How is Taxation Done on Roth Conversions? 

At some point, your client may want to do a Roth conversion: move some or all their money from a traditional 401(k) to a Roth 401(k) plan, or a traditional IRA to a Roth IRA. Roth conversions have tax benefits and tax implications that can affect their financial goals.  

Whether or not the taxation on these Roth conversions will be beneficial to your client ultimately depends on the amounts involved and their financial circumstances during the conversion. Although the taxes are applied once per conversion, the resulting tax bill can be huge. That can undermine your client's financial goals.  

To avoid this situation, it’s crucial to find out how much taxes your client might have to pay. Crunch the numbers and find a way to reduce the tax liability on the Roth conversions.  

In this article, InvestmentNews gives insight into relevant topics like Roth conversion taxation rules. We’ll cover how to pay tax on Roth conversions, when to pay, and other crucial questions.     

The purpose of Roth conversions 

A Roth conversion, whether from a traditional IRA to a Roth IRA or a traditional 401(k) to a Roth 401(k), has its share of benefits. So why would you want to recommend it to your client? Let’s look at the benefits.  

Traditional IRA to Roth IRA conversion benefits 

1. Get tax-free withdrawals upon retirement 

Once your client converts a portion or all their money in their traditional IRA to a Roth, they can make tax-free withdrawals. Roth withdrawals are tax-free only if the account owner is at least 59½ years old when they do the withdrawals. Roth withdrawals must also fulfill the five-year rule.  

2. Withdraw contributions to the Roth IRA anytime 

The account owner (your client) doesn’t have to meet any age requirements when it comes to taking out contributions from the Roth account. Remember, this applies to contributions to the account and not the earnings!  

3. Let your money grow tax-free for a longer time 

Due to the changes introduced by the SECURE 2.0 Act, Required Minimum Distributions (RMDs) are no longer mandatory for Roth IRAs. This is in stark contrast to traditional IRAs, where the account holder must take RMDs once they reach past the age of 72 (73 if the account owner turns 72 after Dec. 31, 2022).  

Since RMDs are not mandatory for Roth IRAs, the account owner can leave their money untouched and let it have tax-free earnings.  

Traditional 401(k) to Roth 401(k) conversion benefits 

1. Tax-free withdrawals on retirement 

After converting a traditional 401(k) to a Roth 401(k) retirement account, withdrawals are not subject to any taxes if done during retirement.   

There are no income tax or penalties if the withdrawals are made when the account holder is at least 59½ years old. 

2. Withdrawals of contributions and earnings on the account are not taxed 

Unlike a Roth IRA, the account holder cannot withdraw contributions at any time. Doing so will incur a tax bill. For withdrawals or earnings or contributions, it must be what the IRS calls a qualified distribution. This means that the account owner must be at least 59½ years old and the account must be open for at least five years.   

3. No Required Minimum Distributions 

Retirement accounts typically require their owners to take RMDs once they reach a certain age. But as of January 1, 2024, Roth 401(k) plan holders are no longer required to take RMDs. They can simply leave the money in the plan to grow tax-free.  

Backdoor Roth IRA conversion benefits 

1. Withdrawals of the converted amount are tax-free 

As with a regular Roth IRA, the backdoor Roth IRA lets account owners withdraw the converted amount without paying any taxes or penalties. The only caveat is that these must be qualified withdrawals. The account must be around for at least five years and the account holder at least 59½ years of age.  

2. Tax-free growth  

The money placed into a backdoor Roth IRA can likewise have earnings and grow with compound interest, without being taxed. The interest can accrue indefinitely if the account owner does not withdraw all the money.   

3. No Required Minimum Distributions 

Thanks to the provisions of SECURE Act 2.0, RMDs have been removed from Roth IRAs, even if they’re backdoor Roth IRAs. Account holders can leave the money in their backdoor Roth IRAs to accumulate tax-free interest.  

4. Bypassed contribution limits 

This is its primary benefit; the backdoor Roth IRA lets people move funds to a Roth IRA even if they go over the income limits. It works by making a deductible contribution to a traditional IRA and then converting that contribution to a Roth IRA. 

How much taxes will your client pay on Roth conversions? 

The taxes due will depend on the amount they convert and the tax bracket they are in.  

Clients must be careful not to convert amounts that can increase their gross income. This can push their taxable income into a higher tax bracket. They will have to pay the taxes the year they make the conversion. Taxation is common across the different types of Roth conversions.  

To have an idea of how much you’ll pay in conversion taxes:  

• add the converted amount to your gross income for the year 
• check the total and see which tax bracket your gross income falls under  
• multiply by the tax rate for your tax bracket  

You can also try using a free calculator to make a tax estimate on the conversion.  

