How to Convert a Roth IRA Without Losing Money or Paying Taxes

Daniel Penzing
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The Benefits of a Roth IRA Conversion

If you have money in a traditional IRA, there are several reasons why you would want to begin a conversion to a Roth IRA. Let’s take a look at some of them.

Pay Taxes on Your Money Early

When you convert an IRA to a Roth IRA, you convert money from a pretax account to an after-tax account. In most cases, you can avoid taxes on interest, dividends, and capital gains that you earn in the Roth IRA.

By converting a traditional IRA to a Roth IRA, you are paying taxes on the money now instead of at some point in the future. You will end up with the same amount of money, but because of the taxes saved, you will likely end up with a higher balance in your Roth IRA.

Get around Required Minimum Distributions

Traditional IRAs come with certain rules and regulations. There are several mandatory withdrawals that you are required to make according to a certain schedule.

In most cases, you must begin making withdrawals from your IRA by April 1 of the year after you reach the age of 70 1/2. The amount that you are required to withdraw is calculated by using a certain formula using your beginning account balance.

You may not want to make these withdrawals and you can avoid doing so if you convert your traditional IRA to a Roth IRA.

The Cost of Doing a Roth IRA Conversion

If you were to convert all of the money in your traditional IRA to a Roth IRA, you would pay taxes on the amount that you converted. You would also pay the taxes again when you file your annual taxes each year on the growth of your Roth IRA. While this may seem like a good deal, it really is not that smart. You’d lose a large percentage of your money.

If you plan on doing a Roth IRA conversion, it’s a much better idea to use a cash out refinance.

If you own your home, you can do a quick refinance to get some cash. That way you don’t have to pay any penalties on your IRA account. After the refinance, you will have used your house as security for the loan while also freeing up money to invest in a new Roth IRA.

Converting Non-Deductible IRA Funds

If the value of the IRA is greater than the basis, the entire IRA is considered non-deductible. In this case, the conversion taxes are calculated using the highest tax rate in effect for the year.

The results of these calculations are used in step five, which determines if any of the conversion is a taxable distribution.

The final step in the conversion process determines if any of the conversion is a taxable distribution based on the IRA balance as of 1/1/1997. If the conversion is not taxable, the inclusion period begins on the conversion date. The IRA adviser should be able to provide you with information regarding the applicable rules you must adhere to.

Leveraging Your 401(k) Plan

When it comes to asset allocation, your 401(k) plan is probably your greatest asset. Ideally, you can save a lot of money in your company’s 401(k) plan (such as matching your contribution).

This is because your 401(k) plan is tax-deferred. It is your money, but you don’t get taxed on your contributions.

The free money invested in your 401(k) plan by your employer allows you to pay for a gigantic house, a lavish car, or even take an expensive vacation.

But saving in your 401(k) plan is not as straightforward as putting money in a bank. Just as sure as you put money in your 401(k) plan, you must retire from your job and must not tap into your 401(k) plan prematurely.

If you don’t follow the rules of your 401(k) plan, you could face steep penalties if you take out your money prematurely. The government will also tax you on the contributions that you put in.

Most people, therefore, do not know how to convert a Roth IRA to a traditional IRA or vice versa.

If Your 401(k) Doesn’t Permit IRA Rollovers

If your 401(k) or other retirement plan doesn’t let you roll over your proceeds into a Roth IRA, there are still a number of other retirement plans that allow it.

Your next best choice is to roll the funds over to your new employer’s 401(k) plan.

Your third option is to roll over the funds to a traditional IRA, either through the same financial institution that holds your existing traditional IRA or through a different financial institution (assuming that your bank allows your existing funds to be transferred).

Your fourth choice is to roll over the funds to a new financial institution or broker through the IRS-approved 60-day rollover process … a process that some financial institutions make exceedingly difficult if you are transferring your funds to another institution.

Your fifth choice is to roll the funds over to an IRA custodial account (that’s an investment account that is administered by company that administers IRAs).

Note that investing in a brokerage account (a brokerage account lets you buy and sell stocks, bonds, mutual funds, etc.) may be a better option than an IRA custodial account (which simply holds your IRA assets and offers limited investment choices).

Whenever you transfer your IRA assets to another financial institution, make sure to ask if there are any associated fees or taxes.

How to Not Lose Money on a Roth IRA Conversion

When you convert money from a traditional IRA to a Roth IRA, you have two options: liquidate the money or have the money transferred by the custodian trustee. When you liquidate it, you pay taxes on the amount you take.

The alternative is to have the amount transferred to your Roth IRA in the form of a direct rollover. Since the taxes on the conversion have already been paid, you avoid paying tax on the money again. Meanwhile, you still have the option to invest the money as you see fit.

There are some logistical issues, however, that you need to be aware of to make sure you avoid tax penalties during the transfer. Before you do anything, it’s important to know that you need to decide whether you’re going to transfer money from a traditional IRA to a Roth IRA, and a rollover is only an option if you’re moving funds from one traditional IRA to another.

If you’re moving funds from a traditional IRA to a Roth IRA, determine whether the IRA you’re moving to is a new or existing IRA. For example, you won’t be able to move IRA funds into the Roth IRA you already have unless it’s a new account.