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Roth IRA Rules: Smart Ways to Minimize Taxes on a Conversion

Roth IRA rules can appear limiting on first glance—but you may be able to fund a Roth by rolling over funds from another account.

Articles by Eric Bronnenkant

By Eric Bronnenkant
Head of Tax, Betterment  |  Published: November 15, 2018

Even if you are not able to contribute directly to a Roth IRA because your income is too high, you may be able to rollover funds from a 401(k) or traditional IRA.

Plan ahead to use the times in life where you have a lower income to do the conversion—and minimize your tax bill.

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Say you want to fund a Roth IRA to take advantage of those tax-free withdrawals in retirement, but your income is too high. For 2019, this would be the case if your income is over $137,000 if you’re single and $203,000 if you’re married filing jointly.

The good news: Roth IRA rules allow you to get around this restriction if you convert funds from a traditional IRA to a Roth.

See step-by-step instructions for converting your Traditional IRA to a Roth IRA.

There are no income limits for converting to a Roth, and no limit on the amount you can convert. If your traditional IRA is already at Betterment, the conversion just takes a couple of clicks.

The not-so-good news: In most cases, when you convert funds from a tax-deferred account to a Roth, it’s considered a taxable event, meaning you may owe taxes on some or all of the amount converted.

How can you minimize the tax hit?

One strategy that could enable you to take advantage of a Roth, but not get hit with a super high tax bill, is to do what’s known as a backdoor Roth contribution—the how-to is detailed below—or plan ahead and take advantage of upcoming life or career changes that could nudge you into a lower tax bracket.

Here’s how to make that Roth conversion happen.

Note: Betterment is not a tax advisor, nor should any information in this article be considered tax advice. You should contact a tax professional to discuss your specific situation.

High Earners Go For Roth IRAs

If a Roth account sounds appealing, you’re in good company. Roth IRAs suit many high-income earners because they want a way to help minimize taxes in retirement—and unlike distributions from a traditional IRA, Roth funds are withdrawn tax-free if they meet basic requirements.

Indeed, when the IRS removed the income limit on Roth conversions in 2010, the number of conversions “increased over 800%, to $64.8 billion,” according to a January 2014 IRS report. It was the first time conversions exceeded contributions. And 57% of the conversions were from people with six-figure incomes.

With the income barrier removed, the big question now is the taxes: What’s the best way you can help minimize the amount you have to pay when you convert?

The Backdoor Roth

The so-called backdoor Roth is one way one can avoid a big tax bill when you earn more than the income limit for a Roth.

In that case, if you’re also covered by an employer retirement plan like a 401(k), you likely wouldn’t be able to fund a deductible IRA, because of IRS rules. But you could contribute to a nondeductible IRA, and then convert to a Roth.

When you contribute to a nondeductible IRA, you’re effectively depositing after-tax dollars, so you’d only owe tax on the earnings when you withdraw (or convert). If you convert to the Roth soon after, any earnings, and therefore taxes, are likely to be minimal.

This method is most beneficial tax-wise if you don’t have other deducted IRA funds, including those previously rolled out of a 401(k), SEP IRAs, or Simple IRAs. If you do, then the portion that you convert to the Roth has to be prorated over the total amount you have in all your traditional IRAs, SEP IRAs, and Simple IRAs. This is an important point that often surprises IRA converters at tax time.

As you can see in this Roth conversion example, if you have $15,000 in traditional IRAs for which you’ve received a deduction, and want to deposit $5,000 into a nondeductible IRA and convert it to a Roth, you would divide $5,000 by $20,000 (the total value of all IRAs) to get the amount you can convert tax-free, which is 25%. So you’d owe tax on the other $3,750 based on your current tax bracket.

If you have an employer plan that allows you to “roll in” funds from IRAs, you can avoid the taxes on conversion by first moving any previously deducted IRA balances into your employer plan. You’d do this first, before any conversions.

So to review, execute a backdoor Roth conversion with these three steps:

  1. Minimize pre-tax IRA account balances by rolling them into your employer plan, if possible.
  2. Make a current year traditional IRA contribution, and don’t deduct it on your taxes (also report on Form 8606).
    1. Form 8606 is where after-tax Traditional contributions are tracked and helps determine how much of a conversion or distribution is taxable.
  3. Execute a Roth conversion of the contributed amount

Note: At Betterment, we do not track whether or not you take a deduction on your Traditional IRA contributions. You keep track of this yourself when you file IRS Form 8606 with your tax return.

You aren’t able to open multiple Traditional IRAs to keep pre-tax and post-tax contributions separate, because even if you did, the IRS would view them all as one account anyway, due to the pro-rata rule. The same rule applies across Simple IRAs, SEP IRAs, and even Traditional IRAs held at other providers.

The only way to truly isolate after-tax contributions to a Traditional IRA would be to roll any pre-tax money (which also includes earnings on after-tax contributions) into an employer-sponsored plan, such as a 401(k), 403(b), 457 governmental plan, of Thrift Savings Plan (TSP).

