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Roth Conversion Rules FAQ

After the recent article “Roth Conversion Planning, a Step-by-Step Approach,” it has become clear through emails from readers that lots of people have questions — not just about the decision making process, but about the rules themselves. So what follows is a brief FAQ about the rules surrounding Roth conversions.

Is there an income limit for Roth conversions?

No. There used to be a limit. (Prior to 2010, you could not do a Roth conversion if your modified adjusted gross income exceeded $100,000.) But there is no longer an income limit.

Is there an income requirement for a Roth conversion?

No. While you (or your spouse) must have earned income in order to make a Roth IRA contribution, you do not have to have any earned income in order to do a Roth conversion.

Is there a maximum amount you can convert per year?

No. There is no maximum conversion — other than the fact that you can’t convert more than you have in tax-deferred accounts.

Can you do a partial conversion, or do you have to convert the whole account at once?

You can do a partial conversion of a traditional IRA. For example, converting $20,000 of a $100,000 account is perfectly allowed.

And in most cases in which conversions make sense, doing partial conversions over a period of years is in fact what’s most desirable — converting only enough to put your income up to a particular threshold each year, rather then converting the whole account at once. Converting the whole account at once would often mean paying a high tax rate on the conversion, as it would mean having a very high level of income that year. (Of course, this depends on the size of the account.)

Note that the same is true for a 401(k). If your 401(k) allows for in-plan conversions, you can do a partial conversion to Roth 401(k).

How is a Roth conversion (from a traditional IRA) taxed?

Generally, a Roth conversion will be taxable as ordinary income.

If, however, you have made nondeductible contributions, a portion of the conversion will not be taxable. Specifically, the percentage of the conversion that is not taxable is calculated as:

  • Your basis in traditional IRAs, divided by
  • The sum of your traditional IRA balances on 12/31 of the year of the conversion and any distributions and conversions from traditional IRAs that occurred that year.

Your basis in traditional IRAs is the sum of your nondeductible contributions, minus any portions of those amounts that have been distributed or converted.

For example, if you have made $20,000 of nondeductible contributions over the years (and none of those amounts have been distributed or converted), you have $20,000 of basis in your traditional IRAs. If you do a $100,000 conversion, and at the end of the year your traditional IRAs are in total worth $400,000, then 4% of your $100,000 conversion would be nontaxable.

That is, $20,000 (basis in traditional IRAs) divided by $500,000 (i.e., the sum of the conversions/distributions for the year and the sum of your traditional IRA balances at the end of the year) equals 4%. So you would have $96,000 of gross income as a result of the $100,000 conversion.

Something that surprises many people is that if, for example, you do a Roth conversion in March and then in November of the same year you roll a 401(k) into a traditional IRA, that rollover is going to affect the portion of the conversion that’s taxable (because it will increase your traditional IRA balance on 12/31 of that year).

Another key point here is that all of your traditional IRAs (including SEP and SIMPLE IRAs) are considered to be a single IRA for the purpose of this calculation. (See: “When are IRAs Aggregated?”)

How is an in-plan Roth conversion (e.g., a conversion within a 401(k)) taxed?

As with a conversion of a traditional IRA, the conversion will generally be taxable. Also similarly, if you have made nondeductible, non-Roth (i.e., “after-tax”) contributions to the plan, a portion of the conversion will be nontaxable. And again, it’s a pro-rata calculation.

However for this calculation, unlike with IRAs, the 401(k) is not aggregated with other 401(k) plans.

Also, if the plan separately accounts for the after-tax contributions and their earnings, then it’s possible to largely avoid the pro-rata rule, because you can have just those amounts (i.e., the after-tax contributions and their earnings) converted. In such a case you would only have to pay tax on the earnings on the after-tax contributions.

Can a Roth conversion trigger the 10% penalty?

If you are under age 59.5, any money that comes out of the traditional IRA and does not end up going into the Roth IRA may be subject to the 10% penalty. For instance, if you take $100,000 out of your traditional IRA, $75,000 goes into your Roth IRA, and $25,000 is withheld to pay the tax on the conversion/distribution, the $25,000 would be subject to the 10% penalty if you’re under age 59.5 and don’t meet one of the other exceptions to the penalty.

