Roth In-Plan Conversion: Best Tax Strategy

What is Roth in-plan conversion? Is it an ideal savings tool for your retirement? Find out these and more in this comprehensive review.

Personal finance can be tricky when it comes to retirement savings. Not many of us think about it, especially when we are young. However, this is something we should not ignore to ensure that our old age is not faced with unprecedented financial challenges.

Contributing to retirement plans is one way to ensure a financial cushion later in life. But what if you're not happy with your employer's retirement plan? What happens if the equity markets decline or weaken, resulting in some losses in your traditional IRA contributions?

Well, the good news is that you may be able to convert your employer-sponsored retirement plan, such as a 401(k), into a Roth IRA. This will help you take advantage of tax-free contribution withdrawals and tax-free growth on the Roth money.

But before we go further, let's understand what a Roth IRA is all about.

What Is a Roth IRA?

A Roth IRA is an individual retirement account that offers tax-free growth and tax-free withdrawals in retirement. Unlike a traditional IRA, contributions to a Roth IRA are made after taxes have been paid. This means you won't get a tax deduction for your contributions, but all future growth and withdrawals will be tax-free.

Usually, there are income limits for contributing to a Roth IRA. For instance, if your annual MAGI (modified adjusted gross income) exceeds $144,000 for a single filer or $214,000 for joint filers, you are ineligible to contribute directly to a Roth IRA. This is because your income surpasses the statutory ceilings set by law.

The good news is even if you're ineligible to contribute directly to a Roth IRA, you may still be able to open one by doing a Roth conversion. We will see all about this later!

Roth IRAs are not that different from traditional IRAs. In fact, their only distinction is mostly on how the two accounts are taxed. How do I mean?

Usually, with traditional IRAs, you make pre-tax contributions – you contribute from gross income before tax. As such, your contributions are tax-deductible, although this also depends on your income. Taxing traditional IRA accounts is done at the point of withdrawal.

This means that while you may enjoy tax reductions on your contributions, they will be taxed when you are making the withdrawals. You should also note that the growth of your contributions will be taxed.

Roth IRAs, on the other hand, are made from after-tax income. As such, contributions are not tax deductible. However, these contributions and earnings from the account are tax-exempt at the point of withdrawal.

Now, let's get to the main issue.

What is Roth In-plan Conversion?

A Roth in-plan conversion is simply the process of rolling over assets from a traditional retirement plan, such as a 401(k), into designated Roth accounts. The Internal Revenue Service (IRS) views this as a distribution from the traditional retirement account followed by a contribution to the Roth IRA.

You will be required to pay taxes on the amount rolled over. But, since the Roth IRA is tax-free, you will not have to pay any taxes on the growth or withdrawals made after 59.5 years or any other time after your account hits five years.

It's also important to note that not all employer-sponsored retirement plans allow for in-plan conversions. Therefore, checking with your employer before proceeding with the conversion is important.

If your employer's retirement plan does allow for in-plan conversions, there are usually two ways to go about it. The first one is to roll over the assets into a Roth IRA you set up. And the second one is to have the assets rolled over into a Roth 401(k) offered by your employer.

See Related: Alternative Financing Now a Means to Funding

Factors to Consider before you Set Up a Roth IRA

You should consider a few things before converting your retirement assets into a Roth IRA, such as:

• Your current and future tax bracket: If you expect to be in a higher tax bracket when you retire, it may be beneficial to convert your traditional retirement account into a Roth IRA. This is because you will pay taxes at your current rate, which is likely to be lower than your future tax rate.
• The amount you plan to convert: It's important to consider the amount you plan to convert because this will have an impact on your taxes. For instance, if you convert $50,000 from a traditional IRA to a Roth IRA, you will have to pay taxes on the entire amount. However, if you only convert $5,000, the taxes will only be levied on that amount.
• Your retirement goals: Another thing to consider is your retirement goals. A Roth IRA may be a good option if you want more control over your retirement savings. This is because you can withdraw your contributions without having to pay any taxes or penalties. With a traditional IRA, you will be required to pay taxes and penalties if you withdraw your funds before the age of 59.5 years.

The benefits of a Roth IRA outweigh the cons, making it a good option for retirement planning. However, speaking with a financial advisor is still important to see if a Roth IRA is right for you.

How Does A Roth In-Plan Conversion Work?

A Roth in-plan conversion is the process of transferring eligible assets from a traditional retirement plan into a Roth account. The Roth in-plan conversion allows you to transfer part or all of your eligible rollover of assets from traditional IRAs or other retirement plans into a Roth account.

The assets are first distributed from the traditional retirement account and then contributed to the Roth IRA within the same plan. This is seen as a distribution from the traditional retirement account followed by a contribution to the Roth account.

