What Are the Roth IRA Rollover Rules?

A Roth IRA rollover is the process of moving funds from another type of retirement account into a Roth IRA. This financial maneuver is often considered by individuals who anticipate being in a similar or higher tax bracket during their retirement years. The main benefit is that qualified distributions, including all investment earnings, are withdrawn tax-free in retirement. This differs from traditional retirement accounts where withdrawals are taxed as ordinary income. A rollover allows you to consolidate savings and apply this tax treatment to a larger sum of money than what could be gathered through annual contributions alone.

Accounts Eligible for Rollover to a Roth IRA

A wide array of retirement accounts can be rolled over into a Roth IRA. The most common source is a Traditional IRA, which is funded with pre-tax contributions. Moving these funds to a Roth IRA is a taxable event known as a conversion.

Other eligible accounts include:

• SEP IRAs for self-employed individuals and small-business owners.
• SIMPLE IRAs, another small-business retirement plan.
• 401(k) plans from private sector employers.
• 403(b) plans for employees of public schools and tax-exempt organizations.
• Governmental 457(b) plans.
• Roth 401(k)s, which can be rolled over directly without being a taxable event.

A specific waiting period applies to SIMPLE IRAs. You must participate in the plan for at least two years from your first contribution before you can roll the funds into a Roth IRA. This rule ensures the plan is used for its intended purpose before funds are transferred. A rollover before this two-year period concludes can result in a 25% penalty on the amount moved, in addition to regular income taxes.

Tax Implications of a Roth Conversion

When you roll over money from a Traditional IRA, 401(k), or a similar plan funded with pre-tax dollars, the entire amount you convert is added to your ordinary income for that tax year. This can impact your tax liability, potentially pushing you into a higher tax bracket. It is best to plan for this tax bill and pay it with funds from outside the retirement account to maximize the amount that begins growing tax-free.

The pro-rata rule applies if you have both pre-tax and after-tax (non-deductible) money in any of your Traditional, SEP, or SIMPLE IRAs. The IRS requires you to aggregate all your non-Roth IRAs to determine the taxability of a conversion. You cannot choose to convert only the after-tax funds; any conversion is considered a proportional mix of your pre-tax and after-tax dollars. This prevents individuals from selectively converting non-taxable basis to circumvent taxes.

For example, consider an individual with $100,000 total in their Traditional IRAs, consisting of $80,000 in pre-tax funds and $20,000 in after-tax contributions. If this person converts $50,000 to a Roth IRA, the pro-rata rule dictates that 80% of that conversion ($40,000) is taxable income, and 20% ($10,000) is a tax-free return of basis. The calculation is based on the total values of all non-Roth IRAs on December 31 of the conversion year.

The tax treatment differs when rolling over assets from a Roth 401(k). Since contributions to a Roth 401(k) are made with after-tax dollars, moving these funds into a Roth IRA is not a taxable event. The assets maintain their tax-favored status for continued tax-free growth.

Key Rollover Rules and Timelines

The 5-Year Rule

Two distinct five-year rules can affect your withdrawals. The first rule applies to your total contributions and determines if the earnings portion of a withdrawal is tax-free. This clock starts on January 1 of the tax year for which you made your first contribution to any Roth IRA. Once this five-year period is met and you are over age 59.5, withdrawals of both contributions and earnings are qualified and tax-free.

A separate five-year rule applies to each Roth conversion. For every amount you convert, a new five-year holding period begins for that specific amount on January 1 of the year the conversion was made. If you are under age 59.5 and withdraw any converted principal within this five-year window, that portion of the withdrawal will be subject to a 10% early withdrawal penalty. This rule prevents using conversions to access pre-tax retirement funds early without penalty.

Direct vs. Indirect Rollovers

You can choose between a direct or an indirect rollover. A direct rollover, or trustee-to-trustee transfer, is the most straightforward method. The financial institution holding your old account sends the money directly to your new Roth IRA custodian, and you never take possession of the funds. This process avoids mandatory tax withholding.

An indirect rollover is more complex. The distributing institution sends you a check, and you have 60 days from receipt to deposit the full amount into your Roth IRA. If the funds come from an employer plan like a 401(k), the administrator must withhold 20% for federal income taxes. To complete the rollover of the full amount, you must make up that 20% from other funds. Missing the 60-day deadline makes the entire distribution taxable income, plus a potential 10% early withdrawal penalty if you are under 59.5.

The One-Rollover-Per-Year Rule

The one-rollover-per-year rule applies exclusively to indirect rollovers between IRAs. This IRS regulation states you can only make one IRA-to-IRA indirect rollover within any 12-month period, which begins on the date you receive the distribution. A second indirect IRA rollover within this timeframe will cause the second distribution to be fully taxable and potentially subject to penalties.

This limitation does not affect direct, trustee-to-trustee transfers between IRAs, which can be done an unlimited number of times. The rule also does not apply to rollovers from an employer-sponsored plan to an IRA or to Roth conversions. This allows for flexibility when consolidating funds from various sources.

The Rollover Process and Reporting

Preparatory Step

Before initiating a rollover, understand the tax forms involved. The distributing institution will send you Form 1099-R, which reports the gross distribution amount to you and the IRS. You will use this form to complete your tax return for the year of the rollover. To properly report a Roth conversion, you will also need to file IRS Form 8606 to calculate the taxable amount of the conversion, which is important if the pro-rata rule applies.

Action Step

The most common method for a rollover is the direct, or trustee-to-trustee, transfer. First, open a Roth IRA at the financial institution of your choice. Once the account is established, contact the administrator of your existing retirement plan to request a direct rollover to your new Roth IRA. You will need to provide the administrator with the details of your new Roth IRA, including the account number and the name and address of the new institution. The administrator will then handle the transfer of funds directly.

Post-Action Step

After the rollover is complete, you must report the event on your federal income tax return. Using the information from Form 1099-R and your records of any after-tax contributions, you will complete Form 8606. On this form, you will calculate the taxable amount of the conversion, which is then transferred to your Form 1040. Properly filing these forms is the final step to ensure you are in compliance with IRS reporting requirements.