The Complete Guide to Roth IRA and Roth 401(k) Conversions

We all feel that there must be a catch when something comes just a bit too easily. When it comes to Roth conversions, quite ironically, it’s Congress and the IRS that gave us the ability to complete one in just a few simple steps. Too good to be true?

While the process was created with the best of intentions, doing a Roth conversion without understanding all the nuances and implications can be a recipe for disaster. Roth IRAs (Individual Retirement Accounts) hit their quarter-century birthday this year and its much lesser-known brother—the Roth 401(k)— just turned a sweet 16. Using these powerful investment tools, we pay taxes on our contributions now in exchange for vast tax savings in the future.

What is a Roth Conversion?

A Roth conversion is the process of moving existing assets from a Traditional IRA or qualified employer-sponsored retirement plan (QRP)—such as a 401(k), 403(b), or 457(b)—to either a Roth 401(k) or a Roth IRA . Simplified employee pension (SEP) and SIMPLE IRAs may also be converted to Roth IRAs. And if you don’t want to take the required distributions of a Roth 401(k), converting the funds to a Roth IRA can give you that freedom.

Repositioning your assets from a traditional 401(k) to a Roth 401(k) is also called an In-Plan Roth Rollover.

What is the Principal Difference Between Roth and Traditional Accounts?

The most obvious difference between Roth and traditional accounts is that Roth accounts are funded with after-tax dollars. Traditional IRA and 401(k) accounts are funded with pre-tax dollars. The latter reduces adjusted gross income (AGI) and the tax bill associated with it during the contribution year.

While their benefits aren’t immediately felt, Roth IRAs and Roth 401(k)s have several distinct advantages over their traditional counterparts. For those who can wait for their tax benefits to be realized later, the advantage of having tax-free withdrawals during retirement can be substantial.

Factors to Consider with Roth Conversions – IRAs

Understanding the Internal Revenue Service (IRS) rules, legislative requirements, and the timing and thresholds associated with IRAs and 401(k)s is necessary in order to make educated Roth conversion decisions. And like anything in life, these guidelines are subject to change.

When made before the age of 59 ½, withdrawals are prohibited for five years following a Roth conversion. If a withdrawal is made within that timeframe, it is subject to a 50% excise tax penalty and the withdrawn earnings are taxed . Penalty exceptions are made for first time home buyers, those who become disabled, and when the original account owner dies.

Tip: The 5-year withdrawal rule applies if IRA account funds are used to pay the taxes owed at the time of a Roth conversion. When possible, use outside funds to pay for the taxes to avoid incurring the penalty.

You’ll need to complete Roth conversions by December 31, 2022 to use it for the 2022 tax year. Contact your investment advisor early  since paperwork can get backlogged in November and December. It is also important to remember that estimated tax payments may be required  and late payment penalties can be assessed if the payment isn’t timely.

Financial institutions issue IRS information return Form 1099-R for Roth Conversions. The contributions to the Roth are also reported on Form 5498 by the financial institution holding the account.

IRAs and Roth IRAs – What They Have in Common

IRAs are set up by individuals rather than being employer-based like a 401(k) plan.

• Contributions for the prior year can be made through Tax Day (April 15) of the current year.
• The standard contribution limit is $6,000 for taxpayers under 50, $7,000 for taxpayers 50 and older. The difference is a catch-up contribution to allow those nearer retirement to contribute more money to their IRA. These amounts are indexed for inflation. Note: The IRA contribution limit does not apply to rollover contributions.
• IRA investments can be utilized at any age as long as the individual making the contribution has earned income  equal to or greater than the contribution amount. Grandma, a parent, or anyone can fund an IRA on behalf of an individual when the collective amount doesn’t exceed that individuals earned income, as a result it can be an effective way to gift money to children and grandchildren that have reached working age.
• Inheritance – While Roth IRA owners don’t need to take required minimum distributions (RMDs), those who inherit Roth IRAs follow the same provisions as traditional IRAs.
  • If the original owner had started their distributions and the spouse is the sole beneficiary, they are required to take their distributions within five years or over their lifetime.
  • Spouse and non-spouse heirs of IRAs generally, must withdraw all the funds within 10 years of the original owner’s death, although there are some exceptions, for example, minors that inherit IRAs must withdraw all funds within 10 years of their 18^th birthday.

IRAs and Roth IRAs – The Differences

As mentioned, generally, IRAs are taxed upon withdrawal including both contributions and earnings. In the contribution year, deposits are generally deducted from the Adjusted Gross Income (AGI) on income tax returns. Roth IRAs are not deductible.