When is a Roth conversion taxed?

A Roth conversion is taxable in the year in which it occurs. That is, conversions work on a calendar-year basis. There’s no “I’m doing this in March of 2022, and I want it to count for 2021” option as there is for contributions to an IRA.

How are distributions from a Roth IRA treated, after a conversion?

When amounts that were converted to a Roth IRA are distributed from the Roth IRA, they will not be subject to ordinary income tax. They might be subject to a 10% penalty. But that penalty will not apply if you’re at least age 59.5, or if the conversion was at least 5 years ago, if the conversion itself wasn’t taxable, or if one of several other exceptions applies. For more details, see “Roth IRA Distribution Rules” or the Roth IRA Distribution Tool.

Can I do a Roth conversion of an inherited IRA?

No — unless you inherited it from your spouse, in which case you’re allowed to treat the account as your own, which allows you to do a conversion into your own Roth IRA.

Can I recharacterize (undo) a Roth conversion?

No. As a result of a change made by the Tax Cuts and Jobs Act of 2017, you can no longer recharacterize a Roth conversion.

Does a Roth conversion satisfy my RMD for the year?

No. If you have to take a required minimum distribution (RMD) in a given year, a Roth conversion does not count toward that RMD.

Roth IRA Withdrawal Rules

Mike’s note: In talking to people about Roth conversions, it has become clear to me that people have a lot of misunderstandings about the general rules for Roth IRA distributions. So today’s article is something of a back-to-basics post.

Types of Roth IRA Distributions

Withdrawals from a retirement account are known as “distributions.” The way a distribution from a Roth IRA is taxed depends on what type of money is being distributed. Specifically, a Roth IRA can consist of (up to) three types of money:

  1. Contributions,
  2. Amounts converted from a traditional IRA or other retirement plan, and
  3. Earnings.

An important point to note here is that earnings are not considered to be “earnings on contributions” or “earnings on converted amounts.” They’re simply earnings.

Example: In Year 1 Kevin contributes $6,000 to a Roth IRA. In Year 2 Kevin contributes another $6,000 to the Roth IRA. He also converts $30,000 from his traditional IRA to his Roth IRA. At the end of Year 2, Kevin’s Roth IRA is worth $50,000. That $50,000 is considered to be a) $12,000 of contributions, b) $30,000 from conversions, and c) $8,000 of earnings. It does not matter whether the earnings are the result of growth from the converted amounts or growth from the contributed amounts. Earnings are simply earnings.

Another important point here is that distributions from a Roth IRA are considered to happen in the order listed above. That is, distributions are considered to first come from contributions, then from converted amounts, then from earnings.

Distributions of Contributions

The tax treatment of distributions of contributions is simple: contributions can come out at any time, tax-free and penalty-free.

Example: Kelly is 24 years old. She opens her first Roth IRA and contributes $3,000. Two weeks later, she takes the $3,000 back out. Kelly does not owe any tax or penalty.

Distributions of Converted Amounts

Distributions of converted amounts are not subject to ordinary income tax.

Distributions of converted amounts are subject to a 10% penalty, unless (at least) one of the following is true:

  • The distribution is occurring at least 5 years from January 1 of the year in which the conversion occurred,
  • The distribution is of a converted amount that was not taxable in the year of the conversion,
  • The distribution is for a “qualifying reason” (listed below), or
  • One of the “other exceptions” to the 10% penalty (also listed below) applies.

Distributions of converted amounts are considered to occur on a first-in-first-out basis. That is, if you do a Roth conversion in Year 1 and another in Year 2, distributions will be considered to come from the Year 1 conversion first. And for a given conversion, if it was partially taxable and partially nontaxable, the taxable portion (i.e., the portion of the conversion that was taxable in the year of conversion) is considered to be distributed before the nontaxable portion.

Qualifying Reasons

The following are the “qualifying reasons” for a distribution from a Roth IRA:

  • You have reached age 59½.
  • The distribution was made to your beneficiary after your death.
  • You are disabled.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.

Other Exceptions to 10% Penalty

The following are the “other exceptions” to the 10% penalty:

  • The distributions are part of a “series of substantially equal payments.”
  • You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
  • You are paying medical insurance premiums during a period of unemployment.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the account.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified birth or adoption distribution (up to $5,000 per parent per birth/adoption).
  • The distribution was a “qualified coronavirus-related distribution.”

