Which Account Types Can You Convert to a Roth IRA?

What To Consider Before Doing a Roth Conversion

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Roth IRAs, or individual retirement arrangements, are retirement accounts that allow investments to grow tax-free until retirement. Unlike other types of IRAs in which distributions are taxed, individuals are required to pay tax on contributions to Roth IRAs in the year that they make the contribution (or conversion). Other types of retirement accounts can be rolled over or converted to a Roth IRA so that distributions won’t be taxed when they’re made after retirement.

Let’s go over each of the four main retirement account types that can be converted to a Roth IRA: traditional IRAs, 401(k)s, SEP IRAs, and SIMPLE IRAs. We’ll discuss how each type of account works and summarize how to convert each one.

Key Takeaways

  • Many retirement accounts can be rolled over or converted into a Roth IRA.
  • If converting a pre-tax retirement account into a Roth IRA, the converted amount must be reported as taxable income in the year that the conversion is done.
  • Before converting, investors should consider the cost of paying the tax bill now versus in retirement.

Account Types That Can Convert to a Roth IRA

Each of the main retirement account types can be converted or rolled over into a Roth IRA. For the purposes of this article, a “retirement account” is one that shields investments from taxes until distributions are made in retirement. The government refers to these as “qualified retirement plans.”

Let’s take a look at how a Roth IRA conversion works with the most popular retirement accounts.

Traditional IRA

In a traditional IRA, an investor contributes pretax dollars to the IRA, then pays taxes when the funds are distributed in retirement. In 2021 and 2022, the annual limit for traditional IRA contributions is $6,000, or $7,000 for people aged 50 or older.

Converting a traditional IRA to a Roth IRA should be easy. Often, you can simply fill out a form with your financial institution to convert the account type if you’re making the conversion with the same brokerage. Otherwise, you will roll over the account by receiving a check for the full amount then depositing it into a Roth IRA within 60 days. If you’re switching brokers, you can opt for a trustee-to-trustee transfer to move money from your current account to a Roth account at the new broker.

401(k)

A 401(k) is a type of defined contribution plan that is sponsored by an employer. Typically, an employee contributes a percentage of their pretax income to the plan, and the employer may match that amount or a portion of it.

If you have a Roth 401(k), the conversion process is as simple as filling out forms with the 401(k) provider and the financial institution that will host your new Roth IRA account. The money can be moved electronically or by check. This transfer allows you to manage the funds as you wish, rather than being restricted to the options offered by the 401(k) provider. You won’t need to pay any tax on the amount you roll over.

If you have a traditional 401(k), you’ll go through the same process to roll it over and convert it into a Roth IRA. However, you’ll need to pay taxes on the amount you rolled over at your current marginal income tax rate.

Similar to 401(k)s, 403(b) and 457(b) retirement plans can typically also be converted to a Roth IRA.

SEP IRA

Simplified Employee Pension (SEP) IRAs allow businesses to contribute funds directly to an employee’s retirement account. SEP IRAs are often used by small businesses and self-employed professionals, and they’re known for having low administrative costs.

Like a 401(k) rollover, a SEP IRA rollover can be done once you leave the employer that sponsored the plan. The rollover amount is paid out in a check and must be deposited into the Roth IRA within 60 days. You’ll then report and pay tax on the amount at the end of the year.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is another retirement plan option for small businesses with fewer than 100 employees. The employer must make contributions matching up to 3% of compensation for each eligible employee and 2% of compensation for employees who don’t choose to participate.

SIMPLE IRAs can be rolled over just like the other account balances, with one key difference: You must have invested the money for two years before it can be converted.

The IRS imposes a one-per-year limit on some types of IRA rollovers, including those from SEP and SIMPLE IRAs. Conversions of traditional IRA to a Roth IRA are exempt, as is a direct trustee-to-trustee rollover from a 401(k) to a Roth IRA.

Should You Convert Your Retirement Accounts to a Roth IRA?

If you’re considering converting your retirement account to a Roth IRA, ask yourself the following questions to help you determine whether or not it’s worth it.

What are the tax consequences of conversion?

The amount converted into a Roth IRA must be reported as taxable income in the year that the conversion is done. That means you’ll pay tax on the amount you rolled over based on your marginal tax rate.

It’s a good idea to set aside money outside your retirement account to cover the tax bill. This strategy helps you maximize the benefits of a Roth IRA conversion. Plus, using money from your retirement account could require you to pay capital gains tax and, if you’re under 59½, a 10% penalty fee.

What is the opportunity cost of paying the tax?

It’s helpful to think of the tax payment on a Roth IRA conversion as an investment. You’re making it now so that you don’t have to make it later.

What is the opportunity cost of paying the tax now? It’s likely you’ll be paying with cash from outside the retirement account, so you need to consider what amount you could have earned by investing that money in some other way. What if you pay a big tax bill now, then the market increases by more than average over the next few years?

You should also think about tax brackets. What tax bracket are you in now, and where do you expect to be during retirement? If you’re making a high salary now and expect to have a lower income in retirement, converting now might mean paying a much higher rate of tax on the funds than you would if you held off.

Frequently Asked Questions (FAQs)

What is a backdoor Roth conversion?

A backdoor Roth conversion is when you contribute to a traditional IRA with the sole purpose of eventually converting it to a Roth IRA. Using this method, you can establish a Roth IRA through the “back door,” even if your income is too high to start one directly.

When do you pay taxes on a Roth IRA conversion?

Tax on the amount converted to a Roth IRA must be reported as income on the tax return for the year that the conversion is done. Some people convert accounts to a Roth IRA over several years to spread out the tax penalty.

Article Sources

  1. IRS. “Rollover Chart.”

  2. IRS. “Traditional and Roth IRAs.”

  3. IRS. “IRA FAQs,” see “How Long Do I Have To Roll Over a Distribution From a Retirement Plan to an IRA?”

  4. IRS. “SIMPLE IRA Plan.”

  5. IRS. “Rollovers of Retirement Plan and IRA Distributions,” see “IRA One-Rollover-Per-Year Rule.”

  6. Charles Schwab. “Why Consider a Roth IRA Conversion and How To Do It,” see “How Do You Convert to a Roth IRA?”

  7. IRS. “Publication 590-A (2021), Contributions to Individual Retirement Arrangements (IRAs),” see “Converting From Any Traditional IRA Into a Roth IRA.”