17 Apr What do I need to know about converting to a Roth IRA?

Q. I would like to know more about converting a standard IRA into a Roth IRA, which is tax-free after the five-year rule.
— Saver

A. Sure.

The five-year rule is one of the important considerations you must know before converting a traditional IRA to a Roth IRA.

First, let’s assume your traditional IRA is made up of all “pre-tax” monies, meaning you have never paid income tax on those monies, said Michael Cocco, a certified financial planner with Beacon Wealth Partners in Nutley.

He said when you convert a traditional IRA to a Roth IRA, you will need to pay taxes at your ordinary income tax rate in the year you convert.

“There are no income limits to doing a Roth IRA conversion, so anyone could be eligible to do it, which is great,” he said. “However, things could get tricky as the amount of the conversion is counted in your total taxable income, so it may increase your marginal tax rate, making some of your other income taxed at a higher rate.”

It could also affect other areas such as a potential Senior Freeze on your real estate taxes, property tax rebates, or even the amount you pay each month for Medicare because these are all income-dependent items, Cocco said. For these reasons, it is extremely important that this decision is not made in a vacuum, and you discuss this with your financial advisor and tax advisor, he said.

Cocco said if you have traditional IRAs that are comprised of “after-tax” contributions, you potentially can convert some or all of that money to a Roth IRA with zero or a reduced tax.

These rules are even more complex, as you are only able to convert your “after tax contributions” — and not your earnings — tax-free to a Roth IRA, he said.

If you have a combination of after-tax IRAs along with after-tax earnings, as well as pre-tax IRAs, you would be subject to the “pro-rata rule” and all of your traditional IRAs must be used in the overall calculation of what is taxable in your conversion, and not just the specific traditional IRA account you choose to convert, Cocco said.

So when can you access the Roth IRA money tax-free?

“In order for your Roth IRA distributions to be completely tax-free and free of any penalties, you must have the Roth IRA in existence for at least five years and be at least 59 ½ years old at the time of the withdrawal,” he said. “If planned out well and executed correctly, conversions to Roth IRAs could have a meaningful impact on your retirement plan and give you the ability to access part of your retirement assets free of income taxes.”

But again, working very closely with your financial advisor and tax advisor is strongly recommended to ensure you follow all the tax rules and guidelines in this complicated but potentially impactful process.

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This story was originally published in April 2024.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.