Converting funds to a Roth IRA depends on your current tax bracket and expected tax rates in retirement, but any money distributed before then would incur ordinary income taxes and potentially an additional 10% penalty tax bill.
The indirect rollover process provides 60 days to transfer any preexisting account balance (before 20% withholding is applied) into another tax-advantaged retirement account.
What Can I Roll Over to a Roth IRA?
If you own or are considering opening a Roth 401(k), eligible distributions from your retirement accounts can be transferred directly into it. Furthermore, non-Roth IRA distributions can also be moved into it or even directly into a designated Roth account within your plan (if such an option exists).
Converting between different IRA accounts presents the challenge of an increased tax bill, though you may be able to reduce its effects by stagger transfers across several tax years and working with a financial advisor to ensure your strategy fits with your overall savings and retirement goals. Otherwise, paying taxes you don’t owe can be a costly mistake; here’s how you can avoid that misstep; rules may differ depending on which plan type you select so always consult your provider beforehand for details.
Traditional IRAs
Traditional IRAs allow individuals to save for retirement tax-free; however, withdrawals will be taxed as income in retirement. You can roll over pre-tax contributions from a 401(k) or qualified plan into one of these traditional IRAs.
Your paycheck allows you to transfer funds directly into a traditional IRA, though withdrawals before age 59 12 may incur income taxes and an early withdrawal penalty of 10%.
No matter whether it is direct or indirect rollover, your conversion amount will be taxed immediately when made, which can unintentionally push you into a higher tax bracket and potentially damage retirement savings. Therefore it is crucial that you seek advice from a financial advisor regarding eligibility for Roth and what the optimal conversion amount for you might be.
SEP IRAs
SEP IRAs are similar to traditional IRAs in that they accept employer contributions. When used by business owners with multiple accounts and contributors contributing both ways, assets can be moved between accounts without tax consequences (unless done as an indirect rollover).
However, the move must be performed using trustee-to-trustee direct transfer and notify the administrator of the old plan. Furthermore, annual contributions cannot exceed 25 percent of an employee’s compensation or an established dollar limit which may be adjusted periodically due to cost-of-living adjustments.
Rollovers from profit-sharing plans and other qualified accounts are also permitted; however, funds moved within 60 days will be considered taxable distributions and subject to taxes accordingly.
SIMPLE IRAs
A SIMPLE IRA is an employer-matched retirement plan for small businesses. Employers usually match employees’ contributions up to a set percentage of compensation.
SIMPLE IRAs may accept rollovers from traditional and SEP IRAs as well as eligible employer plans such as 401(k), 403(b), and 457(b). However, due to an IRS two-year rule prohibiting this action if less than two years have elapsed since an individual first joined such plans, such as traditional or SEP IRAs.
To avoid penalties, individuals should check with their plan’s custodian that they have met the two-year rule before initiating any rollover efforts. Furthermore, professional guidance may be beneficial before initiating transfer paperwork – failing to adhere to annual notification requirements may incur substantial fines; business attorneys can be invaluable resources in helping ensure compliance.
401(k) Plans
Converting from a traditional or SIMPLE account to a Roth can create complex tax implications and should be conducted under guidance by an advisor in order to understand any possible income tax ramifications as well as manage logistics effectively.
Your employer is required to withhold 20% of the taxable portion of your distribution for federal taxes and may impose an early withdrawal penalty of 10% if you’re under age 59-1/2.
One effective strategy to minimize the tax impact of conversions is spreading them out over several years, so as to avoid suddenly jumping to a higher tax bracket. Converting assets during low-tax years may also prove advantageous, particularly if RMDs or Social Security benefits become due later.