Usually, the money converted into the Roth IRA is taxed. This is because contributions for a Roth IRA account come from after-tax money. However, it also means that the amount you've converted will not be taxed when withdrawing. Also, the earnings from this account are tax-free.

As the owner of the Roth account, you need to report the amount to be converted as taxable gross income for the said tax year. But, the mandatory 10% tax penalty and the 20% withholding tax will not apply to this taxable income.

One more thing you should note here is that you need to have held the Roth account for at least 5 years before you can enjoy free withdrawals on your converted contributions.

Best In-Plan Roth Conversion Options

As you've seen above, the in-plan Roth conversion process is a pretty simple one. It includes:

• A conversion whereby you pick a check of your distribution from your traditional IRA account and deposit it into your Roth IRA account. This should be done within 60 days of picking up the check.
• A transfer from one trustee to another trustee. Here, you direct one financial institution (the one holding your traditional IRA account) to make the necessary transfer to another institution.
• Transfer within the same trustee: Here, you direct the institution holding your retirement account to transfer the eligible rollover amount into a designated Roth account within the same institution.

Now, these are pretty simple options. However, there's one thing you might need to be keen about.

If you pick a check for the rollover amount and fail to deposit it into the right Roth account within 60 days, regular income taxes (20%) plus a 10% penalty will apply to the amount. But if you are at least 59.5 years, the 10% will not apply.

For this reason, it might be wise to use the last two methods to avoid any mistakes or delays. Also, for any of these methods, IRS requires you to report the conversion through form 8606.

How Many In-Plan Roth Conversions are Possible into a Designated Roth Account?

If you are worried about the number of times you can make an in-plan Roth conversion, don't be. The IRS has no limit on how many times you can make an in-plan Roth conversion. You can do it as often as you want and as long as the retirement plan permits it.

The only limits occur when you are transferring assets from one traditional IRA to another. It can only be done once in a 12-moth period. But for an in-plan Roth conversion from a traditional IRA, there are no limits currently.

As such, you can decide to either transfer all your traditional IRA contributions or part of them to your Roth account at any time. However, the former is not advisable.

By moving all your contributions, your income might scale to a higher marginal tax bracket. Consequently, this will result in higher taxes. Therefore, try to convert these contributions several times.

In addition, if you want to benefit more from the in-plan Roth conversions, do it during periods when your income is lower. This will help you benefit from reduced taxes on each converted dollar.

How to Escape the Roth IRAs Limits

There are two limits to Roth IRAs. The first one is the contribution limit, and the other is the income limit.

For the 2022 tax year, you can contribute $6,000 to your Roth IRA account if you are 49 years or younger. If you are 50 years or older, you get a catch-up contribution of $7,000.

The second limit is on your income. You cannot make a Roth IRA contribution if your modified adjusted gross income (MAGI) is over a certain amount. For instance:

• For the head of household, singles, or married people who didn't live with their spouse in the last year, it is $143,999
• Married and filing jointly – 213, 999.
• For married but filing separately – less than $10,000

You cannot make a Roth IRA contribution if your MAGI is more than these amounts. However, there's a way around this limit if you still want to contribute to your Roth IRA account and enjoy the benefits that come with it.

You can use what is known as the backdoor Roth IRA contribution strategy. This strategy involves making before-tax contributions to a traditional IRA account and then converting them to Roth IRA.

This way, you get to avoid the income limits on the Roth IRAs since there are no such limits on the traditional IRAs.

What Are The Benefits Of A Roth Conversion?

Several benefits come with in-plan Roth rollover. These include:

• You get to pay taxes at your current tax rate: When you convert your traditional IRA into a Roth IRA, you will be required to pay taxes on the amount rolled over. However, since the Roth IRA is tax-free, you will not have to pay any taxes on the withdrawals, either when you satisfy the 5-year rule or after you are 59.5 years. This is a great tax strategy in case you anticipate higher future tax rates.
• Your earnings grow tax-free: With a Roth IRA, you won't have to pay income tax on either your Roth contributions or the earnings – It grows tax-free and can be withdrawn tax-free after you reach the age of 59.5 years.
• There are no required minimum distributions: With a traditional IRA, you are required to take minimum distributions starting at the age of 70.5 years. However, with Roth IRA, there are no required minimum distributions. This means that you can let your money grow tax-free for as long as you want.
• You can access your money penalty-free: With a traditional IRA, you will be charged a 10% early withdrawal penalty if you withdraw your money before the age of 59.5 years. However, with a Roth IRA, you can withdraw your principal (contributions) at any time without being charged a penalty – as long as the account is over five years old. This makes it a great option for emergency funds.
• It is an excellent retirement savings tool: A Roth IRA is an excellent retirement savings tool since it allows your money to grow tax-free and gives you tax-free withdrawals in retirement. So, if you want to enjoy some tax savings, this is the retirement account to choose.

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