Distributions of Earnings

Distributions of earnings will be subject to ordinary income tax unless they are “qualified distributions.” In order for a distribution to be a qualified distribution:

  • It must be for a “qualifying reason” (listed above), and
  • The distribution must not occur any earlier than 5 years from January 1 of the year in which you first established and contributed to a Roth IRA. (For example, if you first opened and contributed to a Roth IRA on May 18, 2019, this 5-year rule would be satisfied as of January 1, 2024.)

And distributions of earnings will be subject to a 10% penalty unless:

  • The distribution is for a “qualifying reason” (listed above), or
  • You meet one of the “other exceptions” to the 10% penalty (also listed above).

The following flowchart summarizes tax treatments of distributions of earnings from a Roth IRA:

All Roth IRAs Are Viewed as One

When applying the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, distributions from a Roth IRA will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2018, you contributed $2,000 to a Roth. In 2019, you opened a Roth IRA with a different brokerage firm and contributed $3,000 to it. By 2021, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA for these purposes.

What if You Have Rolled a Roth 401(k) or 403(b) into Your Roth IRA?

If you have rolled assets from a designated Roth account in an employer plan (i.e., what we would typically refer to as a Roth 401(k) or Roth 403(b)) into your Roth IRA, those rollover amounts are separated into contributions and earnings — and then lumped into the appropriate category along with regular Roth IRA contributions and earnings.

Of note: at least in theory, this information should be transmitted from the administrator of the employer plan to the administrator of the Roth IRA. But it’s best if you keep records of your own, to be able to demonstrate the portion of the rollover that is attributable to contributions.

Example: Over the course of a few years, you contribute $50,000 to your Roth 401(k). After leaving that employer, you roll the entire Roth 401(k), which is worth $80,000 at the time of the rollover, into your Roth IRA. For the sake of applying the distribution rules discussed above, the $50,000 is treated as if it were regular Roth IRA contributions (i.e., it can be withdrawn from the Roth IRA tax-free and penalty-free at any time). And the additional $30,000 will be treated just like any other earnings in the Roth IRA (i.e., it will be treated in keeping with the rules shown in the flowchart above).

What is a Rollover IRA? (Rollover IRA vs. Traditional IRA)

A reader writes in, asking:

“At my primary brokerage firm I have two IRAs: a traditional IRA and a rollover IRA that holds assets that came from my prior employer’s 401-k plan. What is the difference between the two?”

“Rollover IRA” is just a subcategory of “traditional IRA.” In other words, a rollover IRA is a traditional IRA. Specifically, rollover IRAs are traditional IRAs that contain nothing but assets that came from an employer-sponsored plan.

Because a rollover IRA is a traditional IRA, it gets all the same tax treatment as a normal traditional IRA. That is, distributions from the account are generally taxable; you can do a Roth conversion of the assets in the account; it’s treated the same way with regard to aggregation rules as other traditional IRAs; and so on.

Rollover IRAs are designated as such (rather than just being called regular traditional IRAs) for two reasons.

Reason #1: some employer plans only accept rollovers from an IRA when the IRA contains only assets from another employer-sponsored plan. So keeping those assets separate in their own IRA (rather than combining them with other assets in a traditional IRA) could preserve your ability to roll those assets into a different employer plan at a later date. But fewer and fewer employer plans have this policy every year, so this distinction is becoming less relevant.

Reason #2: assets in an employer-sponsored plan have unlimited creditor protection in bankruptcy under federal law. In contrast, IRA assets are only protected up to a certain limit ($1,362,800 as of 2020). If assets from an employer-sponsored plan are rolled into an IRA and kept separate (i.e., kept in a separate “rollover IRA”), they continue to receive that unlimited protection. If the assets get commingled with other assets in a traditional IRA, then they might lose that unlimited protection and “only” be protected up to the $1,362,800 limit.

That said, some people make the case that if you have good records and could prove that the assets in question came from an employer plan, you would still have unlimited protection for those assets. Also, many states provide additional protection to IRA assets beyond what federal law provides. And of course most people’s IRA assets are never going to exceed the federal protection limit anyway.

