Thinking of converting to a Roth IRA?

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Key points

  • Partial conversions enable you to spread out your tax payments over multiple years
  • There are no income restrictions on Roth IRA conversions — anyone can make the switch
  • Roth IRAs generally provide federal (and possibly state) tax-free income in retirement and greater flexibility when it comes to distributions
  • Be sure to consult a tax advisor before making your decision
While there are many factors to consider, including tax-planning considerations, converting your traditional IRA or employer-sponsored retirement account to a Roth IRA may offer you more flexibility and control over your nest egg in retirement. Consider all of your choices and learn whether converting to a Roth IRA might be right for you.

Anyone can convert

As long as taxes are paid on the conversion (i.e., pre-tax) amount, anyone can convert a traditional IRA, or other eligible retirement plan assetFootnote 1 to a Roth IRA. This presents an opportunity for investors who wish to potentially lessen their tax burden in retirement and enjoy greater flexibility as no distributions are required to be made to the original Roth IRA account holder. Of course, every financial situation is unique, so consult with a tax and/or legal advisor to get help in determining whether converting to a Roth IRA is right for you.

But not everyone can contribute

There can be restrictions to your ability to contribute to a Roth IRA based on your modified adjusted gross income (MAGI). That's the adjusted gross income of your household plus any tax-exempt income you may have. For the 2021 tax year, you are not eligible to contribute directly to a Roth IRA if your MAGI equals or exceeds $140,000 ($139,000 for 2020) as a head of household or single filer, or $208,000 ($206,000 for 2020) as a married joint-return taxpayer, or if you are a married taxpayer who files separately and your MAGI equals or exceeds $10,000.
Eligible investors can contribute up to $6,000 in 2020 and 2021. Those age 50 or older can make additional catch-up contributions of $1,000, for a total contribution of up to $7,000 in 2020 and 2021.Footnote 2 If you are married and file separately but do not live with your spouse at any time during the year, your maximum deduction is determined as if you were a single filer. However, the contribution limit declines for head of household or single filers with a MAGI of $125,000 or more in 2021 ($124,000 or more in 2020), and married couples filing jointly with a MAGI of $198,000 or more in 2021 ($196,000 or more in 2020). In 2020 and 2021, the contribution limit also declines for married couples filing separately until a MAGI of less than $10,000 is reached.

It's not an "all or nothing" proposition — consider a partial conversion

Pre-tax assets that are converted from a traditional IRA or other eligible retirement plan to a Roth IRA are treated as a taxable distribution and are subject to ordinary income tax rates in the year of the conversion. You can do a partial conversion — that is, convert a portion of your assets over two years or more, thereby spreading out your tax payments. You don't actually have to convert the entire account at once.
Converting to a Roth IRA may be worth considering if you:
  • Have assets invested in traditional IRAs or employer-sponsored retirement plans
  • Think you'll be in a higher tax bracket in retirement, or if you're temporarily in a lower tax bracket now
  • Can afford to take the tax hit now without dipping into your retirement account to pay taxes on the income generated by the conversion
  • Have unused tax deductions (such as charitable contributions or medical expenses) that can help offset the taxable income generated by the conversion
  • Wish to reduce the taxable value of your estate or potentially leave income tax-free assets to your heirs
Note that if you have multiple non-Roth IRAs, any conversion will be deemed to be made from all of the IRAs on a proportionate basis. Also, if you have both deductible and non-deductible contributions held in your non-Roth IRAs, any conversion will be deemed to be taken pro rata from each contribution type.

Understanding Roth IRAs

There are a variety of factors to consider before you determine whether to convert your traditional IRA or other eligible retirement plan to a Roth IRA. Again, you should consult with a tax professional to assess the potential impact on your long-term financial goals before making any decisions.

How do they work?

Earnings on your assets will have the potential to grow tax-deferred and can be distributed income tax-free (on a federal and possibly state level) in a "qualified distribution" after five years from the first day of the year in which you make your first Roth IRA contribution or Roth conversionFootnote 3 if one of the following applies:
  1. You are age 59½ or older at the time of the distribution
  2. You qualify for a special purpose distribution for the purchase of a first home (lifetime limit of $10,000)
  3. You die or become permanently disabled
If you make a withdrawal that does not meet these or certain other exceptions, you will owe ordinary income tax (at the federal and possibly state level) on any taxable distribution (generally, any distribution of earnings) and, potentially, a 10% additional federal tax for taxable withdrawals prior to age 59½.Footnote 4
When you make a conversion, keep in mind that if you have both pre-tax funds and after-tax funds in one or more non-Roth IRAs, you cannot choose to convert only the after-tax funds first. Instead, any conversion will be deemed to be made proportionately from all your funds across all your non-Roth IRAs.
Also, as of Jan. 1, 2020, new legislation allows an individual to receive a distribution from a Roth IRA without application of the 10% federal additional tax if the distribution meets the requirements to be a qualified birth or adoption distribution. However, a qualified birth or adoption distribution attributable to earnings is generally includable in taxable income. Qualified birth and adoption distributions are limited to $5,000 (not indexed for inflation) per birth or adoption. The $5,000 limit applies to individuals, so that spouses could each receive a distribution of up to $5,000 per qualifying birth or adoption.

What are the benefits?

Since there are no income restrictions on Roth IRA conversions, many investors are taking a hard look at the potential benefits — primarily, federally tax-free withdrawals and no mandatory distribution schedule — to determine whether a conversion makes sense.
  • Take future taxation into account — While Roth IRA contributions are not tax-deductible, qualified distributions are federal (and possibly state) income tax-free. This is a great perk if you anticipate being in a higher tax bracket when you withdraw your money — typically in retirement. Many investors hold a significant portion of their retirement savings in a tax-deferred plan — such as a 401(k) or other employer-sponsored retirement plan — money that is taxed as income upon distribution. Converting some of your savings to a Roth IRA (accomplished through a partial or complete conversion) allows you to diversify your retirement assets from a tax perspective.
  • Enjoy greater flexibility — Unlike a traditional IRA, Roth IRAs are not subject to required minimum distributions (RMDs) while the original account holder is still alive, so you are not required to begin taking distributions at or shortly after age 72 (although distributions still will be required after your death).Footnote 5 You also can continue to contribute to your Roth IRA for as long as you earn income at any age, provided your MAGI is within the eligibility limits for Roth IRA contributions.
Next steps

Footnote 1 The following account types are eligible for conversion to a Roth IRA: traditional IRA, rollover IRA, SEP IRA and SIMPLE IRA (after held for 2 years), as well as assets in tax-qualified retirement plans such as 401(k), 403(b), 457(b), profit sharing and money purchase plans.

Footnote 2 You are treated as being age 50 or older if you will turn age 50 or older at any point during the calendar year.

Footnote 3 This five-year period begins on January 1 of the tax year for which the first contribution to a Roth IRA was made.

Footnote 4 In addition, a special provision applies for converted assets. If a non-qualified withdrawal is made within five years following the beginning of the conversion tax year the entire withdrawal may be subject to the 10% additional federal taxes for pre-59½ withdrawals unless an exception applies.

The required beginning date for RMDs is age 72. You may defer your first RMD until April 1st in the year after you turn age 72, but then you'd be required to take two distributions in that year. Failure to take all or part of an RMD results in a 50% additional tax applicable to the amount of the RMD not withdrawn. Consult your tax advisor for more information on your personal circumstances.
Investment involves risk. Diversification does not ensure a profit or guarantee against loss.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.