs. Distributions from a 401(k) or workplace retirement plan are subject to mandatory 20 percent tax withholding, but that withholding will be deferred if your distribution is transferred directly into a traditional IRA.
NerdWallet’s Arielle O’Shea and Kevin Vogt note that you can convert a 401(k), 403(b) or other employer-sponsored retirement account to a Roth IRA if you are no longer under their employ. This process would subject you to a tax bill, as is the case with converting a traditional IRA, unless your money is stored in a post-tax Roth 401(k).
From traditional to Roth
The biggest difference between a traditional IRA and a Roth IRA is the relationship with taxes. In a traditional IRA, like a 401(k) you are saving pre-tax money, which means that you are subject to withholding upon distribution of your savings. In a Roth IRA, all money is post-tax, so everything saved in a Roth grows free from tax.
Because of this, according to O’Shea and Vogt, converting your traditional IRA into a Roth will require that you pay taxes on your IRA contributions and investment gains. Unlike a traditional IRA, your contributions to a Roth will not be tax-deductible, but you benefit on the backend by being able to withdraw your money free of tax. You can effectively time your conversion to reduce the amount of taxes that you’ll owe, however; O’Shea and Vogt recommend converting while you are in a lower tax bracket than normal (i.e. being unemployed or between jobs), if your IRA’s balance is diminished, if it’s early in the tax year or converting in increments so that you can pay off your taxes as you go.
How it’s done
Per the IRS, there are three methods for converting funds from a traditional IRA to a Roth IRA. With direct rollover, you tell your retirement plan administrator that you wish for a payment to be made directly into a Roth IRA. In some cases, this distribution will be issued to you in the form of a check made payable to your Roth IRA account. In a trustee-to-trustee transfer, you can ask the financial institution with whom you have your traditional IRA to pay directly into your Roth IRA. In both cases, taxes will not be withheld from the transfer, meaning you will need to pay them later.
With a 60-day rollover, you can deposit a distribution made to you in whole or in part within 60 days. This method sees taxes withheld, so you will need to pay the difference when making the deposit to ensure that the entire distribution makes it into your Roth account.
Converting your traditional IRA into a Roth IRA is not a difficult process, but it is one that has severe implications if not done properly. Your best approach is to consult with a trusted financial advisor to ensure that you are doing your due diligence and that converting to a Roth IRA is truly your best option.