Why the mechanics matter
Investment advisory services described on this page are offered through Avinci Wealth Management, Inc., a Registered Investment Adviser registered in California, Arizona, Illinois, Texas, and Nevada. This page is general information for educational purposes and is not tax, legal, or individualized investment advice. Avinci does not prepare tax returns. Confirm your own position with your CPA.
Most of the planning attention on a Roth conversion goes to its size: how much to move in a given year, against which bracket, and over how many years. That modeling is covered in Roth conversion planning. This page is about the rules underneath it.
These rules rarely decide whether a conversion makes sense. They decide what it costs, when the converted money becomes accessible, and whether the year it was done in was the right year. They are also the rules most often learned after the fact, because the forms that report them arrive months after the decision.
The size of a conversion is a planning question. What it costs is often settled by rules that apply before the planning starts.
The pro-rata rule
Anyone who has made nondeductible contributions to a traditional IRA has after-tax basis in it. When part of an IRA is converted, the owner cannot choose to convert only the after-tax dollars.
When an individual holds both pre-tax and after-tax amounts in traditional, SEP or SIMPLE IRAs, the pro-rata rule generally determines the taxable portion of a Roth conversion using the combined IRA balances, relevant distributions and conversions during the tax year, and the individual's documented after-tax basis. The calculation is reported on IRS Form 8606, and year-end IRA balances are an important component of it. The December 31 balance alone does not determine the result.
Two consequences follow. The calculation reaches across every one of those accounts, so a separate rollover IRA holding pre-tax money changes the result for a conversion done from a different account. And because year-end balances feed the calculation, money that lands in a traditional IRA later in the same year, including a rollover from an employer plan, can affect the outcome even though it arrived after the conversion.
Employer plans such as 401(k) and 403(b) accounts are not part of the calculation, and neither are inherited IRAs. That is why the timing of a rollover out of an employer plan can change the cost of a conversion in the same year, and why some households look at whether an employer plan will accept pre-tax IRA money before converting. Whether that is available, and sensible, depends on the plan and the household, and it carries trade-offs of its own.
| Account | Counted in the ratio? | Note |
|---|---|---|
| Traditional IRA, including rollover IRAs | Yes | Aggregated across all of them, with year-end balances one component of the calculation |
| SEP IRA and SIMPLE IRA | Yes | Aggregated with traditional IRAs |
| 401(k), 403(b) and other employer plans | No | A rollover into an IRA during the year brings that money into the calculation |
| Inherited IRA | No | Generally cannot be converted by a non-spouse beneficiary |
| Roth IRA | No | Already after-tax |
A general summary. The calculation also takes account of distributions and conversions made during the tax year, and basis depends on prior Form 8606 filings, which your CPA can confirm.
The two five-year clocks
Roth accounts carry two separate five-year rules, and they answer different questions. Treating them as one is the most common source of confusion about when converted money can be used.
Each Roth conversion has a separate five-tax-year period relevant to the 10 percent federal additional tax on early distributions of taxable converted amounts. This rule generally matters when an individual withdraws those amounts before age 59½, unless an exception applies. Separately, the Roth IRA qualified-distribution five-year period determines whether earnings may be distributed tax-free when another qualifying condition is satisfied.
| Clock | When it starts | What it governs |
|---|---|---|
| Conversion clock | January 1 of the year of each conversion; every conversion has its own | Whether taxable converted amounts withdrawn early are subject to the 10 percent additional tax for owners under 59½ |
| Qualified-distribution clock | January 1 of the year of the first contribution or conversion to any Roth IRA | Whether earnings come out free of income tax, once the owner is also 59½ or meets another qualifying condition |
The conversion clock matters mainly for people converting before 59½, and it is the taxable portion of a conversion that it governs rather than necessarily every dollar converted. Once the owner reaches 59½, the additional tax on converted amounts generally no longer applies, though the qualified-distribution clock still governs earnings. Withdrawals from a Roth IRA are treated as coming first from regular contributions, then from conversions in the order they were made, then from earnings, which is why the sequence of past conversions affects what a given withdrawal costs.
That distinction matters most for anyone who has made both taxable and nontaxable conversions, since the two are not treated alike on withdrawal. California applies its own additional tax on early distributions alongside the federal one, covered in early withdrawal penalties in California.
Conversions in an RMD year
Required minimum distributions generally begin at 73 for people born from 1951 through 1958, and at 75 for those born in 1960 or later, with a technical statutory ambiguity affecting those born in 1959. In any year a distribution is required, the first dollars out of the account are treated as satisfying it. The required amount cannot be converted, so it has to be taken before a conversion from that account, and it adds to the year's income on its own.
This is part of why the years between retiring and the first required distribution are often described as a conversion window. Income may be lower, and no required distribution is competing for room in the same bracket. Once distributions begin, each conversion stacks on top of income the household did not choose. How distributions and withdrawal order interact is covered in RMDs and withdrawal order.
