Not everyone can contribute to a Roth IRA because of IRS-imposed income limits. But you still may be able to benefit from a Roth IRA’s tax-free growth potential and tax-free withdrawals by converting existing money in a traditional IRA or other retirement savings account.1 Here we answer some questions we often hear from would-be converters.
Does it matter when you convert?
There are potential benefits to converting either early or late in the year. That said, converting earlier generally gives you more flexibility than converting later. Consider the pros and cons.
Early in the year
- Taxes aren’t due until April 15 of the following year, so you may have more than 16 months to pay the taxes on your converted balances (Note: If you pay estimated taxes, you may need to make payments sooner.)
- If you change your mind, you have more time to act—until October 15 of the following year (the extended deadline for tax filing) to undo the conversion.
If you convert an amount early in the year and then undo the conversion within the same tax year, you’ll have to wait until January 1 of the following year before you can reconvert those balances into a Roth IRA.
Later in the year
- The clock on the five-year rule for taking a distribution from a Roth IRA begins in January of the year you convert, no matter when you actually convert. So a conversion on December 31, 2014, is considered the same as a conversion made on January 1, 2014. Both are eligible for penalty-free withdrawals beginning January 1, 2019, assuming one of the other IRS "qualified" distribution triggers has been met (i.e., the IRA owner has reached age 59½). So if you convert later in the year, you have the potential to access these funds almost a full year sooner than if you converted earlier in the year. (Note, however, that the five-year aging clock starts from the year you fund your first Roth account.)
- You’ll have more information about your income taxes for the year, which may allow you to convert a more targeted amount to ensure that the conversion doesn’t bump you into a higher marginal tax bracket.
- Should you need to undo the conversion later in the year, you may have a shorter reconversion waiting period. For instance, if you convert in December it could be as little as 30 days after the recharacterization.
Assuming that you don't undo the conversion, taxes on the amount you converted will be due not long after your conversion.
Why would I want to consider undoing a conversion?
There are good reasons you may want to undo a conversion, put the assets back into a traditional IRA (or other account), and, if applicable, get a refund of taxes paid:
- Your taxable income ended up higher than you expected and/or the additional income from the Roth IRA conversion bumped you into a higher marginal federal income tax bracket.
- You’ve determined that your taxable income in retirement will likely be lower than you expected, reducing the potential benefits of a Roth IRA’s tax-free distributions.
- The value of your investments in the converted Roth IRA declined. Undoing the conversion and then reconverting when eligible might result in a lower tax bill.
- You don’t have enough cash on hand to pay the taxes.
- Any other reason, really. The IRS has no requirements on this front.
The process of undoing a Roth IRA conversion, called “recharacterization,” needs to be completed by the last date to file or refile your prior-year taxes, including extensions. This is typically on or about October 15. For instance, a Roth IRA conversion made in 2014 needs to be recharacterized, and taxes refiled, by October 15, 2015. That’s why the earlier in the year you convert, the longer you have to get a clearer picture of your taxes and to determine whether a recharacterization makes sense. You can generally recharacterize all or a portion of what you converted. If you want, assets that you recharacterize to a traditional IRA can be reconverted to a Roth IRA in the next tax year or 30 days after the recharacterization, whichever is later. You can undo as many Roth conversions in a year as you want.
Can I convert just part of my IRA balances to a Roth IRA?
Yes, you can choose to convert as much or as little as you want of your eligible balances in IRAs and/or workplace savings plans from former employers. This flexibility enables you to manage the tax cost of your conversion.
For instance, because the amount you convert is generally considered taxable income, you may want to consider converting no more than what you think will bring you to the top of your current federal income tax bracket. You also may want to consider basing your conversion amount on the tax liability you may incur so you can pay it without using money from your conversion.
See the federal income tax brackets for 2014.
How can I estimate my tax liability on a conversion?
Your tax liability is based on two things: the taxable income generated by the conversion and your applicable tax rate. To determine what portion of your conversion is taxable income, you need to know the types of contributions in your conversion-eligible IRA or workplace retirement accounts. This is because your contributions to these accounts could be either pretax (deductible) (i.e., no income taxes were paid when you made the contribution) or after tax (i.e., income taxes were paid when you made the contribution).
Estimating your taxable income can be straightforward if all your contributions in conversion-eligible accounts were pretax. In this case, whatever amount you convert will be taxable income. It becomes a little tricky if you have after-tax contributions in your conversion-eligible accounts. It also depends on the type of non-Roth account you are converting from. Generally, the portion of your conversion representing pretax contributions and any earnings will generate taxable income for the year of conversion. Therefore, you’ll need to determine what portion of the conversion amount will be after-tax contributions and then subtract that amount from your proposed total conversion amount to estimate the taxable income portion. It’s a good idea to check with a tax advisor before you convert.
