Several Key Technical Aspects of a Roth Conversion
There are several technical details to understand about a Roth conversion in order to avoid surprise tax bills. The following section outlines some tax rules to consider.
Roth conversions can no longer be undone – The 2017 Tax Cut and Jobs Act eliminated a tax law that allowed investors to undo their Roth conversion decision. This was known as a recharacterization and investors used this law to undo Roth conversions on investments that decreased in value. Roth conversions are now final in the year of the transaction.
Roth funds cannot be withdrawn for five years without penalty – If an investor needs IRA money to live on, it is unwise to convert to a Roth IRA. Withdrawals from a converted Roth IRA are subject to a 10% penalty tax if the withdrawal occurs within five years of the conversion and the investor is below age 59 1/2.
Quarterly income tax payments may need to be made– The taxation of a Roth conversion occurs in the year of conversion. If a substantial Roth conversion occurs early in the year, quarterly income will increase and estimated quarterly taxes may need to be paid. If waiting until the tax filing deadline, extra penalties and interest may be owed on taxes not promptly paid. You should consult your tax advisor to see whether you might be able to use an exception to quarterly payments based on paying 110% of last year’s liability.
Don’t forget about states taxes – A Roth IRA conversion is a taxable event for state income taxes as well. One strategy may be waiting to convert Roth funds when moving to a state with a lesser tax rate, or one with no income taxes. Conversely, converting to Roth before retiring to a state with higher income taxes may be a very beneficial long-term strategy.
Tax deductions may offset the tax cost of a Roth IRA conversion. Tax deductions that reduce ordinary income, such as charitable contributions to qualified charities or a donor advised fund, will reduce the taxes owed on Roth conversions. Other itemized deductions will also reduce the amount of tax owed on a Roth conversion.
Roth conversions do not count toward an RMD – A Roth conversion does not count toward a required minimum distribution (RMD). If pre-tax funds remain in an IRA account, an RMD will need to be taken as if no Roth conversion occurred since RMDs are based on the balance in the traditional IRA as of the prior year end, before the conversion.