2023 Tax Brackets 

Important note: Due to inflation of unprecedented levels, the income thresholds for the 2023 tax brackets were adjusted significantly and increased by about 7% from 2022. This means that your clients might find themselves in a lower tax bracket than they were previously. 

2024 Tax Brackets 

How to reduce or avoid the taxes on conversions 

Since the conversions taxes are part of income taxes, there is no way to avoid them.  

But there is a way to reduce their impact by restructuring them, so they are reduced and are more manageable. When it comes to minimizing conversion taxes, timing is important.  

You can advise your client to restrict the amounts so that they aren’t placed in a higher tax bracket.  

They can also stagger the conversions or do them in years where they have less income or portfolio losses and therefore lower taxes. These and other strategies can significantly lower the conversion taxes. 

What tax form is used for the Roth conversion tax? 

The appropriate form for reporting a Roth conversion for taxation is Form 8606, Part II. You must also use Form 1099-R to fill out Form 8606. 

In the case of a Backdoor Roth IRA, do you pay taxes twice on it? 

The simple answer to this is no, you do not have to pay taxes more than once on a backdoor Roth IRA. However, taxes are due when the conversion from the traditional IRA to a Roth IRA is in line with the Pro-Rata Rule. 

If the five-year rule and other requirements are fulfilled, then no taxes are imposed on money withdrawn from the Roth account.  

What is the Pro-Rata Rule? 

If your client converts an amount from a traditional retirement account to a Roth IRA (as in a backdoor Roth IRA), the Pro-Rata Rule applies since the converted amount has both after-tax and pre-tax money. The Pro-Rata Rule is applied to compute what percentage of the converted amount is non-taxable. 

This rule is important to keep higher-income earners from exploiting the backdoor Roth conversion and avoiding additional taxes.  

What is the Pro-Rata Rule formula and how is it applied? 

The formula has two parts:  

1. (non-deductible amount) ÷ (total of all non-Roth IRA balances)  

= non-taxable percentage 

2. (amount to be converted to Roth IRA) x (non-taxable percentage)  

= amount of after-tax funds converted to Roth IRA 

So, for example, your client has $106,000 in a traditional IRA. They have $6,000 in it that’s after-tax. Assuming they’re over 50 years old, then decide to convert that amount of $6,000 to a Roth IRA. Some may think that they won’t have to pay taxes on it again, but this is incorrect. The Pro-Rata Rule applies. The computation in this case is as follows: 

$6,000 ÷ $106,000 = 0.06%    

$6,000 x 0.06% = $360 

In this instance, only $360 is non-taxable, making the rest of the converted amount of $5,640 subject to tax. This is added to the account owner’s taxable income for the year.  

Here’s a short video that talks about the Pro-Rata Rule a bit more. But what if the investor decides to only convert $1,000 at a time to avoid being placed in a higher tax bracket? Watch the video to see the computations. 

How is the Roth conversion amount taxed?  

Any amount of money in a Roth conversion is simply taxed as if it was ordinary income. If your client wants to do a Roth conversion, they should have enough money from another source to pay for the conversion taxes.  

What are good ways to pay for the conversion taxes? 

First, it’s important for your client to have a separate source of funds to pay for the taxes that result from converting to a Roth. It’s not a good idea to pay for the conversion taxes with the 401(k)’s or IRA’s funds as this will reduce the principal and the earnings potential.  

Depending on your client’s financial footing, they can choose to pay the conversion taxes by either: 

• paying a lump sum – they can pay for the Roth conversion tax when filing their annual returns. But remember, this can be a hefty payment so make sure your client has another source of funds. 
• paying installments – they can make tax payments on the Roth conversion during the year, spreading out the amounts to manage their cash flow. This requires you to estimate the tax they’ll pay on their Roth conversion.  

Avoiding the taxation on Roth conversions may be unavoidable, but it is certainly manageable.  

By timing the conversion right and/or staggering the conversion process, your client can systematically transfer IRA funds to a Roth and pay no taxes when they make withdrawals in the future.  

They can also convert smaller amounts into a Roth, making sure that they don’t land in a higher tax bracket – so if any income taxes become due, they will be minimal.  

Optimizing taxation on Roth conversions is tedious, but with the tax-free withdrawals and new no-RMDs rule, it’s certainly worth it. And remember, you can always enlist a trustworthy institution to do the Roth conversion.  

What do you think about Roth conversion taxes? Are your clients well within the income limits? Will you have to resort to a backdoor Roth IRA? Don’t forget to look up other expert opinions on this and other tax topics on InvestmentNews.