As part of the Tax Cuts and the Jobs Act that were enacted in 2017, Congress eliminated the provision that made it possible for people to undo a Roth conversion. This conversion was called a recharacterization. This means that when deciding to convert your traditional IRA, it better be a conscious decision.
Fortunately, if you made the decision to convert your traditional IRA prematurely, Roth conversions are almost always a good idea. Converting something in prospects of a good outcome is better than doing nothing. Right now with the relative market lows, it makes sense why a person would wish to convert now.
How to Do a Roth Conversion
First off, even before you do a Roth Conversion, it is good that you first understand that this conversion turns a traditional IRA into a Roth IRA which has so many tax benefits. Here is how to do a Roth conversion;
- Pay money on your IRA contributions. What you need to understand is that when it comes to Roth conversions, only the taxed amount will go into the Roth IRA accounts. It is good that you also note that the IRA contributions as well as any investment gain you receive will be added to your taxable income when you file for a tax return.
- Convert the account. Open a new account if you do not already have a Roth IRA account. Your IRA administrator will help you will all the relevant documentation and instructions regarding the paperwork.
- Make sure you follow all the conversion rules. Essentially, you may want to stay in sync with the IRS issued rules, and some of the valid ways to convert these accounts include;
- 1) indirect rollover where you receive a distribution from the traditional IRA and contribute it to your Roth IRA account within 60 days.
- 2) trustee-to-trustee AKA direct rollover: here, you will instruct the financial institution where you have active traditional IRA assets to transfer the amount directly to the trustee of the Roth IRA if it is in a different financial institution.
- Same trustee transfer: assuming that your traditional IRA and Roth IRA accounts are at the same financial institution, you can ask the trustee to transfer an amount from your traditional IRA to your Roth IRA.
Any employer-sponsored retirement plan may be rolled over to your Roth IRA if you are no longer working for the employer.
Once you make the rollover, you will need to report the conversion to the IRS. Here, you will use form 8606 when you file your income taxes for the year.
Are There Any Implications to the Conversions?
Once the conversion has been made, you will owe taxes on any money in the traditional IRA that would have been taxed when you withdrew it. This includes all the tax-deductible contributions that you made to the account and also the tax-deferred earnings that you have been saving in the account over the years. This money will be taxed as an income for the year when the conversion was made.
Does it Make Any Sense to Convert?
Yes, it does! Even though there is a trade-off in that you may face a large tax bill, the benefit of the Roth conversion is that you will be able to make tax-free withdrawals from the account in the future. If you also expect to be in the higher tax bracket after you retire, converting the account now makes a lot of sense. This might happen to the people whose income is unusually low during a particular time, for instance, during the COVID pandemic.
In addition, Roth IRA accounts do not require any required minimum distributions after you reach the age of 72. As such, it may be a good idea to leave the money in the Roth IRA account if you do not need it for your heirs.