Investors may have many strategic reasons for converting from a self-directed Traditional IRA (or any other pre-tax account structure) into a self-directed Roth IRA. There are a few methods available to bring funds into a Roth IRA; including opening a new account and making a contribution, making a rollover, making a conversion, and initiating a transfer.
There is no limit to the amount that can be converted from a Traditional or other pre-tax retirement plan into a Roth. The amount converted is added to the account holder’s ordinary income for that tax year. The Traditional to Roth conversion deadline is Dec. 31 of any given year.
For self-directed IRAs, asset performance can influence an account holder’s decision to convert from a Traditional IRA to a Roth IRA. Since self-directed retirement plans can invest in a wide variety of IRS-sanctioned assets (including real estate, precious metals, private loans, etc.), certain market factors may push a self-directed IRA investor to convert their pre-tax plan into a post-tax plan in any given year. This may be especially true with IRA-owned real estate.
Below is a discussion of a few important factors that self-directed IRA investors may want to take into account when considering converting from a pre-tax plan to a post-tax Roth IRA.
Since contributions into a Roth IRA are taxed upon going into the account, it’s important for clients to analyze whether or not they believe they will be in a higher tax bracket when they retire versus the year in which they open and contribute to their Roth. One strategy behind choosing a Traditional IRA account lies in the projection that the account holder will be in a lower tax bracket when they take a distribution at retirement, and then pay taxes on the amount withdrawn. Account holders should “do the numbers” before converting to a Roth to make sure paying taxes on contributions now versus at retirement is the best strategy for them.
As mentioned above, the performance of self-directed IRA assets can play a role in a retirement investor’s decision to convert a pre-tax Traditional IRA to a post-tax Roth IRA. For example, if an account holder owns a rental duplex in their self-directed IRA, they may decide it is more beneficial to pay taxes on contributions now in order to accumulate tax-free returns for the life of the account. Or, if the IRA property lost value during a certain tax year, a retirement investor may benefit from converting to a Roth that year, since their income tax bracket will be lower.
In order to make a rollover into a self-directed Roth IRA, the account holder must receive a distribution from a Traditional IRA and contribute it to a Roth IRA within 60 days after the distribution (the distribution check is payable to the account holder personally). After the 60 day limit the amount withdrawn is treated as regular distribution, and taxed at the IRA holder’s current income tax rate. If withdrawn before the account holder reaches 59.5, the distribution could also incur a 10% penalty.