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Roth IRA Conversion: A Step-by-Step Guide

By Matthew Frankel, CFP® - Updated Sep 2, 2020 at 11:42AM

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If you're considering converting a traditional IRA or 401(k) to a Roth IRA, here's what you need to know.

Anyone can convert a traditional IRA account or eligible 401(k) to a Roth IRA. Certain rules governing Roth IRAs are different from traditional IRA rules, such as RMD requirements, IRA tax rules, and the ability to withdraw Roth contributions early. Before you convert, here's what you need to know.

Person crunching numbers on a laptop.

Image source: Getty Images.

Step One: Decide if converting to a Roth IRA is the best move for you

This is the most important step -- making an informed decision on the type of retirement account you should use. There are several good reasons you may want to convert to a Roth IRA:

  • A Roth IRA gives you tax-free retirement income. You won't get an immediate tax break for Roth contributions, but qualified withdrawals will be completely tax-free, even if your investments do incredibly well and your account balloons to millions of dollars in value.
  • You are free to withdraw your Roth IRA contributions, but not your investment gains, at any time, and for any reason. In other words, the money you contribute to a Roth IRA isn't as "tied up" until retirement as traditional IRA contributions are.
  • Roth IRAs have no required minimum distributions. Traditional IRAs and 401(k)s require the account holder to start withdrawing their money by age 70 1/2, but Roth IRAs do not.
  • You can contribute to a Roth IRA for as long as you have earned income. Traditional IRAs stop allowing new contributions after age 70 1/2.
  • Roth IRAs can be valuable estate planning tools. You can set up tax-free income for your heirs that can be stretched over their entire lifetime.

Step Two: Do some tax planning

The major drawback of a Roth IRA conversion is generally the hefty tax bill that comes with it.

Traditional IRA contributions are typically made on a pre-tax basis, which means that they are eligible for a tax deduction in the year in which they were made. On the other hand, Roth contributions are made on an after-tax basis, with the benefit that future withdrawals will be 100% tax-free.

Therefore, to convert from a traditional IRA to a Roth, you'll need to pay taxes on the entire amount of the conversion, unless you had any non-deductible traditional IRA contributions (not common).

When it comes to paying taxes on a Roth conversion, you have two options. You can choose to pay the taxes out of pocket, which is preferable since it allows the entire amount of the conversion to transfer, and therefore maximizes the tax benefits of your new Roth IRA. However, this is obviously not practical for everyone.

Alternatively, you can choose to have the taxes withheld from the traditional IRA at the time of the conversion. Theoretically, even though this results in a smaller balance in the new Roth IRA, you're not losing any money by doing this. You're simply exchanging a larger amount of money that will eventually be subject to tax for a smaller amount of money that won't. However, be aware that doing it this way may result in a 10% IRA early withdrawal penalty on the money you used to pay taxes on the conversion.

Finally, it's important to mention that if you haven't yet received a tax break on your traditional IRA contributions, this discussion doesn't apply to you. For example, if your income is above the current Roth IRA income limits, you can't contribute directly to a Roth IRA. However, you can contribute to a traditional IRA and then convert to a Roth, a process known as the backdoor method. If the conversion takes place before a tax deduction was taken for the traditional IRA contribution, no additional tax will be due.

Step Three: Fill out the paperwork

This is the easy part. Once you've decided that a Roth IRA is right for you, and have planned for the tax implications, converting a traditional IRA to a Roth typically involves simply filling out a short form.

Here's how the process works. First, if you don't already have one, open a Roth IRA through your brokerage of choice. You can check out The Motley Fool's IRA Center to compare some of the major brokers and the various fees and features of each.

Then, fill out an IRA rollover form, which should be readily available from the brokerage with whom you opened the Roth IRA, and request a rollover or transfer of the IRA's assets. It's also worth noting that you can convert a 401(k) account from a former employer into a Roth IRA with the same process.

The bottom line on Roth IRA conversions

The most important part of a Roth IRA conversion is weighing the pros and cons and deciding if it's the smartest move for you. As we've seen, there are some clear benefits to investing for retirement with a Roth IRA, but there can also be some pretty big tax implications to consider. Once you determine the conversion is the right move and plan for the tax hit, the conversion itself is pretty easy.

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