How to Do an IRA Rollover to a Roth

An IRA rollover to a Roth account, formally known as a Roth conversion, involves transferring funds from a pre-tax retirement account into a post-tax Roth IRA. This process allows future investment growth and qualified withdrawals to be tax-free. The core of the transaction is that you agree to pay income tax on the converted amount in the year the transfer occurs. This differs from a traditional IRA, where contributions may be tax-deductible, but withdrawals in retirement are taxed as ordinary income.

The decision to convert is often based on an individual’s expectation of future tax rates. If you anticipate being in a higher tax bracket during retirement than you are currently, paying the taxes now through a conversion could be advantageous. This action moves assets from a tax-deferred status to a tax-free growth status.

Key Information and Decisions for a Roth Conversion

Two distinct five-year rules are associated with Roth IRAs, which govern when you can withdraw funds without taxes or penalties. The first rule applies to the tax-free withdrawal of investment earnings. This clock starts on January 1 of the tax year you made your very first contribution to any Roth IRA. Once this five-year period is met and you are over age 59½, withdrawals of earnings are qualified and completely tax-free.

A separate five-year clock applies to each conversion you make. This rule is designed to prevent individuals from using a Roth conversion to circumvent the 10% early withdrawal penalty. If you are under age 59½ and withdraw converted funds before five years have passed since the conversion, the amount of the withdrawal that was taxable at the time of conversion will be subject to a 10% penalty. Each conversion has its own five-year holding period, beginning on January 1 of the year the conversion was made.

Calculating the Taxable Amount

One of the most impactful regulations for a Roth conversion is the pro-rata rule. This IRS regulation comes into play if you hold both pre-tax funds and after-tax, non-deductible contributions across any of your traditional, SEP, or SIMPLE IRAs. The rule prevents you from selectively converting only the after-tax money to avoid taxes.

The pro-rata rule requires you to aggregate the value of all your non-Roth IRAs to determine the taxability of a conversion. The IRS views all of these accounts as a single pool of money for this calculation.

For example, imagine an individual has a total of $150,000 in their traditional IRAs. Of this total, $30,000 came from non-deductible contributions, meaning it is their after-tax basis, while the remaining $120,000 consists of pre-tax contributions and earnings. If this person decides to convert $50,000 to a Roth IRA, the calculation begins by finding the percentage of the total IRA value that is non-deductible: ($30,000 basis / $150,000 total IRA value) = 20%.

This 20% figure represents the non-taxable portion of any conversion. When the $50,000 is converted, 20% of that amount, or $10,000, is considered non-taxable. The remaining 80%, or $40,000, is the taxable portion of the conversion. This $40,000 must be reported as ordinary income on the individual’s tax return for the year the conversion took place.

This additional income can have a significant impact on your overall tax liability. Adding a substantial amount to your income can push you into a higher marginal tax bracket, meaning the converted funds could be taxed at a higher rate than your other income.

The Rollover Process

Once you have evaluated the tax implications and decided to proceed, the physical movement of funds can be accomplished through two distinct methods: a direct rollover or an indirect rollover. Each approach has specific procedural requirements set by financial institutions and the IRS.

The most common and recommended method is the direct rollover, often called a trustee-to-trustee transfer. In this process, you instruct the financial institution holding your traditional IRA to transfer the funds directly to the custodian of your new Roth IRA. The money never passes through your hands, which simplifies the process and eliminates certain risks. This method ensures there is no tax withholding and creates a clear paper trail for tax reporting purposes.

The alternative is an indirect rollover, which involves more steps and carries greater risk. In an indirect rollover, you request a distribution from your traditional IRA, and the financial institution sends you a check for the requested amount. From the date you receive the funds, you have a strict 60-day window to deposit the entire amount into a Roth IRA. If you miss this deadline, the IRS will treat the entire distribution as a taxable event, and if you are under 59½, it may also be subject to a 10% early withdrawal penalty.

Required Tax Reporting and Documentation

After completing a Roth conversion, specific tax forms must be managed to properly report the transaction to the IRS. These documents provide a record of the fund movement and are used to calculate the final tax liability. Failing to handle this paperwork correctly can lead to tax notices and potential penalties.

Early in the year following your conversion, you will receive Form 1099-R from the financial institution that held your original IRA. This form reports the gross amount of the distribution from your traditional IRA. Box 7 will contain a distribution code that indicates to the IRS the nature of the transfer.

When you file your federal income tax return, you must include Form 8606, Nondeductible IRAs. This is the form where you officially report the conversion and perform the pro-rata calculation to determine the taxable amount. The result of this calculation flows to your Form 1040, where it is included as part of your total taxable income for the year.

Finally, your new Roth IRA custodian will send you Form 5498, IRA Contribution Information. This form confirms the amount that was received into your Roth IRA as a rollover contribution. While you do not need to file Form 5498 with your tax return, it serves as important proof that the funds were successfully deposited, corroborating the information on your other forms.