Everything you’ve always wanted to know about Roth IRA conversions, but were afraid to ask

With the lure of tax-free distributions, Roth IRAs have become popular retirement savings vehicles. According to the 2017 Investment Company Fact Book, about 17.4% of U.S. households owned Roth IRAs in 2016. One way to fund a Roth IRA is to convert some or all of your traditional IRA or other retirement plan money to a Roth IRA.

Roth IRAs
There are three ways to fund a Roth IRA — you can add money directly, you can convert all or part of a traditional IRA to a Roth IRA, or you can roll over funds from an eligible employer retirement plan.

Most people are permitted to contribute up to $5,500 to an IRA (traditional, Roth, or a combination of both) in 2018 ($6,500 if you’ll be age 50 or older by December 31). However, your ability to make annual contributions may be limited (or eliminated) depending on your income level (“modified adjusted gross income,” or MAGI), as shown in the chart below:

Unlike a traditional IRA, you can contribute to a Roth IRA even if you’re 70½ or older. However, your contributions generally can’t exceed your earned income for the year; special rules apply to spousal Roth IRAs.

Important changes since 2010
Prior to 2010, you couldn’t convert a traditional IRA to a Roth IRA (or roll over non-Roth funds from an employer plan to a Roth IRA) if your MAGI exceeded $100,000 or if you were married and filed separate federal income tax returns.

The Tax Increase Prevention and Reconciliation Act (TIPRA), however, repealed the $100,000 income limit and marital status restriction, beginning in 2010. Since then, regardless of your filing status or how much you earn, you can convert a traditional IRA to a Roth IRA. There’s one exception — you generally can’t convert an inherited IRA to a Roth. Special rules apply to spouse beneficiaries.

SEP IRAs and SIMPLE IRAs can also be converted to Roth IRAs (for SIMPLE IRAs, you’ll need to participate in the plan for two years before you convert). You’ll need to set up a new SEP/SIMPLE IRA to receive any additional plan contributions after you convert.

How do you convert a traditional IRA to a Roth?
Start by notifying your Azzad advisor that you want to convert all or part of your traditional IRA to a Roth IRA, and we will provide you with the necessary paperwork.

Calculating the conversion tax
When you convert a traditional IRA to a Roth IRA, you’re taxed as if you received a distribution, but with one important difference — the 10% early distribution tax doesn’t apply, even if you’re under age 59½. However, the IRS may recapture this penalty tax if you make a nonqualified withdrawal from your Roth IRA within five years of your conversion.

If you’ve made only nondeductible (after-tax) contributions to your traditional IRA, then only the earnings, and not your own contributions, will be subject to tax at the time you convert the IRA to a Roth. But if you’ve made both deductible and nondeductible IRA contributions to your traditional IRA, and you don’t plan on converting the entire amount, things can get complicated. Under IRS rules, the amount you convert is deemed to consist of a pro rata portion of the taxable and nontaxable dollars in the IRA.

For example, assume that your traditional IRA contains $350,000 of taxable (deductible) contributions consisting of $50,000 of nontaxable (nondeductible) contributions and $100,000 of taxable earnings. You can’t convert only the $50,000 nondeductible (nontaxable) contributions to a Roth, and have a tax-free conversion. Instead, you’ll need to prorate the taxable and nontaxable portions of the account. So in the example above, 90% ($450,000/$500,000) of each distribution from the IRA (including any conversion) will be taxable, and 10% will be nontaxable.

You can’t escape this result by using separate IRAs. Under IRS rules, you must aggregate all of your traditional IRAs, including SEPs and SIMPLEs, when you calculate the taxable income resulting from a distribution from or conversion of any of the IRAs.

Using conversions to make ‘annual contributions’
Unfortunately, TIPRA didn’t repeal the income limits that may prevent you from making annual contributions to your Roth IRA. But if your income exceeds these limits, and you want to make annual Roth contributions, there’s an easy workaround: you can make nondeductible contributions to a traditional IRA, as long as you haven’t yet reached age 70½. You simply make your annual contribution first to a traditional IRA, and then convert that traditional IRA to a Roth. There are no limits to the number of Roth conversions you can make. (But again, you’ll need to aggregate all of your traditional IRAs — including SEPs and SIMPLEs — when you calculate the taxable portion of the conversion.)

Employer retirement plans
You can also roll over non-Roth funds from an employer plan such as a 401(k) to a Roth IRA. Like traditional IRA conversions, the amount you convert will be subject to income tax in the year of conversion (except for any after-tax contributions you’ve made).

Is a Roth conversion right for you?
The answer to this question depends on many factors, including your current and projected future income tax rates, the length of time you can leave the funds in the Roth IRA without taking withdrawals, your state’s tax laws, and how you’ll pay the income taxes due at the time of the conversion.

And don’t forget — if you made a Roth conversion in 2017 and it turns out to be disadvantageous (for example, the value of your investments declined substantially), IRS rules allow you to “undo” the conversion for 2017 only. You generally have until your tax return due date (including extensions) to undo, or “recharacterize,” your conversion. For most taxpayers, this means you have until October 15, 2018, to undo a 2017 Roth conversion. (The Tax Cuts and Jobs Act passed in December 2017 eliminated the ability to recharacterize a Roth conversion for tax years 2018 and beyond.)