Rules for Roth IRA conversions 

A Roth IRA can be an excellent vehicle in which to keep your retirement savings. The fact that your client can enjoy tax-free earnings in the account and leave tax-free money to their heirs is hugely beneficial. Other benefits include not having to take Required Minimum Contributions (RMDs) like in a traditional IRA, so the money in a Roth IRA can be left to earn and grow. Plus, thanks to its tax-free nature, a Roth IRA can be very flexible in providing retirement income.  

But what if your client has other retirement plans or accounts? Well, there’s good news for them too – other non-Roth accounts like the 401(k) and the traditional IRA can be converted into a Roth IRA.  

Converting to a Roth IRA has its benefits, but investors and advisers should be wary of the taxes on contributions to a Roth, income limits and other restrictions. To leverage the Roth IRA conversion well, we discuss the rules on Roth IRA conversions.  

Guidelines for Roth IRA conversions 

A Roth IRA conversion takes money from a traditional IRA or an employer-sponsored retirement plan (like the 401(k)) into a Roth IRA. Making a Roth IRA conversion is ideal for clients who want to:  

• enjoy tax-free investment earnings 
• lower their taxable income in retirement  
• not have to bother with any required minimum distributions 
• leave a tax-free inheritance to their heirs 

But when doing a Roth IRA conversion, certain rules must be followed. To comply with them, the conversion has to be performed in one of these main methods: 

1. Direct/Trustee-to-Trustee Rollover: The financial institution (the trustee) handling the traditional IRA is instructed to transfer an amount directly to the trustee of the Roth IRA at a different financial institution. 

2. Indirect Rollover: Here, the account owner receives a distribution from their traditional IRA, then contributes it to a Roth IRA within a 60-day period.  

3. Same Trustee Transfer: In this case, the traditional and Roth IRAs are handled by the same financial institution (the trustee). The owner of both accounts simply instructs the trustee to transfer an amount from the traditional IRA to the Roth IRA.  

The 5-year rule for Roth IRA conversions 

Roth IRAs are subject to a five-year rule stipulating that account owners cannot withdraw earnings unless it has been five years since they last contributed to the Roth IRA. However, the five-year rule for Roth IRA conversions is different. Each conversion has its own five-year holding period.  

So, if the account owner withdraws funds before the five years are up, they will have to pay a 10% early withdrawal penalty. Moreover, the early withdrawals may also incur income taxes for the tax year they were withdrawn.  

Note also that the five-year period is counted based on tax years. For instance, even though a conversion was made at any time in the year 2024, it is considered to have been done on January 1, 2024. 

Read more: Understanding the 5-Year Rule for Roth conversions   

What accounts may be converted to a Roth IRA? 

There are several types of retirement plans that can be converted into a Roth IRA, including: 

• 401(k)s 
• 403(b)s 
• 457(b)s 
• Traditional IRAs 
• SEP IRAs 
• SIMPLE IRAs 

In addition, almost any type of distribution can be rolled into a Roth IRA. The only exceptions are RMDs and hardship distributions. 

When would you recommend converting to a Roth IRA? 

Having or converting to a Roth IRA offers many advantages. These are the more common situations when converting to a Roth IRA would make sense:  

1. Your client’s earnings are too high. A client with a large income can place them beyond the limits set by the IRS for contributions. Converting to a Roth IRA lets them bypass the restrictions – this strategy is known as the Backdoor Roth IRA.  

2. Your client thinks they’ll be paying higher taxes by the time they retire. If your client believes that they’ll be in a higher tax bracket when they retire, then it would be more beneficial to convert to a Roth IRA. Situations where they think they might be put in a higher tax bracket include: 

• Moving to another state when they retire. For example, you have a client who is a Texas resident, but will move to California when they retire. A good strategy would be for them to convert their traditional IRA when they move to California and avoid the taxes on their withdrawals. The state of California typically taxes IRA income but not Roth IRA income.  
• Earning more as they advance in their careers. If a client performs well at their job and has a fair idea of their career trajectory, they’ll earn more and be placed in a higher tax bracket. Converting to a Roth IRA can reduce their tax bill.   
• Federal income tax rates are predicted to rise in the future. Your client may be convinced that they will be made to pay higher income taxes later. The rise in income taxes (state or federal) could be to prevent a recession, fund infrastructure projects, or fund more social programs.  

3. Your client brought in less income for the year. Converting some or all the money from another account to a Roth IRA makes sense when your client has less income for a tax year. There could be a myriad of reasons for your client’s income taking a dip for the year, such as:  

• experiencing a downturn in their business 
• losing employment 
• taking a sabbatical from their job or career 

• switching to a new industry 
• pursuing higher education  

Whatever the reason for the lower income, converting to a Roth IRA is a good strategy, since it lowers their taxable income.   

4. Your client wants to leave tax-free income for their heirs. A Roth conversion is also an excellent way to ensure your client’s heirs receive tax-free income once your client passes on. Doing this is particularly important and beneficial to heirs who are not the decedent’s spouse.  

