How do Roth IRA Contribution Limits Affect Roth Conversions?
As with most investment options, Roth IRAs carry their fair share of rules set and governed by the Internal Revenue Service to prevent people from abusing the tax benefits of these accounts.
IRS regulations only allow people to make after-tax contributions to Roth IRAs in 2024 if they make less than $161,000 as an individual or $240,000 for married couples filing jointly. There are, however, no income limits with regard to Roth IRA conversions.
Although there are limits with regard to how much you can contribute to a Roth IRA each year — the annual contribution limit in 2024 is $7,000 for anyone under 50 and $8,000 for anyone 50 and older — there are no restrictions regarding how much you can convert from a traditional IRA, Simple IRA, or 401(k) to a Roth IRA. Still, there are some important tax consequences to remember when making Roth IRA conversions.
For starters, each Roth IRA conversion from a tax-deferred account is considered a taxable event. Whether it’s a direct rollover or an indirect rollover, you’ll owe taxes on the amount converted in the year you make a conversion. Based on the size of the conversion and your other income sources, this rollover to a Roth account could end up pushing you into a higher tax bracket.
Another thing to keep in mind is how Roth conversions can impact other aspects of your larger financial strategy. Say your child is getting ready to enter college, and you’ll be helping them apply for financial aid. Roth IRA conversions could increase your income for a given tax year, which might end up reducing your family’s eligibility for financial aid.
Finally, you must consider that the five-year rule for Roth IRAs also applies to Roth conversions. If you’re younger than 59 ½ and take IRA distributions within five years of a conversion, you’ll end up paying taxes on the earnings portion as ordinary income and be subject to a 10% early withdrawal penalty. The five-year clock starts ticking on January 1 of the year you made a conversion, but each one begins its own countdown if you make multiple conversions.
How Do Roth IRA Conversions Impact My Taxes?
When you convert money from a traditional IRA to a Roth IRA, you might end up paying taxes on the amount you convert between IRA accounts. The taxes you owe on those funds will depend on your taxable income and tax rate at the time of the conversion.
To calculate your tax bill, you must first know which income tax bracket you fall into. If your income already is taxed at a higher rate — rates in 2024 range from 10% to 37% — the tax implications will be more severe for those rollover funds.
Your chosen conversion amount, which is considered a distribution from your retirement account, is added to your gross income for the given tax year. Here, the conversion could unintentionally push you into a higher tax bracket for the year — which means a higher effective tax rate.
Say you’re in the 24% tax bracket and decide to convert $30,000 from your traditional IRA to a Roth IRA. Provided this move doesn’t land you in a higher tax bracket, you’d end up owing about $7,200 in taxes on that conversion (ignoring deductions).
Those taxes could be worth it today if it means you’re able to enjoy qualified distributions in retirement — meaning they are tax-free and incur no early withdrawal penalty — when you could potentially be in a higher tax bracket than you’re in now.
While IRA conversions can be a valuable way to boost your retirement savings, they can carry significant tax consequences. And if you’re rolling over retirement funds from a pre-tax employer-sponsored plan like a 401(k), it’s generally advisable to roll the money into a traditional IRA first before attempting a Roth conversion.
How to Start the Rollover Process
If you think a Roth IRA conversion might be the right choice for you, it’s time to navigate the IRA rollover process.
While the IRA rollover process is relatively straightforward — it always starts with opening an IRA — it can vary slightly depending on whether you’re making a direct rollover or an indirect (60-day) rollover. Let’s learn more about these two approaches to retirement plan distributions.
Direct IRA Rollovers
A direct IRA rollover involves moving funds from one retirement account to another without incurring any tax penalties or other consequences. The IRS allows direct rollovers between accounts, such as from one IRA to another IRA or from a 401(k) to an IRA.
With a direct rollover, the funds are transferred directly between financial institutions. As the account holder never actually handles the money, those funds are not subject to taxes or penalties, and there is far less risk involved.
A direct IRA rollover can be initiated by contacting the bank or financial institution and asking them to move the money for you. You can also ask your former employer to transfer funds from your work retirement account to your IRA.
Indirect IRA Rollovers or 60-Day Rollovers
Meanwhile, an indirect rollover inserts the account holder into the process. The individual receives a distribution directly, and they then have 60 days to deposit their entire pre-existing balance (before tax withholding) into another tax-advantaged retirement account. It can be costly if you fail to re-deposit your funds.
With an indirect rollover, individuals who do not complete the rollover process within that 60-day time frame are subject to taxes and penalties. The distribution from the original account is considered ordinary income, and it is taxed at the individual’s income tax rate. Moreover, that person also faces a 10% early withdrawal penalty if they are younger than 59 ½ years.
Indirect rollovers can be a useful option if a direct rollover is not available or if a person needs to use those funds briefly before transferring them to a new account. Note that the IRS limits people to one indirect rollover every 12 months.