Roth Conversions: Everything You Need to Know

| April 06, 2022

Saving for retirement is as important as choosing which accounts you save into.

If you’ve saved a lot of money in a traditional individual retirement account (IRA), 401(k), or 403(b), you might want to consider a Roth conversion.

Depending on your situation, there are a few good reasons you may want to consider making a Roth conversion. For most, the main reasons are managing taxes and avoiding required minimum distributions (RMDs).

What is a Roth Conversion?

Roth conversions are when you move money from a traditional retirement account such as Traditional IRAs, 401(k)s, or 403(b)s into a Roth IRA account.

If the contributions you made to a traditional retirement account were taken out of your paycheck pre-tax, you’d owe income tax on any funds you convert to a Roth account. It’s important to note that a large conversion in a single tax year runs the risk of bumping you into a higher tax bracket.

If you made after-tax contributions to qualified plans offered by employers, you must file an additional form with the IRS, Form 8606. You will need to file Form 8606 for every year you contribute after-tax amounts (non-deductible contributions) to your 401(k) or 403(b), as well as conversions from a traditional IRA, SEP IRA, or SIMPLE IRA. Furthermore, you will need to file the form every year you receive a distribution from your Roth IRA or your traditional IRA if you ever previously contributed after-tax amounts.

With that in mind, you don’t need to convert the entire balance of a traditional retirement account to a Roth account all at once — you can do partial conversions. To minimize the impact on your taxes, consider spreading multiple conversions of a large balance across multiple years.

Can a 401(k) or 403(b) be Converted to a Roth?

Roth conversions aren't just for your traditional IRA accounts. If you still have funds in a former employer's 401(k) or 403(b), you can convert some or all that money to a Roth IRA.

401(k):

A 401(k) Roth conversion is taxed in the same way as an IRA conversion. If you have a distributable event and are eligible to convert, you will incur taxes for converting the pre-tax funds. So, if you don't have non-deductible contributions, you'd pay taxes on the entire converted amount. You can withdraw contributions, but not earnings, from your Roth at any time, no matter what your age is. However, to withdraw earnings from a Roth IRA, you must have held the Roth IRA for at least five years. Withdrawing earnings before age 59½ could incur taxes and a 10% penalty.

403(b):

You can either directly transfer the funds from your 403(b) into a Roth IRA, or you can choose to take a distribution from the account and redeposit the funds in a Roth IRA within 60 days. However, to transfer funds from your 403(b), you must either be over age 59½ to withdraw your retirement funds penalty-free, or you must no longer be working for the sponsoring employer.

Roth vs. Traditional: How to Choose?

The biggest difference between a Roth IRA and a Traditional IRA account is how and when you get a tax break:
- Pre-tax contributions to traditional IRAs are tax-deductible, but withdrawals in retirement are taxable.
- After-tax contributions to a qualified account are non-deductible and distributions must be tracked with IRS Form 8606.
- Contributions to Roth IRAs are not tax-deductible, but the withdrawals in retirement are tax-free.

The difference between a Traditional and a Roth 401(k)/403(b) comes down to when you pay the taxes:
- With a traditional 401(k)/403(b), you make contributions with pre-tax dollars, so you get a tax break upfront, helping lower your current income tax bill.
- With a Roth 401(k)/403(b), you make contributions with after-tax dollars, meaning there's no upfront tax deduction.
- Withdrawals of both contributions and earnings are tax-free at age 59½, as long as you've held the account for five years.

Advantages of a Roth Conversion:

Tax-Free Growth and Withdrawals: Once the conversion tax is paid, there won’t be any more tax due on money inside a Roth account while it compounds, and no tax when you make withdrawals (after clearing the five-year rule and reaching at least 59 ½).

Minimize RMDs: Most retirement accounts – Traditional IRAs, Traditional and Roth 401(k)s, and Traditional and Roth 403(b)s – have RMDs. However, Roth IRAs do not have any RMDs.

Tax Diversification: If all your retirement savings is currently in traditional accounts, shifting some to a Roth account can make it easier to pay for big-ticket expenses without adding to your taxable income.

Is a Roth Conversion Right for You?

A Roth conversion can be a smart way to manage your tax bill in retirement if you currently have most of your savings in traditional retirement accounts. But given that money you convert is reported as taxable income, it requires a careful approach that doesn’t trigger a large tax bill.

Consult with your financial advisor to help you navigate all the moving pieces of a Roth conversion. It’s also a good idea to consult with a tax advisor to discuss the possible tax ramifications of a Roth conversion.

CONTACT US today to schedule a review of your retirement plan and to discuss whether a Roth conversion is a good choice for you.

Sources:

None of the information in this document should be considered as tax advice. You should consult your tax professional for information concerning your individual situation. Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions). Tax services are not offered through, or supervised by, The Lincoln Investment Companies.