Under the SECURE Act 2.0, non-spousal beneficiaries of a traditional IRA must withdraw all the funds in 10 years. A Roth conversion can help your heirs avoid this requirement and allow their inheritance to grow. 

In the past, clients could do without a Roth conversion and do what was known as the stretch IRA. The SECURE Act removed this IRA strategy. Although there are legal ways to replicate the stretch IRA, a Roth conversion can be better, since it is less complicated. 

When would you not recommend converting to a Roth IRA?  

With most financial strategies, it’s not a “one-size-fits-all” situation. Some clients may benefit from a Roth conversion, while others are better off sticking to their Traditional IRAs or 401(k). Here are some situations when converting to a Roth IRA may not be advisable:  

1. Your client plans on donating a significant amount of their traditional IRA to a charity. Some retirees choose to make a Qualified Charitable Distribution (QCD) to satisfy their RMDs and avoid taxable income. Converting to a Roth IRA can be less advantageous, since making a QCD means paying comparably less taxes.   

2. Your client doesn’t have the money for the conversion tax or is forced to sell assets that could mean higher taxes. If your client pays for the conversion tax from funds in the IRA, this can negate the tax benefits of the conversion. Even worse, if they must resort to selling assets to pay for the conversion tax, they may end up with more taxable gains, and therefore more tax.  

It would be best to have extra cash on hand to pay the tax, or at least pay the tax with assets without taxable gains in this instance.  

3. Your client is on Medicare or Social Security. A Roth conversion can potentially increase their taxable income and cause a larger part of their Social Security benefits to get taxed. This can also increase the costs of their Medicare.  

4. Your client is close to retirement or is retired and needs the traditional IRA to pay for living expenses. It is not advisable to convert money that your client needs soon (or now), since the assets will not have time to earn and recover the amount paid on the conversion taxes.  

Converting from a traditional IRA to a Roth is easy and straightforward, but the trick is knowing when to do it. Remember, timing is crucial to maximizing its benefits. Check out this video for information on when it’s a good time to do your Roth conversion: 

What to consider when converting 

While it’s relatively easy and straightforward to do a Roth IRA conversion, this financial tactic has a few caveats. Here are some items that financial experts advise that you watch for or consider:  

1. A Roth conversion can mean paying more taxes. 

Converting a traditional IRA or traditional 401(k) to a Roth IRA comes with a tax bill. That’s because that contribution is considered as income and has corresponding taxes. Remember that taxes were not paid, as pre-tax dollars went into the traditional account. 

Should your client convert a Roth 401(k) into a Roth IRA, they avoid the taxes since they’re both after-tax accounts. But any employer match in a Roth 401(k) can be placed in a traditional 401(k), so this portion cannot be converted without getting taxed.  

Note, however, with the passage of the SECURE Act 2.0, matching funds can be held in a Roth 401(k) and your client can avoid the conversion taxes. This is so because they would have paid taxes when the money entered the account.  

2. A conversion works better when you wait before using the money.  

If it can be helped, advise your client to wait and not to use the money for five years, due to the five-year rule on withdrawals. The more time they leave the funds in the Roth IRA, the more growth they can get and recoup on the taxes. Speaking of waiting, putting off the conversion until the right time works too.  

3. Remember the five-year rule. 

The IRS typically requires that account owners keep their Roth IRA untouched for the first five years before making withdrawals. But if your client is over the age of 59½, they are exempt from the 10% penalty on early withdrawals despite not meeting the five-year rule. 

4. Conversions can affect government programs. 

If your client is on Obamacare, Medicare, gets Social Security benefits or has children receiving benefits, these can be affected by the conversion. Make sure that they convert only up to amounts that will not impact their eligibility for government programs like these. 

5. Don’t forget the pro-rata rule.  

Should your client have traditional IRAs with deductible contributions, that must be factored in when converting any nondeductible amounts into a Roth IRA. The IRS’s pro-rata rule requires you to calculate the tax consequences while considering your IRA assets in total. In effect, you’ll have to figure out what proportion of the funds have never been taxed, meaning which are deductible contributions and earnings in your total IRA assets. That percentage of the conversion is subject to tax at ordinary income tax rates. 

6. Don’t put off the conversion when you decide. 

Don’t wait until December to decide on a conversion. The IRS does not give any extensions, so allow for enough time to complete the conversion by December 31 of the year you or your client wants to convert. 

A Roth IRA conversion can provide several benefits, such as creating tax-free income for your clients or their heirs. But it’s worth understanding the possible tradeoffs to using this financial strategy, then applying it in ways that benefit your client and suit their needs best. If you’re working on a significantly large account, find ways to minimize the up-front tax bill. 

How many of your clients are looking to convert to a Roth IRA this tax year? What are their prevailing motives for doing so? Don’t forget to check out Retirement section on this and other important topics!