Carpé Career Change

Another way to help minimize taxes is to plan ahead, if you can, when you know that a career or life change is coming that will push you into a lower tax bracket. Then, when you convert from a traditional IRA to a Roth, the tax you’d owe would be based on that lower bracket.

Consider these major life events:

  • Going to graduate school
  • Making a career change that lands you in a lower-paying (but perhaps more rewarding) line of work
  • A planned or unplanned period of unemployment.
  • Starting your own business

In each case, you can and should continue to save in tax-deferred accounts prior to making the conversion. Then, when the life transition is underway, you can strategize about the amounts you plan to convert and when, depending on your new tax bracket.

Bear in mind that the amount you convert is considered income, so you want to make sure that amount doesn’t bump you up into a higher tax bracket. Again, this example is only an illustration; individual specifics could change the numbers.

The greater point is that converting to a Roth may be highly desirable from a tax perspective down the road—so understand the Roth IRA rules and don’t let the tax bill today stand in your way.

Benefits Of A Roth Conversion

  • You generally won’t have to pay taxes when you withdraw money at retirement, as long as you’ve had the account for more than five years and are either over 59½, disabled, or you’re a homebuyer using up to $10,000 on your first home. If you think your tax rate will be the same or higher than your current rate when you withdraw your money, paying taxes now could be beneficial.
  • The tax-free distributions in retirement may help reduce the taxes on other income such as Social Security, and may also reduce Medicare premiums.
  • There are no required minimum distributions after you retire.
  • There are no income limits to converting to a Roth IRA.

Disadvantages Of A Roth Conversion

  • You may have to pay income taxes now on conversion amounts that were previously deducted from your income. Betterment will not withhold these funds for you.
  • The converted amount will be added to your adjusted gross income for the year, and could potentially increase your tax bracket overall.
  • Taxpayers with incomes or an adjustable gross income (AGI) over $200,000 who file individually, or $250,000 for married couples filing jointly, could be subject to a 3.8% tax on income from interest, dividends, annuities, royalties and rents which are not derived in the ordinary course of trade or business. Exceptions apply. You can read more about the tax by clicking here.

Step-By-Step Instructions

We recognize that many investors are interested in this technique, so we’ve created a quick process that allows an investor to authorize a Roth conversion online in less than a minute.

  1. Log in to your account on a web browser.
  2. Click on Settings in the menu on the left-hand side of the page.
  3. Click the Accounts tab at the top of the page.
  4. Find your Traditional IRA and click the 3 dots that appear off to the right.
  5. Choose the option that says “Convert IRA to Roth.”
  6. You’ll have the option to convert either a partial amount or the full amount.

SEP IRA To Roth IRA Conversion

If you’d like to convert your SEP IRA to a Roth IRA, we can help you with that, although there are a few additional steps involved.

  1. First, we will assist you with rolling your SEP IRA contributions into a Traditional IRA. Note that the rollover doesn’t change the type of the contributions you made, it just changes the account they are housed within. To roll your SEP IRA funds into a Traditional IRA, please email us with your request and we will complete the rollover from our end. There is no paperwork required.
  2. Once the funds are in your Traditional IRA, you’ll be able to request the conversion online.
  3. Log in to your account on a web browser.
  4. Click on Settings in the menu on the left-hand side of the page.
  5. Click the Accounts tab at the top of the page.
  6. Find your Traditional IRA and click the 3 dots that appear off to the right.
  7. Choose the option that says “Convert IRA to Roth.”
  8. You’ll have the option to convert either a partial amount or the full amount.

Required Minimum Distributions

If you are 70 ½ or older, you must take your Required Minimum Distribution (RMD) before you can convert your Traditional IRA to a Roth IRA.

The conversion process on our website includes a step to do this. Note that IRS rules allow you to take your total RMD from one or more IRA accounts, including those not held at Betterment. Therefore, you can choose to take your RMD from Betterment or from a different IRA account. The IRS is not kind to people who do not take their RMD on time. There is a 50% penalty on any RMD amount that you didn’t take. However, if you do miss your RMD, there is a potential waiver available in the case of a reasonable error.

Please consult a tax advisor or IRS Publication 590 for additional information related to your specific situation.

Michigan Residents

As a Michigan resident, if you want to convert or withdraw from your IRA, the State of Michigan requires you to fill out Form MI W4P. You must check Box 1 to state that you opt out of state tax withholding.  Return the form to us at support@betterment.com. If you download the free Adobe Reader, you can fill it out and sign it electronically (and easily).

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This article is intended for educational purposes only. The information provided is educational in nature, and is not intended to be relied upon as financial or tax advice. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.

When deciding whether to roll over a retirement account, you should carefully consider your personal situation and preferences. The information on this page is being provided for general informational purposes and is not intended to be an individualized recommendation that you take any particular action.

Factors that you should consider in evaluating a potential rollover include: available investment options, fees and expenses, services, withdrawal penalties, protections from creditors and legal judgments, required minimum distributions, and treatment of employer stock. Before deciding to roll over, you should research the details of your current retirement account and consult tax and other advisors with any questions about your personal situation.

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