Here are some general guidelines for converting after-tax contributions:
For after-tax (nondeductible) contributions in IRAs
Per IRS rules, you cannot “cherry-pick” and convert just after-tax contributions (leaving pretax amounts in the account) in your eligible non-Roth IRAs so you won’t incur any taxes. Instead, you need to determine the percentage of after-tax contributions across all your non-Roth IRAs. Then use that percentage to determine the portion of the converted amount that is not considered the taxable amount of your conversion. In order to calculate this percentage, you need to total both the balances and the after-tax amounts in all non-Roth IRAs in your name, even if they are held at different IRA providers. Don’t include your living spouse’s IRAs or any inherited IRAs when doing this.
Consider this example: Let’s say you have $100,000 eligible for conversion in two IRAs. One account has $85,000 in pretax contributions and earnings; the second account has $10,000 in after-tax contributions and $5,000 in earnings (pretax), for a total of $15,000. You decide you want to convert $10,000 this year. Ninety percent ($90,000) of the total eligible IRA balance ($100,000) is in pretax contributions and earnings. So your taxable percentage is 90%. For the $10,000 conversion amount, that’s $9,000.
Tip: If you and your spouse both have conversion-eligible IRAs, you may want to compare your total percentage of pretax contributions and earnings with that of your spouse. Why? If your spouse has IRAs with mostly after-tax contributions and you have IRAs with mostly pretax contributions, you might consider converting your spouse’s IRAs before yours to reduce the potential tax impact of conversion. Converting when after-tax contributions are a high proportion of your total IRA balances is advantageous, not only because of the reduced tax bill today, but also because of the tax-free earning potential once they are in a Roth account. While after-tax contributions are not taxable when withdrawn from a traditional IRA account, the earnings they generate are. So by converting to a Roth IRA before those earnings are generated, you could potentially reduce taxes.
For after-tax contributions in a 401(k) or other workplace savings plan account
Determining the taxable amount of a conversion from an eligible workplace savings plan with after-tax contributions is similar to doing so for an IRA. You need to determine what percentage of your account balance would generate taxable income. This is based only on the workplace savings plan account you are converting. Do not include any of your IRA balances or other workplace savings plan balances.
For example, let’s say you have $50,000 in after-tax contributions and $50,000 in pretax contributions and earnings, for a total of $100,000, in your 401(k) plan from your former employer, ABC. You also have $100,000 in a 401(k) plan from another former employer, XYZ, with only pretax contributions. Both account balances are eligible to be converted to a Roth IRA. The chart below illustrates the estimated taxable income. In this example, it makes sense to convert from the account with after-tax contributions, ABC, because the taxable income will be lower.
Tip: In addition to converting balances in a workplace savings plan from a former employer to a Roth IRA, you have the option of rolling them into a traditional IRA. If there is a chance that you may want to convert this money to a Roth IRA at some point, and either your existing IRAs or the workplace balances include after-tax contributions, consider this before rolling over those plan assets to a traditional IRA. Once these balances are in an IRA, they have to be included along with your other IRA balances (non-Roth) in determining what portion of your conversion generates taxable income. This could potentially change the portion that may need to be recognized as taxable income. It’s important to consult a tax adviser when considering a conversion of after-tax assets.
Do I still need to take a required minimum distribution (RMD) in the year I convert?
Yes. People age 70½ and older are generally required to take an RMD, or MRD (minimum required distribution) every year from their tax-deferred retirement accounts (traditional, SEP, rollover, and SIMPLE IRAs, and workplace plan accounts). MRD amounts are not eligible to be converted to a Roth IRA. IRS rules specify that you must satisfy the MRD for the year of conversion before initiating a Roth IRA conversion. Converting the MRD amount can result in an excess contribution to the Roth IRA and can trigger possible excise taxes. You can satisfy your MRD amount from any one or more of your non-Roth IRAs (other than an inherited IRA).
Say, for example, you have a $100,000 traditional IRA with a $7,000 MRD for 2013. If you were to convert the entire $100,000 balance to a Roth IRA this year, you’d want to satisfy the MRD first. If you didn’t, the $7,000 MRD amount would be considered an annual contribution to the Roth IRA, not a conversion. (In this example, you’d effectively be making a $93,000 conversion and a $7,000 Roth IRA contribution.)
If you were not eligible to make an annual Roth IRA contribution because your income was too high or because the MRD amount of $7,000 was above the annual Roth IRA contribution limit of $5,500 ($6,500 for those age 50 or older), the $7,000 might be subject to IRS excess contribution penalties, including excise taxes of 6% annually on some or all of the $7,000 contribution until the excess contribution is corrected.
To avoid this situation, take your MRD from your traditional IRA(s) (other than an inherited IRA, which has its own MRD) before converting. If you have already done a conversion in 2013 but didn’t take the MRD, you should speak with your tax adviser.
How does my state tax Roth IRA conversions?
A Roth IRA conversion is a taxable event. If your state has an income tax, the conversion will likely be treated as taxable income by your state, as well as for federal income tax purposes. Because each state’s income tax rules can be different, however, it makes sense to check with a tax adviser before you convert.
We believe that because of the tax-free growth potential and withdrawals, most investors should consider having a Roth IRA as part of their overall retirement plan. But deciding whether to convert isn't necessarily a straightforward decision. That’s why we suggest that you carefully assess your situation and check with a tax adviser to help you make an informed decision.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917