If you’ve ever considered converting your traditional Individual Retirement Account into a Roth IRA, you should understand the rules before you proceed. Here is what you need to know:
Affluent investors are eligible for Roth conversions.
For many years, only IRA investors who had modified adjusted gross incomes below $100,000 were eligible to convert. That rule disappeared in 2010, which unleashed a stampede of high-income investors into Roth conversions.
Accounts that you can convert.
If you’re interested in a Roth IRA conversion, you aren’t limited to converting just a traditional IRA. Assets in employer plans such as 401(k)s and 403(b)s are eligible, as are SEP-IRAs and SARSEP IRAs. SIMPLE IRAs can be converted after an account has been open for at least two years.
If your company offers a Roth 401(k) option, you can also convert your traditional 401(k).
Know the required minimum distribution rule.
A huge reason why people like Roth conversions is because Roth IRAs don’t require minimum distributions during an owner’s lifetime. Roth owners only make withdrawals if they wish. In contrast, traditional IRA owners must usually begin tapping into their accounts the year in which they turn 70 ½.
In addition, when Roth investors pull money from their accounts, they won’t pay income taxes on the withdrawals, but owners of other types of IRAs will.
What some people don’t realize is that Roth 401(k)s do require distributions. Investors will generally have to begin pulling money out of their Roth 401(k)s when they turn 70 ½. For those who are still working at that age, you can delay the withdrawals until December 31 of the year you retire.
The price for a conversion
When you complete a Roth conversion, you will pay federal income taxes on the amount you convert. Avoid using money from the converted account to pay the tax. Instead tap cash from a taxable account.
You can change your mind.
If you regret converting a retirement account into a Roth IRA, you can change your mind if you act quickly enough. The funds can be returned to a traditional IRA up to October 15 of the year after the conversion year. This process is called “recharacterization.” You can also recharacterize contributions made to a Roth IRA.
Why you might change your mind.
It can make sense to reverse a Roth conversion if the value of the account has dropped. As mentioned earlier, when you convert a traditional retirement account into a Roth, you must pay taxes on the value of the assets being moved into the tax-free Roth. If months later, the value has plunged, the potential tax bill would have been lower.
Investors might also reverse course if they don’t have enough cash to pay the tax generated by the conversion. In addition, investors may want to reconsider if the conversion would bump them into a higher tax bracket for the year.