How the tax gets paid
A conversion adds the taxable amount to ordinary income for the year, federally and in California. The tax can be paid from money held outside the IRA, or withheld from the conversion itself, and the two are not equivalent.
Amounts withheld from a conversion are treated as distributed rather than converted. They never reach the Roth, and for an owner under 59½ they can be subject to the additional tax on early distributions. Paying from outside funds keeps the full converted amount in the Roth, but it requires those funds to exist, and raising them may mean selling taxable investments with tax consequences of their own.
A large conversion can also change how much tax is due during the year. Estimated payments, or increased withholding elsewhere, may be needed to avoid underpayment penalties at both the federal and state level, which is a question for the CPA preparing the return.
Tax rules described here are general summaries of published law as of the date of this article and are subject to change. They are not tax advice. Confirm your own position with your CPA.
No undo after 2017
Before 2018, a conversion could be recharacterized, effectively reversed, if the account fell in value or the tax turned out higher than expected. The Tax Cuts and Jobs Act ended that for conversions made in 2018 and later. A completed conversion now stays completed.
The practical effect is on timing within the year. With no way to reverse it, the amount is generally decided with as much of the year's income visible as possible: bonuses, fund capital gain distributions, a business sale, or other one-time income. A conversion done early in the year carries the risk that the rest of the year's income arrives higher than expected.
The California layer
California generally follows the federal treatment of Roth conversions. The taxable amount is generally ordinary income for California purposes in the year of the conversion, with no separate exclusion and no preferential rate.
Residency on the date of the conversion is generally what determines whether California taxes it, though the result also depends on residency status, the source and character of the income, and the applicable federal and state rules. That timing question is covered in leaving California in retirement. A conversion also raises modified adjusted gross income, which feeds Medicare premiums two years later, as described in retirement health care before and after Medicare.
How Avinci approaches it
Avinci Wealth Management is a Registered Investment Adviser registered in California, Arizona, Illinois, Texas, and Nevada, firm CRD #327780, headquartered at 23929 Valencia Blvd, Suite 404 in Santa Clarita, with additional offices in Beverly Hills and Woodland Hills. When providing investment advisory services, Avinci Wealth Management is subject to its fiduciary obligations under applicable investment adviser law.
Avinci Wealth Management is headquartered in Santa Clarita, and most clients from the Santa Clarita Valley meet with Lindahl Lucas at the Valencia Boulevard office. As a financial advisor and financial planner, Avinci coordinates investment management, retirement income, estate coordination, and tax planning done alongside each client's CPA into one plan. Insurance and annuity products are available separately through our affiliated agency, Lucas Insurance Services.
Under the Retirement Blueprint, conversions are modeled against the rest of the income plan with these rules applied: basis and the balances and transactions that feed the pro-rata calculation, the required distribution calendar, and how the tax would be paid. Founder Lindahl Lucas is involved in overseeing the development of Retirement Blueprint planning. Tax scenarios are modeled in coordination with your CPA, who prepares the returns.
Avinci receives advisory fees for investment advisory services. Separately, insurance and annuity products may be offered through our affiliated insurance agency, Lucas Insurance Services, which may receive commissions from issuing insurance companies. This compensation arrangement creates a conflict of interest and is disclosed in our Form ADV.
Important disclosures. This material is for informational purposes only and should not be construed as individualized investment, tax, or legal advice, or as a recommendation to buy or sell any security or insurance product. Consult your CPA or attorney before acting on anything described here.
Registration. Investment advisory services are offered through Avinci Wealth Management, Inc., a Registered Investment Adviser, firm CRD #327780, registered in California, Arizona, Illinois, Texas, and Nevada. Registration as an investment adviser does not imply a certain level of skill or training. Our Form ADV Part 2A brochure describes our services, fees, and conflicts of interest, and is available on request and through our IAPD record. The firm can also be verified through the SEC adviser search and, where applicable, FINRA BrokerCheck.
Projections. Financial projections and retirement models described here are hypothetical and illustrative in nature, are based on assumptions provided by the client and on market data, and do not guarantee future results.
Tax rules. Federal and California tax rules described here are general summaries, reflect published law as of the date of this article, and are subject to change. The pro-rata calculation is reported on IRS Form 8606 and depends on documented basis from prior filings. Avinci Wealth Management, Inc. does not prepare tax returns or provide tax advice.
Insurance and risk. Insurance and annuity products are offered through our affiliate, Lucas Insurance Services, which may receive commissions from issuing insurance companies on products it places. This compensation arrangement creates a conflict of interest and is disclosed in our Form ADV. Guarantees associated with annuity and insurance contracts are subject to the claims-paying ability of the issuing carrier. Investments involve risk and, unless otherwise stated, are not guaranteed. Past performance is not indicative of future results.