How to Maximize Your Roth IRA Conversion Account

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  • A Roth IRA conversion is when you roll some or all of the funds from other retirement accounts — such as traditional IRAs and 401(k)s — into a Roth IRA.
  • Roth IRA conversions can be a useful option if you expect to have a relatively high income during retirement, since a conversion can reduce how much you’ll pay in taxes.
  • The right Roth IRA conversion strategy can help you minimize the taxes you’ll pay on your retirement savings while still allowing you to build wealth for the future.

Saving for retirement is a lifelong process, so it can be tricky to predict exactly which retirement accounts will be right for your situation. As your circumstances change, it may make sense to pivot from one savings plan to another. This is where a Roth IRA conversion may work well for you.

The right Roth IRA conversion strategy can help you minimize the taxes you’ll pay on your retirement savings while still allowing you to build wealth for the future. Learn about the most common Roth IRA conversion accounts and when they might be right for your situation.

What is a Roth IRA?

A Roth IRA is a retirement savings account that’s funded with after-tax income. Contributions to these accounts grow tax-free.

Other retirement accounts, such as traditional IRAs and 401(k)s, are funded with pre-tax income, meaning contributions must be taxed at the time of withdrawal. But with a Roth IRA, you’ve already paid taxes on your contributions. So, withdrawals can be made tax- and penalty-free during retirement, provided the account holder is at least 59½ years of age and the account has been open for at least five years.

Roth IRAs offer certain other advantages as well. Unlike many other retirement plans, Roth IRAs don’t have minimum distributions that you are required to withdraw from the account each year. Also, Roth IRAs may be passed to a beneficiary on a tax-free basis, making them a good option for estate planning.

What is a Roth IRA conversion?

In certain circumstances, it may benefit you to move some or all your money from one type of retirement account — such as a traditional, SIMPLE or SEP IRA or a qualified employer-sponsored retirement plan like a 401(k), 403(b) or 457(b) — into a Roth IRA.

Why might you opt for a Roth IRA conversion? If you expect to have a relatively high income during retirement, a conversion can reduce how much you’ll pay in taxes.

You might also choose a Roth IRA for estate planning purposes. Because Roth IRAs have no required minimum distributions, they can be a good way to allow your savings to continue to grow and be passed on to any beneficiaries. Your beneficiaries can also generally withdraw funds from an inherited Roth IRA tax-free.

But there are a few things to consider.

First, the money you convert to a Roth IRA will generally be considered reportable income. So, be sure that your Roth IRA conversion won’t increase your taxable income so much that you move into a higher tax bracket. Should this happen, you may end up owing more taxes on your Social Security benefits during retirement than you would accrue in savings. A higher tax bracket can also affect the amount you pay for Medicare.

Second, you’ll need to follow the five-year holding rule. The IRS requires you to convert your Roth IRA account at least five years before you plan to use it. Early withdrawal during this five-year period puts you at risk of additional tax penalties.

Third, the IRS considers a Roth IRA conversion to be a taxable event when your original retirement account contains pre-tax contributions. So, it’s a good rule of thumb to avoid a Roth IRA conversion if you will have to dip into your retirement funds to pay the resulting taxes. Furthermore, if you draw from your account to pay conversion taxes during the five-year waiting period or before age 59½, then you’ll also risk a 10% penalty on the withdrawal.

Types of Roth IRA conversion strategies

The conversion process itself is generally simple: You’ll contact the financial institution that holds your current account, complete some paperwork and roll your retirement funds into a new Roth IRA. However, certain situations may warrant an adjustment to your conversion strategy:

  • Bracket-bumping conversion. In some cases, a Roth IRA can provide you with so much reportable income that you’re bumped into a higher tax bracket. With a bracket-bumping conversion strategy, you can avoid this scenario by converting only a portion of your funds to preserve your current tax bracket.

    To achieve a bracket-bumping conversion, calculate the difference between the high end of your tax bracket’s income threshold and your current income. The resulting number is how much you can convert to a Roth IRA without altering your tax bracket.
  • Market-timing Roth conversion. Market downturns can create good opportunities for a conversion, though it may seem counterintuitive to convert to a Roth IRA when the value of your retirement funds has decreased. However, because you will pay taxes on any Roth IRA conversion, waiting for a down market can save you money.
  • Back-door Roth conversion. Roth IRAs have income limits that may prevent big earners from opening or contributing to an account. You can find current contribution limits on the IRS website. High-income earners may be able to bypass these restrictions via a back-door Roth conversion strategy. You’ll first contribute to a traditional IRA with pre-tax dollars. Then, when the time is right, you’ll convert some or all of those funds into a Roth IRA. Upon conversion, you’ll owe taxes, but only on your pre-tax contributions and earnings.
  • SEP IRA to Roth conversion. If you’re self-employed or a small business owner, you may have a special type of retirement plan called a SEP IRA. Just like other retirement accounts, SEP IRAs can be converted into Roth IRAs, but keep in mind that any pre-tax contributions you make will be taxed upon conversion.

If you determine that a Roth IRA conversion fits with your retirement goals, one of these strategies may help you secure a brighter financial future. Just remember that Roth IRA conversions can trigger significant tax consequences. If necessary, engage a tax professional or financial advisor to help you run the numbers before you commit.

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