Tip: Considerable attention should be paid to the effect of an increased AGI with Roth conversions and contributions. AGI is used with several government programs such as Medicare, the Affordable Care Act (ACA), and College Financial Aid and having a higher AGI may affect your eligibility with these programs or their health care premium amounts. Medicare has a 2-year ‘look back’ period in determining premiums. Completing your Roth conversion at least two years prior to your Medicare enrollment may be beneficial.

• Contribution Limits: Both IRAs and Roth IRAs have contribution limits.
  • IRA contribution limits are equal to earned income with the deduction phasing out at $68,000 and eliminated at $78,000 for single filers and at $109,000 and $129,000 respectively for joint filers. Non-deductible contributions above these amounts are reported on IRS Form 8606.
  • Roth IRA contributions limits are imposed based on modified AGI and are phased out starting at $129,000 and eliminated at $144,000 for single filers and at $204,000 and $214,000 respectively for joint filers.
• Withdrawal Distributions: This is a significant win for Roth IRAs.
  • IRAs have required minimum distributions (RMD) mandating that the account owner begin the distributions at age 72 whether they are needed or not. If not taken or an insufficient amount is distributed, a 50% excise tax may be imposed on the amount not distributed as required. Also be aware of the April 1 and December 31 distribution due dates.
  • Roth IRAs have no RMD until after the death of the owner, so the money can compound longer if it is not needed.
  • Money in an IRA grows tax-deferred, and withdrawals are taxed as ordinary income when withdrawn after age 59 ½. Roth IRA monies grow tax-free. Tax- and penalty-free withdrawals can be made after 59 ½.

Note: If you are required to take an RMD in the year you convert to a Roth IRA, it must be done before converting to a Roth IRA. RMD amounts are not eligible to convert to a Roth IRA.

• • Early withdrawals before 59 ½ are permitted from principal without penalty from Roth IRA accounts, while IRA withdrawals are subject to both tax and a 10% penalty. Withdrawals before 59 ½ of investment income from a Roth IRA is also be taxed and has a 10% penalty.

Factors to Consider with Roth Conversions – 401(k)s

Employer-sponsored Roth 401(k) plans are a hybrid of Roth IRAs and traditional 401(k) plans, borrowing features from each.

Tip: Regardless of which 401(k) plan you participate in, if your employer provides a matching contribution as a benefit to you, contribute at least the amount needed to receive the match and know your vesting period.

Vesting is your ownership stake in the matched funds. Matched contributions are often vested over a certain number of years—with the trend moving toward shorter periods or no vesting period at all.

If you separate from the company before you are 100% vested, only the portion of the accumulated funds you are vested in are distributed to you.

• Contribution Limits:
  • There is no income limitation to participate in a Roth 401(k).
  • The maximum amount of income that can be considered when computing a contribution to a 401(k) plan is $305,000 in 2022. Employees may contribute to the plan until the annual deferral limit is reached. Employer matching contributions must follow the plan formula (e.g., a 5% match) with the combined total employee and employer contributions not exceeding the match limit correlating to $305,000.
  • Total employer and employer contributions are capped at the lesser of $61,000 or 100% of the employee’s compensation.
  • Employers who match employee contributions in 401(k) plans are required to provide the same benefit for Roth 401(k) plans.
  • Contributions must be processed by December 31.
  • The 2022 maximum contribution across all 401(k) and Roth 401(k) accounts is $20,500 for individuals under 50. Those 50 and over are eligible for catch-up contributions for a total of $27,000.
• Withdrawal Distributions:
  • For a Roth 401(k), employer contributions from matching programs are technically held in a traditional 401(k). It would then be taxed upon conversion.
  • Rolling a Roth 401(k) into a Roth IRA doesn’t require withholding. If it is moved directly into the new account it can be completed without any tax liability.
  • Roth 401(k) and 401(k) accounts both have RMDs. You must start taking money out at 72 unless they are still working or are not a 5% owner in the company sponsoring the plan.
  • If you have reached age 72, some plans may still require that you begin distributions even if you have not retired. Read the fine print.
  • The penalty for not taking RMD or if an insufficient amount is not distributed is a 50% excise tax imposed on the amount not distributed as required.
  • When funds are withdrawn from a Roth 401(k) before the age of 59 ½—whether leaving the company or taking an in-service distribution—you must take out the proportional grown which may be subject to tax and withdrawal penalties.

