Answers to Your FAQs About Roth IRA Conversions & Roth IRA Taxation

Since its inception in 1997,² the Roth IRA (individual retirement account) has become one of the most popular tools for retirement planning. More than 34% of Americans hold at least one type of IRA, and the Roth is the second most popular type, according to the Tax Policy Center (part of the nonprofit think tank Urban Institute & Brookings Institution). Nearly 10% of IRA accounts are Roth IRAs. ¹

At Lundervold Financial, we get a lot of questions about Roth IRAs, so we are sharing some of the more common questions and our best answers. For the best answers to your unique situation, talk to one of our financial advisors; simply call or schedule a time to meet for a free consultation.

What Are the IRS Roth IRA Contribution Limits? 

The annual contribution limit in 2021 is $6,000 if you’re under the age of 50. People who are 50 and over can contribute $7,000 annually. These amounts are the total contributions you can make to all of your traditional IRAs and Roth IRAs. Additionally, there may be limitations on your Roth IRA contributions based on your income and filing status. 

You can learn more about IRA contribution limits here and also by talking with your financial advisor.

Can You Convert a Traditional IRA to a Roth?

Yes, you can convert a traditional IRA into a Roth IRA. There are a few ways you can achieve this, including a rollover, a trustee-to-trustee transfer, and a same-trustee transfer. 

• Converting a traditional IRA to a Roth by rollover: This method involves receiving a distribution from your traditional IRA and contributing it to a Roth IRA within 60 days after that distribution. In this situation, the distribution check must be payable to you.
• Converting a traditional IRA to a Roth by trustee-to-trustee transfer: For this to happen, you instruct the financial institution managing your traditional IRA to transfer funds directly to the trustee of a Roth IRA at a different financial situation.
• Converting a traditional IRA to a Roth by same-trustee transfer: If your traditional IRA is maintained by the same financial institution as your Roth, you can simply transfer between the two. 

Note that contribution limits still apply to transferred funds. Also, conversion to a Roth IRA will result in taxation of untaxed amounts in the traditional IRA. You’ll have to report this on Form 8606 PDF.

Bottom Line: Should You Convert an IRA to Roth?

IRAs, both Roth and traditional, are powerful financial planning tools that can help you build wealth and prepare for retirement. Remember: Retirement planning is a highly individualized process, so there is no single, correct answer. You should talk with an experienced financial advisor who can examine your income, goals, and tax implications before making any decision. 

So, Is an IRA Tax-Deferred?

Traditional IRAs are tax-deferred, which means you pay taxes on the money when you withdraw it or when you start taking mandatory distributions. Roth IRAs are NOT tax-deferred, they are tax-exempt. This means you make contributions with after-tax dollars, but your future withdrawals are not subject to tax. Both types of financial planning tools have benefits, so it is wise to talk with a financial advisor to determine how best to use them.

Are Roth IRAs Subject to RMD?

Traditional IRAs are subject to required minimum distributions (RMDs) starting at age 72. Roth IRAs, however, are not subject to RMDs. This means you do not have to take any distributions from your Roth, but can continue to let the money grow. Should you pass on the Roth to beneficiaries, they may need to take RMDs in order to avoid penalties.

How Do You Do a Roth Conversion?

To convert your retirement account to a Roth IRA, first you need to have established a traditional individual retirement account with funds. Then, you’ll need to set up a Roth IRA, which you can do through your bank or through a broker. And, yes, we at Lundervold Financial can help you open a Roth IRA and help you with your conversion. Because Roth IRAs are funded with after-tax earnings, you’ll likely owe taxes on those contributions that you convert. We look at your existing IRA and help you understand how much you might owe when you file your income tax return. 

Can I Do a Roth Conversion After I Retire?

The short answer is yes, you can convert your IRA into a Roth IRA at any age and at any stage of life — whether you are pre-retirement or retired. The real question, though, is should you convert your IRA to a Roth after you retire?

This is another question that you and your financial advisor should answer together, taking all of your investments, expenses and sources of income into consideration. Lundervold Financial, for example, uses computer programs and other tactics to help us make more informed and beneficial decisions when it comes to Roth conversions.

Do Roth Contributions Reduce Taxable Income?

Roth contributions are made after taxes, so they don’t have a direct impact on your taxable income. Also, any contributions you make to your Roth are not tax deductible. So, if you plan to contribute the maximum amount (in 2020 and 2021, that is $6,000 if you’re 49 or younger and $7,000 if you’re 50 or older), you’re using after-tax income to make those contributions.

So, why invest in a Roth IRA? The advantage of a Roth IRA is that you do not incur penalties when you withdraw funds, because you’ve already paid taxes on these earnings. The advantage of a Roth IRA is that you pay taxes on the income before you transfer funds into the retirement account. You do not pay taxes when you withdraw the funds, and you do not pay additional taxes on your Roth IRA’s earnings.

Do You Pay Taxes on Roth IRA Withdrawals?

We’ve answered that question earlier on this page, but it is worth repeating because if you’re like us, you probably are more of a scanner than a reader. You do not pay taxes on Roth IRA withdrawals.

Can a Retired Person Continue to Contribute to a Roth IRA?

You can contribute to traditional and Roth IRAs in retirement if you are still earning income. IRAs must be funded with earned income, whether it’s from a part-time job, full-time job, or contract work. The rule says you have to earn the income in exchange for work. So, you cannot use funds that you receive from a pension, annuity, gift, or Social Security. The $6,000/$7,000 contribution limit (under age 50/over age 50) still apply.  

Can I Withdraw Funds Early From a Roth IRA?

You can withdraw funds early from a Roth IRA without penalties, as long as you draw from your contributions and not from the earnings.

Can I Do My Own Roth IRA Conversion?

You can, yes, and there are many online platforms that allow you to open an account and select your own investments. You can also work with a financial advisor, who can do it for you and also help you choose the right investments, based on your other sources of income, your tolerance for investment risk, your goals in retirement, and your anticipated expenses. In fact, a lot of people do not realize that even if you do set up your own Roth IRA, you can still work with your financial advisor to help manage self-directed retirement accounts.  

Another thing to keep in mind is that when you sit down with an advisor, we can help you determine the correct amount to convert for the greatest benefit. Whether that means doing the conversion as a lump sum or spreading it out over several years, our software can help us reach a more accurate dollar amount and a more efficient plan.

Sources

¹ Urban Institute & Brookings Institution. Tax Policy Center Briefing Book. Accessed Dec. 11, 2020.

² Troy Segal and Marguerita Cheng. Investopedia. Oct. 30, 2020. “What Is a Roth IRA?” Accessed Dec. 11, 2020.

We are an independent firm helping individuals create retirement strategies using a variety of insurance products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic retirement income strategies and should not be construed as financial advice.

Please remember that converting an employer plan account to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including (but not limited to) a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA.

The information contained in this material is believed to be reliable, but accuracy and completeness cannot be guaranteed; it is not intended to be used as the sole basis for financial decisions. If you are unable to access any of the news articles and sources through the links provided in this text, please contact us to request a copy of the desired reference.Neither our firm nor its agents or representatives may give tax or legal advice. Be sure to speak with a qualified professional about your unique situation.

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