Ready, Set, Convert: How to Switch to a Roth IRA

In previous articles in our Strong & Sexy Retirement series, we discussed the ins and outs of Roth and Traditional Individual Retirement Accounts (IRAs) and how they can really beef up your retirement plans.  I also explained that there are specific IRS guidelines that determine whether you qualify for a Roth or Traditional IRA.

However, what happens if you don’t qualify for a Roth IRA, and want to enjoy the benefits of tax-free growth, tax-free withdrawals, no minimum required distributions (MRD), and the ability to pass the assets on to your heirs tax-free?  You convert!

What Does It Mean To Convert?

When you convert a Traditional IRA to a Roth IRA, you are moving money from your Traditional IRA (or a savings plan from a former employer, like a 401(k)) over to a Roth IRA account.  This can be accomplished in three distinct ways: trustee-to-trustee transfer, same-trustee transfer, or a rollover.

Let’s go through an example so that you understand each conversion method.  Imagine that you have a Traditional IRA through Fidelity and would like to open a Roth IRA with TD Ameritrade.

  • To perform a trustee-to-trustee transfer, you would tell Fidelity to transfer a designated amount to the trustee of the Roth IRA at TD Ameritrade.
  • To perform a same-trustee transfer, you would open a Roth IRA with Fidelity and tell the trustee to transfer a specified amount from your Traditional IRA to your newly created Roth IRA.
  • To covert using a rollover method, you would receive a Traditional IRA distribution (a check payable to you) and, within 60 days, contribute this amount to your Roth IRA.  The conversion deadline is Dec 31st.

A Few Important Details to Consider

There is no limitation on the amount of funds you can convert, but the amount that is converted will be added to your ordinary income for that tax year.  This could potentially push you into a higher federal income tax bracket, meaning that you will owe more in taxes.  So if this will be the case for you, you’ll need to determine whether you have enough cash on hand to pay the taxes.

To manage the tax costs associated with conversion, you can adjust how much of your Traditional IRA or savings plans to convert.  This will safeguard you from moving into a tax bracket that you can’t pay for.  You really do not want to have to pay taxes using money from your conversion.

What Is Your Tax Liability Upon Conversion?

In order to truly understand your liability, you need to discover if the contributions within your Traditional IRA or former workplace retirement accounts are pretax or after tax – that is, did you put the money into the original account prior to or after paying taxes on it?  This is very important information to figure out, and if you’re not sure, your plan administrator can tell you.

In the event that all of your contributions in your conversion-eligible IRA or retirement accounts were pretax, 100% of what you convert will be added to your taxable income.  Additionally, any earnings on these accounts (that is, the interest earned on what you contributed) will increase your taxable income for the conversion year.

Once you determine how much you have in pretax contributions, your can then determine the amount of after-tax contributions and subtract this from the total conversion amount.

Example Calculation for after tax contributions in IRAs:

You have $80,000 for conversion in two traditional IRAs.  IRA 1 has $40,000 in pretax contributions and earnings. IRA 2 has $20,000 in pretax earnings and $20,000 in after-tax contributions.  What if you decided to convert $10,000 of the total amount?  What is the taxable portion of the Roth IRA conversion?

  T. IRA 1 T. IRA 2
Pretax 40,000 20,000
After Tax 0 20,000
Total 40,000 40,000

100% – (After-tax contribution/Total combined balance) * 100

20,000/80,000=0.25 *100 = 25                       100%-25%= 75% (Taxable proportion)

The taxable portion of the Roth IRA conversion = Amount to be converted*Taxable Proportion or 10,000*75%= 7,500

The Takeaway

If you’re planning to convert a Traditional IRA or former employer retirement savings plan to a Roth IRA, understand that this will increase your taxable income.  Know what tax bracket you are in now, and determine if you will be able to pay additional taxes should you be moved into a higher federal tax bracket due to the conversion.  If you do not wish to move into a higher tax bracket, you can convert a lower amount than the full balance. Also, learn what portions of your previous contributions were pretax and after-tax to estimate your tax liability. 

This information is just a small part of the topic of Traditional IRA to Roth conversion.  However, I want to give you some basic tools so that you can try to understand the financial professionals and make solid informed choices.

Amanda Golsch is a six year employee of Children’s Hospital Medical Center and an adjunct professor for the University of Cincinnati. While in grad school, Amanda developed a passion for personal finance. She realized that personal finance can impact every aspect of your life, including your health. Therefore, Amanda has set out to teach as many women as possible basic financial principles that can leave a powerful and lasting impact. Her motto is “A financially literate woman is a powerful woman.” Got a question for Amanda? Write to writers@strongisoursexy.com.

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