What Situations Benefit from Roth Conversions?

Every situation should be evaluated individually considering its fact pattern and the individuals involved, as well as contraindications such as ability to pay the tax at conversion and various withdrawal rules. Below are some scenarios where a Roth conversion is often beneficial.

Note: A conversion to a Roth 401(k) plan is only available when a Roth 401(k) plan is offered by an employer. They are now commonplace and according to the Plan Sponsor Council of America, they are available in 86% of employer-sponsored plans.

If a Roth 401(k) plan isn’t available to you, explore the option of opening and converting your funds into a Roth IRA.

• If you expect to be in a higher tax bracket at retirement due to your increased earnings, paying the taxes for a Roth conversion now can make sense.
• Given the economic climate, if you feel your tax rate may increase in the future, consideration should be given to converting before that occurs.
• If you feel the value of your IRA investments is hitting a low point, the timing may be optimal for converting to a Roth IRA.
• If you live in a low- or no-income tax state and plan to move to a state with much higher income taxes, completing a Roth conversion before the move can provide substantial savings. When optimally timed, you could avoid paying taxes on conversion in your original state and avoid income taxes on withdrawal in your new state.
• If your income is temporarily lower due to reduced work hours or a sabbatical, you may slide into a lower income tax bracket than normal and it could be a good time to convert to a Roth account while your rate is tax rate is lower.
• If you’re nearing retirement with a substantial 401(k) or Roth 401(k) balance and won’t need the mandatory withdrawals at age 72, consider converting to Roth IRA where withdrawals aren’t mandated.
• If you have funds in a traditional IRA and would like to leave non-spouse heirs tax-free income, converting to a Roth IRA can offer them more flexibility. Traditional IRAs under the SECURE Act of 2019 requires that they withdraw all funds within 10 years.
• When budgets permit, an earner in their early years can greatly increase their total gain by converting to a Roth IRA as soon as possible to allow the greatest amount of time for compounding.

Conversion Strategies

While it may be eliminated by Congress in the future, a process known as a backdoor Roth IRA conversion can be done when an individual earns too much to qualify for a Roth IRA. A contribution is made to a traditional IRA first then transferred to a Roth IRA. This accomplishes the goal of having tax-free income while complying with IRS regulations.

The dollar amount converted is taxed as ordinary income, which could push you into a higher marginal federal income tax bracket. Financial modeling can be done to plan for converting the funds to your Roth account over a few years to minimize your tax liability, potentially saving you the marginal difference.

Note: Congress is considering moving the RMD age to 75. If this update is granted, investors will have additional opportunity to convert to a Roth IRA.

The impact of a Roth conversion can offset if you have other losses or deductions that can reduce the tax due on conversion.

Converting from a Roth 401(k) to a Roth IRA relieves the burden of having to take distributions at age 72 if they aren’t needed or desired.

Conversion Steps

The process of completing a Roth conversion is simple, making it all too easy for a misstep to occur if you don’t consider all the nuances of the transaction.

1. Open a Roth IRA or use an existing Roth IRA account.
2. Contact the plan administrators for both the old and new financial institutions to find out what is needed.
3. Submit the completed paperwork to indicate which assets are being converted. Processing the request may take a couple weeks.
4. Once complete, file IRS Form 8606 to report the conversion of an IRA to a Roth IRA and make any necessary tax payment.

Converting from a traditional 401(k) to a Roth 401(k) may be restricted by to an employer’s Open Enrollment period unless a qualified life event has occurred.

Predicting the Future

Making investment decisions is a challenging activity for anyone to undertake. Despite years of business experience, successful planning, and a nest egg that would make anyone proud, your sharpest colleagues can be hindered by the great number of choices and considerations needed when planning Roth conversions.

Sophisticated financial modeling and expertise is often necessary to understand the impact of tax regulations, market volatility, and the tradeoffs for each scenario. Contribution amounts, withdrawals and most importantly—timing—must all be considered while maintaining a goal of tax minimization.

The complexities of Roth conversions go far beyond being able to afford the immediate tax bill of the transaction. At Clayton & McKervey we work to ensure you’re well equipped to make confident decisions for you and your family.

Continue the Conversation

Clayton & McKervey’s Private Client Services team looks forward to discussing your Roth conversion options with you. We’ll help you understand the available options, the tax consequences of converting, and the impact to your AGI so you can get back to your business at hand. Contact us today to learn more.