O’Connor: What you should know about Roth IRA conversions, distributions

The Roth IRA can be an exciting way to save for your future retirement needs. If you earn income (or are married to someone who does and file jointly), you may be able to contribute to a Roth IRA – even if you participate in a qualified employer-sponsored retirement plan where you work or are over age 70½.

A Roth IRA is a flexible way to potentially build substantial retirement balances, to provide future tax-free income or to help accumulate possible significant assets, free from income taxes, for your heirs. Since it also offers a broad range of investments, there may never have been a more attractive way to accumulate assets.

If you are within or under the modified adjusted gross income limits, you can make nondeductible annual contributions to a Roth IRA. Contributing to a Roth IRA can be a viable alternative if you have been making nondeductible traditional IRA contributions. All potential earnings growth in these accounts may be distributed from the Roth IRA income-tax and penalty-free if you are at least age 59½ and have had the account for more than five tax years or as a result of you death, disability or being a qualified first-time homebuyer. Your tax adviser and your financial adviser can help you determine whether a Roth IRA offers you advantages over a traditional IRA.

Conversion to a Roth IRA: Anyone is able to convert as the earned-income and tax-filing-status eligibility limits have been removed. Converting an existing traditional IRA allows you to reposition your current tax-deferred traditional IRA to a tax-free Roth IRA by paying ordinary income tax, but without the 10 percent penalty tax, on the entire taxable amount converted. You will pay federal, and possibly state, income tax on these sums, except amounts attributed to after-tax contributions. Taxes are due in the year the conversion takes place. Once the conversion to the Roth IRA is completed, your tax-free earnings potential is maximized.

Eligible rollover distributions from an employer-sponsored retirement plan balance can be directly rolled to a Roth IRA. These conversions can be made through a direct rollover of before-tax or after-tax money from the plan to the Roth IRA, or an amount can be distributed from the plan and rolled over to the Roth IRA within 60 days. A Roth conversion of after-tax amounts will not be taxable income. Any pre-tax amount converted will be included in the IRA holder’s gross income for the year. Due to the complex nature of this strategy, seek advice from your tax adviser.

Whether to convert to a Roth IRA can be a difficult decision, since the action may involve the current payment of significant income tax.

There are four factors that are critical in determining the value of a conversion to a Roth IRA:

• Your expected tax bracket in retirement. If you expect to be in the same or a higher tax bracket, when you distribute the funds from your Roth IRA, than you are today, there may be value in considering a conversion. 

• Availability of funds to pay income taxes. The benefits of a conversion are increased if the income taxes can be paid out of non-IRA assets. One way to manage your tax liability might be to stagger conversions over a number of years, thereby limiting the amount of tax due in any one tax year.

• The accumulation period. The longer the assets in the Roth IRA can be left untouched, the greater the benefit of tax-free accumulation.

• Investment return. The greater the investments return on assets in your Roth IRA, the larger the tax-free accumulation and the bigger the benefit to you.

Rules for Distribution: Roth IRAs have two types of distributions, qualified and nonqualified distributions. A qualified Roth distribution is one that meets two requirements: a five-year waiting period and age 59 ½, or as a result of your death, disability or being a qualified first-time homebuyer. The five-year waiting period for qualified distributions begins for all of the individual’s Roth IRAs on Jan. 1 of the first taxable year for which the Roth IRA is initially funded and ends Dec. 31 of the fifth year. Qualified Roth distributions are not subject to income tax or the additional 10 percent tax on early distributions. A nonqualified distribution is one that does not meet the requirements. Does that mean nonqualified distributions are subject to tax and the pre 59½ penalty? Not necessarily.

Unlike traditional IRAs, there are ordering rules when taking distributions from a Roth. Annual Roth IRA contributions are the first amounts distributed. Distributions of annual contributions are always tax-free and penalty-free, at any time.

Second amounts distributed from a Roth IRA, after all annual Roth contributions are depleted, are converted funds. Roth IRA distributions representing converted amounts are not subject to taxation, since taxes were paid at conversion. 

Once assets are converted to a Roth, penalty-free distributions of those converted amounts are available after a five-year holding period (beginning with the year of each conversion) or age 59½ has been obtained, whichever is first. Before that, a distribution of converted amounts is subject to a 10 percent penalty, unless an exception applies.

Roth IRA earnings are the last amounts distributed. Any distributions of earnings are tax-free and penalty-free after five years and the owner has attained age 59½, or as a result of death, disability or a first-time homebuyer exception. Earnings, if they are taken earlier, are subject to ordinary income tax and the 10 percent penalty, unless an exception applies.

The exceptions to the 10 percent penalty are for age 59½, death, disability, eligible medical expenses, certain unemployed individuals’ health insurance premiums, limited first-time homebuyer, qualified higher education expenses, Substantially Equal Periodic Payments, Roth conversion, qualified reservist, or IRS levy.

The Roth IRA imposes no requirements for distributions due to age.

Additionally, remember that unlike the traditional IRA, taking required minimum distributions is not necessary during your lifetime with a Roth IRA; this optimizes your opportunity to build tax-free wealth. Your spouse beneficiary has the right to roll over your Roth IRA and to treat it as his or her own, meaning they are not subject to RMDs either. This may allow for an additional period of tax-free compounding of potential earnings that can help a family grow their wealth. If distributions are taken, the ordering rules discussed above will apply. However, if the surviving spouse has other Roth IRAs that pre-date this rollover, their previous Roth IRA five-year rule will apply to all Roth IRAs now owned by the survivor. Your nonspouse beneficiary should start RMDs the year after the year of your death if they want to take advantage of the stretch IRA strategy.

The way you invest for your retirement is a very important financial decision. For help in determining whether a Roth IRA should be part of your investment strategy, talk with your financial adviser.

Qualified Roth IRA distributions are not subject to state and local taxation in most states and are federally tax-free provided a Roth IRA has been open for at least five years and the owner has reached age 59 ½ or meets other requirements. Nonqualified distributions may be subject to income tax and an additional 10 percent early-distribution penalty.

• Patrick S. O’Connor is the managing principal, senior financial adviser, PIM portfolio manager and a chartered retirement planning counselor at Wells Fargo Advisors Financial Network in Algonquin. He can be reached at 847-458-0142, or

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