To summarize, a rollover IRA is a traditional IRA and is taxed as such, but there are two reasons for keeping rollover IRA assets separate from other traditional IRA assets. It may well be the case, however, that neither of those two reasons is particularly applicable to your own circumstances.

When Are IRAs Aggregated?

A reader writes in, asking:

“I have read that your traditional IRAs are all considered one IRA as far as the IRS is concerned. But I recently found another article that explicitly indicated otherwise. Maybe it depends on circumstances? Could you elaborate on this in an article?”

The issue is not so much that it depends on circumstances, but rather that IRAs are aggregated for some purposes and not for other purposes.

Traditional IRAs Aggregated for RMDs

For RMD purposes, all of your traditional IRAs will be treated as if they are one collective traditional IRA. Specifically, each traditional IRA will have its RMD calculated separately, but then you can total up all your necessary traditional IRA RMDs for the year and take that total amount out of any one traditional IRA or any combination of traditional IRAs.

Note that SEP IRAs and SIMPLE IRAs count as traditional IRAs here, so they are aggregated as well.

Employer-sponsored plans are not aggregated with your IRAs though (nor are they aggregated with each other). For example, a distribution from your 401(k) will not count toward satisfying your traditional IRA RMD for the year.

Traditional IRAs Aggregated for Distribution/Conversion Taxability

Similarly, when you take a distribution from a traditional IRA — or do a Roth conversion from a traditional IRA — whether or not it is taxable will depend on an aggregated calculation.

Example: Joan has made $20,000 of nondeductible contributions to her traditional IRA at Vanguard. During 2020, Joan makes a $40,000 Roth conversion from that IRA. At the end of the year, the balance in Joan’s Vanguard traditional IRA is $100,000. She also has a traditional IRA at Schwab with a year-end balance of $60,000. She has taken no other distributions (or done any other conversions) from these IRAs.

The nontaxable portion of Joan’s conversion is calculated as her basis in traditional IRAs (i.e., the amount of nondeductible contributions she has made), divided by the sum of her year-end balances and distributions or conversions from traditional IRAs over the course of the year. (And again, we’re counting all of her traditional IRAs here.)

Joan’s basis is $20,000. The sum of her year-end traditional IRA balances is $160,000. And the sum of her conversions and other distributions from traditional IRAs for the year is $40,000. So the nontaxable portion of Joan’s conversion is calculated as: $20,000 / ($160,000 + $40,000) = 10%. In other words, 90% of Joan’s conversion will be taxable.

IRAs Not Aggregated for “SEPP” Distributions

IRAs are not aggregated for the “series of substantially equal periodic payments” rule, sometimes referred to as 72(t). For that purpose, each traditional IRA is treated as its own separate account.

Aggregation for Roth IRA 5-Year Rule

With regard to the 5-year rule for distributions of earnings from Roth IRAs, once you have satisfied the 5-year rule for one Roth IRA, you have satisfied it for all Roth IRAs.

Inherited IRAs Not Aggregated

Inherited IRAs are not aggregated with other IRAs for RMD purposes, nor are inherited IRAs aggregated with other IRAs for the purpose of calculating what portion of a distribution (or conversion) is taxable.

Inherited IRAs can be aggregated with each other for RMD purposes if the inherited IRAs in question a) were originally owned by the same person and b) are being distributed over the same period (i.e., if the inherited IRAs are being distributed over somebody’s life expectancy, it must be the same life expectancy that is being used for each inherited IRA if you want to aggregate them with each other for RMD purposes).

What Counts as Compensation (Earnings) for IRA Contributions?

I’ve received a few questions recently about what types of income count as “compensation” for IRA contribution purposes.

The definition of compensation is important because your IRA contributions for a given tax year are limited to the amount of your “compensation that is includible in your gross income” for the year. (If you are married, you and your spouse’s combined IRA contributions are limited to your combined such compensation.)

There are two key points here:

  1. The income in question must be something that is included in your gross income (e.g., foreign earned income that is excluded would not count), and
  2. It has to be income that counts as compensation.

So what counts as compensation?

