Roth IRA Conversion Rules

January 30, 2022 · 7 minute read

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Roth IRA Conversion Rules

Individuals choosing a retirement plan have several options: a 401(k), an Individual Retirement Account (IRA), or Roth IRA.

While a 401(k) is typically offered by an employer, the IRA options allow for more user control and personalization when it comes to investing.

There are important differences for investors to know between a traditional IRA and a Roth IRA, especially when it comes to converting from the former to the latter.

Here are some things to know potential tax implications, who it may be right for, and when it may be a good time to convert investments in a traditional IRA to a Roth IRA.

Understanding Roth IRAs

A Roth IRA is a type of account that allows someone to save money specifically for retirement. The account allows people to invest in a number of assets at once and comes with its own specific tax benefits.

Anyone can open a Roth IRA at various financial institutions, at any age and at any time, and they do not need it to be employer-sponsored (as with some 401(k) plans). The Roth IRA was formed in 1997 and named after William Roth, a former Delaware Senator who sponsored the legislation that created the retirement plan option.

As of 2022, individuals can invest as much as $6,000 a year into a Roth IRA. Those over the age of 50 are allowed to put in a bit more, up to $7,000, which is known as a catch-up contribution to help people secure more funds before reaching retirement age.

Unlike an employer-sponsored 401k, an individual can invest in a Roth IRA using after-tax income. This means the contributions to a Roth IRA are not tax-deductible, however, utilizing a Roth IRA comes with its own tax benefits.

Benefits of a Roth IRA over a Traditional IRA

Because a person contributes after-tax money to a Roth IRA, they are typically able to withdraw the funds without paying taxes or a penalty fee (usually at 10%). However, those who withdraw money from an account that is fewer than five years old, or are withdrawing funds prior to the age of 59 ½, can still incur a small penalty.

There are a few circumstances where Roth IRA owners can withdraw cash without a penalty. As long an account has been open—and the person has actively made contributions for at least five years—people can normally take out up to $10,000 to pay for buying, building, or rebuilding their first home.

Roth IRA owners can also withdraw money if they live with a disability and need some of the funds immediately or for continued use, and heirs to an estate can withdraw money if the owner of the Roth IRA dies.

Users of a Roth IRA can take out money for other reasons, though they may have to pay income taxes if they withdraw earnings. Those reasons include withdrawing money for medical expenses that exceed 7.5% of their adjusted gross income or withdrawing money to pay for medical insurance premiums while unemployed.

It’s always a good idea to discuss IRA taxes with a tax professional.

What is a Roth IRA Conversion?

A person may already have the aforementioned traditional IRA and want to convert it into a Roth IRA instead for tax purposes (which we’ll get into in a second). Deciding to convert a traditional IRA to a Roth IRA comes down to a few factors, all of which are personal to each individual investor, making it important to weigh the pros and cons and to discuss any decision with a financial advisor.

That said, to convert into a Roth IRA a person must first put money into a traditional IRA account. If you don’t already have one you will need to open one and put funds in it.

Next, a person must pay taxes on their IRA contributions as well as on gains. That is because, again, only post-tax contributions are allowed in a Roth IRA. Then a person can convert the account to a Roth IRA. This will mean opening a new account during the conversion with a Roth IRA provider.

This IRA rollover can happen a few ways: via an indirect rollover, where the owner of the account receives a distribution from a traditional IRA and can then contribute it to a Roth IRA within 60 days; a trustee-to-trustee, or direct rollover, where an account owner tells the financial institution currently holding the traditional IRA assets to transfer an amount directly to the trustee of a new Roth IRA account at a different financial institution; and a same trustee transfer, used when a traditional IRA is housed in the same financial institution of the new Roth IRA. The owner of the account alerts the institution to transfer an amount from the traditional IRA to the Roth IRA.

What Are the Advantages of Converting to a Roth IRA?

One of the biggest advantages to a Roth IRA may be the ability to withdraw tax-free funds in retirement. Because remember, with a Roth IRA all contributions are already taxed, meaning the money in retirement is fair game. The only thing a person will have to pay taxes on is the money the investments earned (along with any contributions a person originally deducted on their taxes).

A Roth IRA also allows users to invest for a longer period of time. A traditional IRA forces users to take out the required minimum distributions every year after the age of 72 ( or at the age 70½ if the person reached the age 70½ before 2020 ). This means a person must withdraw funds even if they do not need them. However, a Roth IRA has no required minimum distributions so the money can stay right in the account—and continue to grow—until it’s actually needed. This could help someone increase their wealth for an even longer period of time before having to pull from and live off of retirement funds.

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When Would Someone Convert to a Roth IRA?

Timing a conversion can be tricky, and again it’s important to discuss all plans and potentials with a personal advisor who can go over individual risk factors vs. benefits to help people make a decision for themselves. But, in general, there are times that may be more opportune than others to convert.

Those times typically include attempting to convert early in the tax year to give a person more time to pay any applicable taxes on the conversion. More opportune times to look into a Traditional IRA to a Roth IRA conversion also include during any personal economic downturns. Usually, this includes If a person falls into a lower tax rate than normal by switching jobs or experiencing a lengthy unemployment period.

During both of these situations, a person may be able to avoid higher tax penalties on conversion due to finding themselves in a lower-tiered tax bracket. This also applies to when a traditional IRA account balance is down. If the larger market takes a downturn and a personal IRA also takes a hit, it may be a good time to convert to again avoid high tax fees.

What Are the Downsides to Converting to a Roth IRA?

A Roth IRA conversion may not be the best fit for everyone such as those who are nearing retirement, as it’s likely they will have to pay taxes on the funds while converting. Again, think about the future, discuss options with a financial advisor, and consider converting when potential tax implications are low.

The Takeaway

A Roth IRA conversion may help individuals save on taxes. It can help you have tax-free withdrawals in retirement. However, the timing of your conversion may be important.

If you’re ready to take your retirement financial knowledge to the next level it’s time to speak to a specialist. Opening a SoFi Invest® account allows users access to a team of credentialed financial advisors.

With the help of SoFi financial advisors, you can determine your financial goals and establish a plan to help you get to where you want to be today, tomorrow, and far into the future.

Ready to start saving for retirement? See how SoFi retirement investment account can help you meet those retirement goals.

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