How to Convert a 401(k), 403(b), 457(b), Traditional IRA, SEP IRA, or SIMPLE IRA Retirement Plan Rollover to a Self-Directed Roth IRA
IRA Rollovers to the Self-Directed Roth IRA Conversion
In general, Roth IRA conversions and retirement plan rollovers to a Roth IRA are taxable events. The reason for this is a Roth IRA is an after-tax account that allows for tax-free distributions if certain rules are satisfied.
A conversion is a taxable movement of cash or other assets, such as real estate from a Traditional IRA, SEP IRA, or a SIMPLE IRA to a Roth IRA. Note – a SIMPLE IRA can only be converted to a Roth IRA after a two-year period, which begins on the date that the first SIMPLE IRA contribution was deposited.
Are there any Eligibility Requirements to do a Roth IRA Conversion?
Under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) eliminated the eligibility restrictions for Roth IRA conversions, beginning with conversions made after January 1, 2010. Thus, beginning in January 1, 2010, there is no longer any eligibility requirements for making a Roth IRA conversion.
Due to this change, many individuals who earn to much to make a Roth IRA contribution, because earning limitations continue to apply to Roth IRA contributions, can contribute to a Traditional IRA and then complete a Roth IRA conversion.
Roth IRA Conversion Tax & Penalty Applications
An individual engaging in a Roth conversion to a Self-Directed Roth IRA LLC structure must pay tax on the Roth IRA conversion on a pro rata basis – the portion representing pretax assets is taxable in the year of the conversion, and the portion representing after-tax assets is not taxable. The taxpayer must file Form 8606 to determine the taxable portion of the conversion. The taxpayer must aggregate all the pre-tax IRA assets to determine the taxable and nontaxable assets.
Procedures for Doing a Self-Directed Roth IRA Conversion
A Roth IRA conversion can technically be completed either via a direct or indirect rollover. A conversion in which the check is made payable to the receiving financial institution for the benefit of the individual’s Roth IRA is a direct conversion. An indirect conversion occurs when the IRA holder requests and receives a distribution from his or her pre-tax IRA custodian and deposits the amount into a Roth IRA account within 60 days. Note – with an indirect Roth IRA conversion, the one rollover per 12-month restriction does not apply.
Reporting a Roth IRA Conversion to a Self-Directed Roth IRA
Because all conversions are generally subject to taxation, the financial organization distributing the pre-tax IRA assets must apply the withholding rules under Internal Revenue Code Section 3405. However, an exception applies to IRA funds that are being converted to a Roth IRA. The financial institution executing the Roth IRA conversion would report the conversion on the IRS Form 1099-R. On IRS Form 1099-R the amount being converted would be reported in Box 7, using distribution reason code 2, Early distribution, exception applies.
A Roth IRA conversion is a reportable transaction regardless of whether it was handled directly or indirectly.
Retirement Plan Rollovers to a Self-Directed Roth IRA
Eligible participants of a qualified retirement plan, such as a 401(k), 403(b), or 457(b) plan have been able to roll over plan assets to a Traditional IRA for several years. Since 2006, individuals have been allowed to roll over designated Roth account distributions to Roth IRAs, but not Traditional IRAs. However, beginning January 1, 2008, individual may roll over all employer plan assets to a Roth IRA.
Retirement Plan Rollovers to a Self-Directed Roth IRA
Eligible individuals may directly or indirectly roll over retirement plan assets to a Self-Directed Roth IRA. Like a Roth IRA rollover, indirect rollovers must be completed within 60 days after constructive receipt of the IRA assets.
Direct Rollover to a Self-Directed Roth IRA
When an individual directly rolls over an employee sponsored retirement plan distribution to a Self-Directed Roth IRA (excluding a designated Roth account rollover to a Roth IRA), the financial institution transferring the retirement funds must report the tax-free direct rollover distribution on IRS Form 1099-R, using code G, Direct rollover and rollover contribution. The receiving Self-Directed Roth IRA custodian must report the amount as a rollover contribution in Box 2 of IRS Form 5498.
Indirect Rollover to a Self-Directed Roth IRA
If an individual is eligible and takes a distribution from an employer sponsored retirement plan (i.e. 401(k) Plan), the financial institution sending the payment should make the check payable to the individual. If the distribution is eligible for a rollover, the payer financial institution must apply withholding. The payer financial institution must report such distributions on IRS form 1099-R using the applicable distribution code ( code 1,4,7).
The plan participant would then be required to deposit the amount into a Traditional IRA account within 60 days. Once the funds have been deposited in a Traditional IRA account, the IRA funds can be converted into a Roth IRA. The new Self-Directed Roth IRA custodian receiving the rollover assets must report the amounts on IRS Form 5498 as a rollover contribution in Box 2.
To learn more about the Self-Directed Roth IRA conversion rules, please contact a tax professional at 800-472-0646.