When does converting to a Roth IRA make sense?

Reviewed: December 17, 2014
By FinanceWeb

A Roth IRA offers advantages not present in traditional IRA’s and other retirement arrangements. Some important advantages include lifetime contributions, tax-free distributions, and tax-free benefits to heirs. Another advantage is the conversion privilege in which individuals can move funds from other retirement arrangements into a Roth plan.

Conversion Decision Factors

Taxes are at the core of the decision to convert a 401(k) or a traditional IRA to a Roth Plan. The Roth advantage is the very desirable condition of tax-free income in retirement. The traditional and employer-sponsored plans offer tax deferral at the contribution stage and taxation at income rates in the distribution stages. Roth offers greater flexibility in investing and investment strategy because it does not end at age 70; contributions can continue for a lifetime. The no Required Mandatory Distribution feature of the Roth plan is an often overlooked tool to ensure that resources last for a lifetime. While other plans force distributions by age 70, the Roth plan does not, and it can continue to grow as long as one wishes. The amount of taxes due on the conversion can determine the extent of benefits.

Transferring Funds to a Roth Plan

The IRS imposes penalties for early withdrawal of retirement funds. To avoid the early withdrawal tax and penalty, one must complete the transaction on time. The transfers are simple; there is a 60-day rule to withdraw and deposit the funds. There are three useful ways to proceed. First is a direct withdrawal and payment to self, followed by a deposit of the funds in a Roth account. If done within sixty days, there should be no penalty. Second, request a transfer from the trustee holding the funds to the trustee of the Roth Account. Third, simply open a Roth Account with the trustee holding the IRA funds, and direct the funds to the new account.

Convertible Accounts

As a general matter, many accounts are convertible. Beyond a traditional IRA, there are other tax-deferred retirement plans that can also be converted to a Roth IRA. They include Simple IRA, SEP IRA, section 457(b) plan, 403(b) plan, and designated Roth Accounts (including 401(k), 403(b), or 457(b)). The rule is that all conversions are subject to taxation in the year of the conversion except for the Designated Roth Accounts. The IRS defines a designated Roth account as a separate account in a 401(k), 403(b) or governmental 457(b) plan that holds designated, already taxed, Roth contributions.

Tax Consequences of Conversion

The IRS removed the older income restrictions for conversion to Roth plans. While there are no income rules for conversion of retirement accounts into a Roth Plan, there are tax consequences; all tax deferred funds will be taxed as income in the year converted. It is important to note that one cannot convert Required Mandatory Distributions into a Roth IRA. The IRS applies a pro-rata rule to conversions when determining taxable amounts. They use the overall proportion of taxed versus tax-deferred contributions to determine the taxable percentage. Based on the individual tax bracket, the pro rata percentage determines the taxable amount due upon conversion.

Is Conversion Advantageous?

The ultimate question about a Roth Plan conversion is whether it pays to do so. The tax amount can be substantial, and one must ask whether a future tax rate would be lower than the time of conversion. If one has a low tax rate year, then that could be the best time to do the conversion. Taxpayers should seek expert advice when considering conversions to ensure their calculations meet current IRS rulings. Many experts advise that if one cannot pay the taxes from other funds, then one misses the purposes of conversion. Their view is that if one has to pay from earnings accumulated in the converted accounts, then one does not gain by the conversion. The investment goals are important. For example, if the benefit to heirs is a high priority, then conversion offers am excellent tool for tax-free money to heirs.