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.

How a Roth IRA conversion works

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 pre-tax 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.

Benefits:

Reasons to consider a conversion

Considerations:

Conversions make the most sense if you meet the following guidelines

  • If you have a long time before retirement, you may be able to accumulate a significant amount of earnings that may eventually come out tax-free.
  • You can access your conversion assets (excluding earnings) after five years without penalty for any reason.
  • You can use money in your Roth IRA tax-free for a first time home purchase ($10,000 lifetime limit).
  • Assets that have a depressed value 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 70½, 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.
  • A conversion may allow you to reduce the size of your taxable estate.
  • Tax-free Roth IRA distributions do not count towards the income threshold which determines the taxation of Social Security benefits or the 3.8% Medicare surtax on investment income.
  • You have enough money outside your retirement accounts to pay the conversion-related taxes.
  • You have a long time frame (ideally 10 - 15 years or more) before you need the money.
  • You are in a lower 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:

  1. 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
  2. Also meet one of the following conditions:
    • Made on or after the date that the Roth IRA owner reaches age 59½
    • Made due to disability
    • Made to a beneficiary after the owner's death
    • Meets the requirements for a first home purchase (up to a lifetime limit of $10,000)

Distributions of conversion assets (excluding earnings) can be made tax- and penalty-free for any reason five years from the first day of the year you converted.2

Roth 401(k) conversions 

Participants in a 401(k) plan need a distributable event (typically separation from service or attainment of age 59 ½) in order to convert pre-tax 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:

  • Roth 401(k) conversions can’t be undone (recharacterized) while Roth IRA conversions can be recharacterized up to Oct 15 of the year after the conversion.
  • Purchase of a first home up to $10,000 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 from a Roth 401(k) for a non-qualified (potentially taxable) distribution. Roth IRAs allow you to access non-taxable assets first.
  • Roth 401(k) plan participants are subject to required minimum distribution rules while Roth IRA owners are not.1

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 assets being converted, and then enjoy tax-free growth potential and tax-free withdrawal of the assets. You will also be able to withdraw any subsequent earnings tax-free, 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.

It's sometimes possible to solve this problem by reversing or "recharacterizing" the Roth IRA conversion. The assets are returned to a traditional IRA and you avoid taxes. You may also be able to perform another Roth IRA conversion at a later date. The relevant tax rules are somewhat complex, however, so don't try this without the help of a financial advisor. And, as noted above, conversions to a Roth 401(k) are not eligible to be recharacterized.

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 pre-tax amount is directly rolled to a traditional IRA, the conversion is tax-free.

An Ameriprise financial advisor can give you the information you need to determine if Roth conversions and contributions are right for you.