08/30/2021
Common Roth IRA Questions...
It has become clear through emails from readers that lots of people have questions â not just about the decision making process, but about the rules themselves. So what follows is a brief FAQ about the rules surrounding Roth conversions.
đIs there an income limit for Roth conversions?
No. There used to be a limit. (Prior to 2010, you could not do a Roth conversion if your modified adjusted gross income exceeded 100,000.) But there is no longer an income limit.
đIs there an income requirement for a Roth conversion?
No. While you (or your spouse) must have earned income in order to make a Roth IRA contribution, you do not have to have any earned income in order to do a Roth conversion.
đIs there a maximum amount you can convert per year?
No. There is no maximum conversion â other than the fact that you canât convert more than you have in tax-deferred accounts.
Can you do a partial conversion, or do you have to convert the whole account at once?
You can do a partial conversion of a traditional IRA. For example, converting 20,000 of a 100,000 account is perfectly allowed.
And in most cases in which conversions make sense, doing partial conversions over a period of years is in fact whatâs most desirable â converting only enough to put your income up to a particular threshold each year, rather then converting the whole account at once. Converting the whole account at once would often mean paying a high tax rate on the conversion, as it would mean having a very high level of income that year. (Of course, this depends on the size of the account.)
Note that the same is true for a 401(k). If your 401(k) allows for in-plan conversions, you can do a partial conversion to Roth 401(k).
đHow is a Roth conversion (from a traditional IRA) taxed?
Generally, a Roth conversion will be taxable as ordinary income.
If, however, you have made nondeductible contributions, a portion of the conversion will not be taxable. Specifically, the percentage of the conversion that is not taxable is calculated as:
Your basis in traditional IRAs, divided by
The sum of your traditional IRA balances on 12/31 of the year of the conversion and any distributions and conversions from traditional IRAs that occurred that year.
Your basis in traditional IRAs is the sum of your nondeductible contributions, minus any portions of those amounts that have been distributed or converted.
For example, if you have made 20,000 of nondeductible contributions over the years (and none of those amounts have been distributed or converted), you have 20,000 of basis in your traditional IRAs. If you do a 100,000 conversion, and at the end of the year your traditional IRAs are in total worth 400,000, then 4% of your 100,000 conversion would be nontaxable.
That is, 20,000 (basis in traditional IRAs) divided by 500,000 (i.e., the sum of the conversions/distributions for the year and the sum of your traditional IRA balances at the end of the year) equals 4%. So you would have 96,000 of gross income as a result of the 100,000 conversion.
Something that surprises many people is that if, for example, you do a Roth conversion in March and then in November of the same year you roll a 401(k) into a traditional IRA, that rollover is going to affect the portion of the conversion thatâs taxable (because it will increase your traditional IRA balance on 12/31 of that year).
Another key point here is that all of your traditional IRAs (including SEP and SIMPLE IRAs) are considered to be a single IRA for the purpose of this calculation.
đHow is an in-plan Roth conversion (e.g., a conversion within a 401(k)) taxed?
As with a conversion of a traditional IRA, the conversion will generally be taxable. Also similarly, if you have made nondeductible, non-Roth (i.e., âafter-taxâ) contributions to the plan, a portion of the conversion will be nontaxable. And again, itâs a pro-rata calculation.
However for this calculation, unlike with IRAs, the 401(k) is not aggregated with other 401(k) plans.
Also, if the plan separately accounts for the after-tax contributions and their earnings, then itâs possible to largely avoid the pro-rata rule, because you can have just those amounts (i.e., the after-tax contributions and their earnings) converted. In such a case you would only have to pay tax on the earnings on the after-tax contributions.
đCan a Roth conversion trigger the 10% penalty?
If you are under age 59.5, any money that comes out of the traditional IRA and does not end up going into the Roth IRA may be subject to the 10% penalty. For instance, if you take 100,000 out of your traditional IRA, 75,000 goes into your Roth IRA, and 25,000 is withheld to pay the tax on the conversion/distribution, the 25,000 would be subject to the 10% penalty if youâre under age 59.5 and donât meet one of the other exceptions to the penalty.
đWhen is a Roth conversion taxed?
A Roth conversion is taxable in the year in which it occurs. That is, conversions work on a calendar-year basis. Thereâs no âIâm doing this in March of 2022, and I want it to count for 2021â option as there is for contributions to an IRA.
đHow are distributions from a Roth IRA treated, after a conversion?
When amounts that were converted to a Roth IRA are distributed from the Roth IRA, they will not be subject to ordinary income tax. They might be subject to a 10% penalty. But that penalty will not apply if youâre at least age 59.5, or if the conversion was at least 5 years ago, if the conversion itself wasnât taxable, or if one of several other exceptions applies.
Can I recharacterize (undo) a Roth conversion?
No. As a result of a change made by the Tax Cuts and Jobs Act of 2017, you can no longer recharacterize a Roth conversion.
đCan I do a Roth conversion of an inherited IRA?
No â unless you inherited it from your spouse, in which case youâre allowed to treat the account as your own, which allows you to do a conversion into your own Roth IRA.
đDoes a Roth conversion satisfy my RMD for the year?
No. If you have to take a required minimum distribution (RMD) in a given year, a Roth conversion does not count toward that RMD.