Treasury Regulation 1.219-1(c) provides the following definition:

For purposes of this section, the term compensation means wages, salaries, professional fees, or other amounts derived from or received for personal service actually rendered (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses) and includes earned income, as defined in section 401 (c) (2), but does not include amounts derived from or received as earnings or profits from property (including, but not limited to, interest and dividends) or amounts not includible in gross income.

In plain language, that means that the following count as compensation:

  • Wages/salary,
  • Commissions,
  • Net earnings from self-employment,
  • Scholarship or fellowship income if the income is reported in Box 1 of Form W-2 (i.e., reported as wages),
  • Taxable alimony and separate maintenance (i.e., for divorces that became finalized prior to 2019), and
  • Nontaxable combat pay.

And compensation does not include:

  • Interest or dividend income,
  • Other earnings or profits derived from property (e.g., rental income),
  • Social Security benefits,
  • Pension or annuity income,
  • Deferred compensation,
  • Income from a partnership for which you don’t provide services that are a material income-producing factor, and
  • Any income (other than combat pay) that isn’t included in your gross income.

For tax years 2020 and beyond, the SECURE Act made an additional change relating to fellowship/stipend income. Specifically, compensation will also include “any amount which is included in the individual’s gross income and paid to the individual to aid the individual in the pursuit of graduate or postdoctoral study.”

Compensation Reduced by Pre-Tax 401(k) Contributions

One noteworthy point here is that, when it comes to wages, it’s the amount that shows up in Box 1 of your Form W-2 that matters. And this amount in question is reduced by any pre-tax (“traditional”) 401(k) contributions that you make at work. Point being, if your earnings are low enough, pre-tax 401(k) contributions at work could reduce the amount you’re allowed to contribute to an IRA for the year. Roth 401(k) contributions do not, however, reduce the amount in Box 1. So Roth 401(k) contributions would not reduce the amount you can contribute to an IRA.

Should I Roll My 401k into My New 401k or into an IRA?

A reader writes in, asking

“If I’m leaving my employer to take a new position, how should I determine whether to roll my current 401K into the new 401K or into an IRA?”

If you have already decided that you do want to roll your 401(k) somewhere else (e.g., because the old 401(k) has very expensive investment options), there are a handful of factors to consider. Not coincidentally, those factors are very similar to the factors considered when determining whether to roll a 401(k) over to an IRA in the first place.

Where Do You Have Better Investment Options?

If your new employer-sponsored plan has investment options that are better than what you’d have access to in a regular IRA, rolling your money into the new employer plan can be advantageous. Common examples would be people starting a job with the federal government (and who would therefore have access to the super-low-cost Thrift Savings Plan) or people whose new employer plan includes something like Vanguard Institutional share classes (i.e., Vanguard funds with lower costs than Admiral shares).

When Do You Plan to Retire?

If you separate from service with a given employer in or after the year in which you reach age 55, you can take penalty-free distributions from that employer’s 401(k) plan, whereas normally you have to wait until age 59.5 (unless you meet one of a few other exceptions).

As such, if you plan to retire in or after the year you turn 55 but before you turn 59.5, having more money in your final employer’s 401(k) may make it easier to meet your living expenses without having to find another exception to the 10% penalty. If you expect to be in such a scenario (e.g., because you’re age 50 right now when you’re switching jobs and you expect to retire 5-6 years from now), rolling your current 401(k) into your new 401(k) could be advantageous.

Are You Planning Roth Conversions?

If you are planning Roth conversions in your traditional IRA (or you have already done one this year) and your traditional IRA includes amounts from nondeductible contributions (e.g., because you’re executing a “backdoor Roth” strategy), then it can be wise to avoid rolling 401(k) money into a traditional IRA, because doing so would increase the amount of tax you’d have to pay on your conversions.

This wouldn’t necessarily mean, however, that you should roll your old 401(k) into the new 401(k). It might just mean that you should temporarily leave your old 401(k) where it is, with the plan to roll it into an IRA in some future year (e.g., the year after the year in which you do your last Roth conversion).

Expecting a Lawsuit?

I don’t write about this often, as it’s distinctly outside my area of expertise, but in some cases money in a 401(k) may have better protection from creditors than money in an IRA. So if you are expecting to be sued — or you work in a field where lawsuits are common — you should speak with a local attorney to discuss whether your money would be safer in a 401(k) than in an IRA.

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