Operational procedures matter as much as suitability.
Converting a traditional IRA to a Roth IRA is accomplished with two steps: a distribution from a traditional IRA and a rollover to a Roth IRA. But, while seeming simple, the applicable rules can complicate the results.
Here are the key operational considerations for getting Roth IRA conversions right.
4 Roth IRA conversion methods
An individual has four options for accomplishing a Roth conversion. (For this article, a traditional IRA includes a SEP IRA and a SIMPLE IRA. Remember that a conversion may be done from a SIMPLE IRA only if the SIMPLE IRA has been funded for at least two years.)
The four options:
- Redesignating a traditional IRA to a Roth IRA. This results in a conversion of the entire traditional IRA balance. I am not aware of any IRA custodian that offers this option.
- The amount is moved directly from the traditional IRA to the Roth IRA, where both accounts are held with the same custodian. This is the most common method and leaves little room for error.
- The amount is converted directly from the traditional IRA custodian to the Roth IRA custodian via a trustee-to-trustee transfer to the Roth IRA custodian, where different custodians hold the accounts. Generally, the traditional IRA custodian requires a letter of acceptance from the Roth IRA custodian, confirming that a Roth IRA has been established for the taxpayer and that the amount will be deposited to such a Roth IRA as a Roth conversion.
- The IRA owner takes a distribution from the traditional IRA and deposits the conversion amount to a Roth IRA within 60 days of receipt. This indirect conversion can be done by the custodian who holds both accounts or between two different custodians.
Whichever method is used, a Form 1099-R must be issued for the traditional IRA and a Form 5498 for the Roth IRA.
For the first three methods, the IRA custodian must input Code 7 in Box 7 of IRS Form 1099-R if the IRA owner is at least 59 and a half when the amount leaves the traditional IRA. Otherwise, Code 2 must be used. Both codes mean the conversion is not subject to the 10% additional tax on early distributions.
For method four, Code 7 is used if the IRA owner is at least age 59 and a half when the amount leaves the traditional IRA. Otherwise, Code 1 is used. Code 1 means that, as far as the IRA custodian knows, the amount does not qualify for an exception to the 10% additional tax.
Tax reporting tip: If Code 1 is used, the tax preparer must claim the exception to the additional tax on the IRA owner’s tax return.
Cross-year conversions
While the first two methods are usually done simultaneously, there could be a lag between when the amount leaves the traditional IRA and gets deposited in the Roth IRA under methods three and four. This means that the distribution side could be done in 2024 and the rollover side in 2025. However, the transaction applies to 2024 as long as the distribution side is completed by December 31, 2024.
Tax reporting tip: When using method four, ensure that the IRA custodian reports the amount in Box 3 of Form 5498 and not Box 2. The IRS says incorrect reporting of Roth conversion is a common error by IRA custodians and might cause tax trouble for IRA owners.
RMDs must be taken before conversions
Distributions that are not eligible to be rolled over may not be converted to a Roth IRA. A required minimum distribution, or RMD, is one such distribution.
Under the RMD rules, for any year an individual is required to take an RMD, their first distribution includes their RMD until the RMD is satisfied. This means that an individual who is at least age 73 years old at the end of this year must take their RMD before any Roth conversion. Failure to take the RMD would result in an ineligible amount being included in the Roth conversion, which might be subject to a correction as a return of excess distribution.
Example: Susan, 75, plans to convert $2 million from her traditional IRA to her Roth IRA for 2024. Her 2024 RMD is $81,300. Susan must take her $81,300 RMD before converting any amount to her Roth IRA.
If Susan performs the Roth conversion before taking her RMD, any portion of the $81,300 that exceeds her Roth IRA contribution limit is an excess contribution and must be corrected before her tax-filing due date, plus extensions, to avoid owing the IRS a 6% excise tax of the amount. If the return of excess is not done by the deadline, Susan will owe the IRS a 6% excise tax for every year the excess remains in the Roth IRA. There is a six-year statute of limitation on the excise tax, which starts when the owner’s Form 1040 is filed.
Tax withholding is not conversion
An IRA owner can elect to have taxes withheld when requesting a Roth conversion. However, the amount withheld is not considered part of the conversion and would be subject to the 10% additional tax if the Roth IRA owner is under age 59½ when the conversion is done.
Example: 50-year-old Tim’s traditional IRA number 123456789 has a traditional IRA with a balance of $100,000.
In 2024, Tim instructed his IRA custodian to convert traditional IRA number 123456789 to a Roth IRA and withheld $10,000 for federal income tax.
The IRA custodian credits $90,000 ($100,000 – $10,000) to Tim’s Roth IRA, and remits $10,000 to the IRS as a payment of income tax for Tim.
The results are:
- Tim has a Roth conversion of $90,000.
- Tim must include the $100,000 in income
- The $10,000 is credited to Tim’s federal income tax payments for 2024.
- The $90,000 is not subject to the 10% additional tax, even though Tim is under age 59½.
- The $10,000 is subject to the 10% additional tax because Tim is under age 59½ unless he qualifies for an exception.
Whether one should have taxes withheld for Roth conversions depends on one’s tax profile. Roth converters must consult with their tax advisors for assistance with determining whether they should have taxes withheld.
Roth conversion: Not an all-or-none or one-size-fits-all solution
A conversion can be done for any amount up to the entire rollover-eligible balance of a traditional IRA, allowing taxpayers to perform micro-conversions up to the amounts that are determined to be tax-efficient. For example, a taxpayer who wants to convert $100,000 may spread it over multiple years, if it is more affordable and tax-efficient to do so.
Suitability for a Roth IRA is as crucial as getting the operational processes right. Therefore, an IRA owner should consult with their tax advisor to determine whether they should perform a Roth conversion and, if so, the amount.