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Last-Minute Roth IRA Conversion Planning Tips

Operational procedures matter as much as suitability.

Converting a traditional IRA to a Roth IRA is accomplished with two steps: a distribution from a traditional IRA and a rollover to a Roth IRA. But, while seeming simple, the applicable rules can complicate the results. Here, I cover the key operational considerations for getting Roth IRA conversions right.

Roth IRA Conversion Methods

An individual has four options for accomplishing a Roth conversion. (For this article, a traditional IRA includes a SEP IRA and a Simple IRA. Remember that a conversion may be done from a Simple IRA only after the Simple IRA has been funded for at least two years.) The four options are:

  1. Redesignating a traditional IRA to a Roth IRA. This results in a conversion of the entire traditional IRA balance. I am not aware of any IRA custodian that offers this option.
  2. The amount is moved directly from the traditional IRA to the Roth IRA, where both accounts are held with the same custodian. This is the most common method and leaves little room for error.
  3. The amount is converted directly from the traditional IRA custodian to the Roth IRA custodian via a trustee-to-trustee transfer to the Roth IRA custodian, where a different custodian holds the accounts. Generally, the traditional IRA custodian requires a letter of acceptance from the Roth IRA custodian, confirming that a Roth IRA has been established for the taxpayer and that the amount will be deposited to such a Roth IRA as a Roth conversion.
  4. The IRA owner takes a distribution from the traditional IRA and deposits the conversion amount to a Roth IRA within 60 days of receipt. This indirect conversion can be done by the custodian who holds both accounts or between two different custodians.

Whichever method is used, a Form 1099-R must be issued for the traditional IRA and a Form 5498 for the Roth IRA.

For the first three methods, the IRA custodian must input Code 7 in Box 7 of IRS Form 1099-R if the IRA owner is at least 59 and a half when the amount leaves the traditional IRA. Otherwise, Code 2 must be used. Both codes mean the amount is not subject to the 10% additional tax.

For method four, Code 7 is used if the IRA owner is at least age 59 and a half when the amount leaves the traditional IRA. Otherwise, Code 1 is used. Code 1 means that, as far as the IRA custodian knows, the amount does not qualify for an exception to the 10% additional tax.

Tax Reporting Tip: If Code 1 is used, the tax preparer must claim the exception to the additional tax on the IRA owner’s tax return.

Cross-Year Conversions

While the first two methods are usually done simultaneously, there could be a lag between when the amount leaves the traditional IRA and gets deposited in the Roth IRA under methods three and four. This means that the distribution side could be done in 2023 and the rollover side in 2024. However, the transaction applies to 2023 as long as the distribution side is completed by Dec. 31, 2023.

Method 4 Is a Quasi-Solution to Recharacterizations

Conversion amounts are included in the IRA owner’s ordinary income, with any pretax amount being taxable. Before 2018, an IRA owner could reverse a Roth conversion by their tax-filing due date, plus extensions. This allowed the IRA owner to change their minds for any reason and return the amount to their traditional IRA by the deadline, resulting in the amount being nontaxable. Recharacterizations are not permitted for Roth conversions. However, an IRA owner who uses method four could buy themselves some time to assess the Roth conversion and decide whether to proceed with it. Taxpayers who want to use this method must consider whether they could risk breaking the one-per-year IRA-to-IRA rollover rule.

Example: Charlie would like to convert $1 million from his traditional IRA to his Roth for 2023. It’s the last week of December, so he does not have sufficient time to allow his certified public accountant to perform a Roth suitability assessment before year-end and does not want to wait until 2024.

A possible solution for Charlie is:

  • Contact the custodian for his traditional IRA and request a regular distribution.
  • Request that the amount be sent to him as a check. This buys him some time, as the 60-day deadline starts when he receives the check. If it is wired to his account, it starts when the amount is credited to his account.
  • Meet with his CPA during the 60 days for a Roth suitability analysis.
  • If Charlie is happy with the results, he may deposit the amount to his Roth IRA before the 60-day deadline.
  • If unhappy with the results, he may roll over the amount to his traditional IRA before the 60-day deadline. Caution: This option is available only if the rollover will not break the one-per-year limit on IRA-to-IRA rollovers.

Charlie could also do a partial conversion if preferred. For example, he could roll over $500,000 to his traditional IRA (if the one-per-year limit would not be broken) and $500,000 to his Roth IRA.

Tax Reporting Tip: When using method four, ensure that the IRA custodian reports the amount in Box 3 of Form 5498 and not Box 2. The IRS says incorrect reporting of Roth conversion is a common error by IRA custodians that might cause tax trouble for IRA owners.

RMDs Must Be Taken Before Conversions

Distributions that are not eligible to be rolled over may not be converted to a Roth IRA. A required minimum distribution, or RMD, is one such distribution. Under the RMD rules, for any year an individual is required to take an RMD, their first distribution includes their RMD until the RMD is satisfied. This means that an individual who is at least age 73 years old at the end of this year must take their RMD before any Roth conversion. Failure to take the RMD would result in an ineligible amount being included in the Roth conversion, which is subject to a correction as a return of excess distribution.

Example: Susan, 75, plans to convert $2 million from her traditional IRA to her Roth IRA for 2023. Her 2023 RMD is $81,300. Susan must take her $81,300 RMD before converting any amount to her Roth IRA.

If Susan performs the Roth conversion before taking her RMD, any portion of the $81,300 that exceeds her Roth IRA contribution limit is an excess contribution and must be corrected before her tax-filing due date, plus extensions, to avoid owing the IRS a 6% excise tax of the amount.

Roth Conversions Are Not an All-or-None Solution

Suitability for a Roth IRA is as crucial as getting the operational processes right. Therefore, an IRA owner should consult with their tax advisor to determine whether they should perform a Roth conversion and, if so, the amount. A conversion can be done for any amount up to the entire rollover-eligible balance of a traditional IRA, allowing taxpayers to perform micro-conversions up to the amounts that are determined to be tax-efficient.

Denise Appleby is a freelance writer. The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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