Roth Rollover Rules: What You Should Know

A Roth rollover, also known as a conversion, is a transfer of assets from a traditional, pre-tax retirement account to a post-tax Roth IRA. This allows future qualified withdrawals to be tax-free. The appeal is paying income tax on the funds now, at your current tax rate, to avoid uncertain future tax rates. This can be advantageous for individuals who anticipate being in a higher tax bracket during retirement.

The process involves moving funds from tax-deductible accounts to a Roth IRA, where they can grow and be withdrawn tax-free, provided certain conditions are met. A Roth conversion is a permanent decision that cannot be undone. This makes it a financial choice requiring careful consideration of your income and tax situation. The conversion itself is a taxable event in the year it occurs.

Determining Rollover Eligibility and Source Accounts

The ability to move funds into a Roth IRA extends to various retirement accounts. The most common source is a Traditional IRA, where you can convert all or a portion of the balance. SEP IRAs, funded by employer contributions, are also eligible for conversion.

Employer-sponsored retirement plans are frequent sources for Roth rollovers, though in most cases, you can only roll over these funds after leaving the employer. Common eligible plans include:

• 401(k) plans
• 403(b) plans for employees of public schools and tax-exempt organizations
• Governmental 457(b) plans

Some plans may offer in-service rollovers, but this feature is not universal.

A specific rule applies to SIMPLE IRAs. You can convert funds from a SIMPLE IRA to a Roth IRA, but only after a two-year waiting period has passed since your first contribution. A rollover before this period concludes can result in tax penalties. It is also possible to roll over after-tax contributions from a 401(k) or funds from a designated Roth 401(k) account.

Calculating the Taxable Amount

When you roll over funds from a pre-tax account like a traditional 401(k) or IRA, the converted amount is treated as ordinary income for that tax year. The sum is added to your other income and taxed at your marginal rate. For example, converting $50,000 while in the 22% federal tax bracket would result in an additional $11,000 in federal income tax, plus any state taxes.

The calculation is more complex if you have made both pre-tax and after-tax contributions to your IRAs. The IRS requires you to use the pro-rata rule to determine the taxability of your conversion, which prevents you from converting only non-taxable money. For this calculation, the IRS aggregates all of your Traditional, SEP, and SIMPLE IRAs, treating them as a single account.

To illustrate the pro-rata rule, imagine you have a total of $100,000 across all your traditional IRAs, with $80,000 from pre-tax funds and $20,000 from after-tax contributions. If you decide to convert $25,000, you cannot designate that the funds come solely from your after-tax contributions. Instead, you must calculate the proportion: 20% of your total IRA balance ($20,000 / $100,000) is non-taxable. Therefore, only 20% of your $25,000 conversion, or $5,000, is tax-free, while the remaining $20,000 is taxable.

This calculation is formally completed and reported to the IRS on Form 8606, Nondeductible IRAs. This form tracks your pre-tax and after-tax basis in your traditional IRAs and determines the taxable portion of any conversion.

Executing the Rollover

There are two primary methods for moving the money. The most common is the direct rollover, or trustee-to-trustee transfer, where you instruct your financial institution to transfer assets directly to your new Roth IRA custodian. The money never passes through your hands, which simplifies the process and avoids tax withholding issues.

The second method is an indirect rollover, governed by the 60-day rule. Your plan administrator sends you a check, and you have 60 days from receipt to deposit the funds into your Roth IRA. Missing the deadline means the entire amount is treated as a taxable distribution and may be subject to a 10% early withdrawal penalty if you are under age 59 ½.

A complication with indirect rollovers from an employer plan is mandatory tax withholding. The plan administrator must withhold 20% of the taxable portion for federal income taxes. For instance, if you request a $10,000 rollover, you will receive a check for $8,000. To complete the full rollover, you must make up the $2,000 difference with your own funds when depositing the money into the Roth IRA.

To initiate a rollover, contact your existing plan administrator for the required paperwork. For a direct rollover, you must provide your new Roth IRA account details. The transfer process can take from a few days to several weeks.

Post-Rollover Rules and Considerations

After a Roth rollover, specific rules govern when you can withdraw funds without tax or penalty. It is important to understand two distinct five-year rules that apply to Roth IRAs, as they are a frequent source of confusion.

The first is the five-year rule for contributions, which determines if the earnings in your Roth IRA can be withdrawn tax-free. This clock starts on January 1 of the tax year of your first contribution to any Roth IRA. Once this five-year period is met and you are at least age 59 ½, all withdrawals, including earnings, become qualified and tax-free.

A separate five-year rule applies to each conversion. This rule determines whether the taxable portion of your rolled-over funds can be withdrawn without a 10% early withdrawal penalty if you are under age 59 ½. Each conversion has its own five-year holding period. For example, if you convert funds in 2024 and again in 2026, each amount is subject to its own five-year clock.

If you withdraw from a Roth IRA containing both regular contributions and converted funds, the IRS has ordering rules. Withdrawals are sourced from regular contributions first, then from converted amounts (first-in, first-out), and finally from earnings. This is advantageous because you can withdraw your regular contributions at any time, tax-free and penalty-free.