To save you money with account opening fees, it is wise to convert an old traditional IRA to a Roth IRA off-platform and then roll the new Roth dollars into a Rocket Dollar Self-Directed Roth IRA.
Can I do a Roth Conversion at Rocket Dollar?
Because a Roth conversion needs a traditional IRA and a Roth IRA, you would have to open two accounts, resulting in two account fees. As a result, it is often better to convert a traditional IRA to a Roth IRA before rolling it over to a Rocket Dollar Account if you only wish to maintain one account.
Many discount brokerages are able to do this service for free, and then you can roll those dollars into a Roth IRA at Rocket Dollar. Since those brokerages make money off their investments you select, and do not have to create structures that can handle almost any investment, they can open accounts quickly.
If you still want to do a Roth Conversion at Rocket Dollar, at least one if your accounts involved must be a Gold account.
I can't do a transfer from my Traditional IRA outside of RD directly to a Rocket Dollar Roth IRA?
It's important to provide solid records of your Roth conversion for tax purposes and the 5 Year Roth Rule, and the Pro-Rata rule. Currently, Rocket Dollar cannot support that tax reporting from an incoming traditional IRA that could be needed for a Roth Conversion if you were to be audited. We also need to have all three major elements of your IRA with an IRA, LLC, and LCC bank account. We are sorry for the inconvenience.
What is a Roth Conversion?
A Roth conversion, also known as a "backdoor" Roth, is converting a Traditional IRA to a Roth IRA. Traditional dollars are pre-tax and have never been touched by taxes, and Roths are post-tax, which means this process is a taxable event. You do not pay an early distribution 10% penalty for being younger than 59 & 1/2 but must pay for the taxes on that money as income for that tax year. You WOULD pay a 10% early distribution if you took a portion of your dollars out to meet IRS tax obligation. Thus, you must have the cash on hand in a taxable bank account to avoid this penalty.
Regardless of the taxable event, this is a popular strategy for a few reasons.
- Roth IRAs have restrictive income limits which bar many high-income Americans from participating.
- Roth dollars are highly desirable in some financial planning strategies for their post-tax status, ability to take them out after 5 years, which allows you to keep your income artificially lower and protected from future tax rates
- Tax rates, especially after the Tax Cuts and Jobs Act (TCJA) of 2017 are at historic lows.
Is this a legal process?
Yes! It's a process that is supported by retirement law as long as you are reporting the moves correctly on your taxes and keeping proper records of your IRA.
So, to be clear, am I paying the 10% early withdrawal tax penalty or not when I convert?
To discourage people from raiding their individual retirement accounts, the Internal Revenue Service levies a 10 percent additional tax on taxable early distributions. Early distributions for traditional IRAs include only those distributions taken before you turn 59 1/2 years old. When converting money from a traditional IRA to a Roth IRA, the penalty may come into play.
With a Roth IRA conversion, the 10 percent early withdrawal penalty doesn't apply to any amount that gets rolled into the Roth IRA. For example, if you take $50,000 out of your traditional IRA and deposit the full $50,000 in your Roth IRA, you don't have to pay the 10 percent early withdrawal penalty because you haven't withdrawn any of the money.
Portion Used for Taxes
Because a Roth IRA conversion results in taxable income, it's not uncommon for taxpayers to want to use some of the conversion to pay those taxes. But if you take a distribution from your tax-deferred retirement account to pay the income taxes on the conversion, that portion is subject to the early withdrawal penalty if you're under 59 1/2. The IRS does not offer an exception to the penalty for amounts used to pay conversion taxes.
What is the Five Year Roth Rule?
- The Five Year Rule for Roth IRAs means that a timer starts on January 1st of the tax year you execute your Roth Conversion.
- After 5 years, you can withdraw those dollars tax-free.
- You can read more about the Roth five year rule in our other article.
How do I keep track of the Five Year Roth rule?
If you are doing this process very regularly, it might make sense to have multiple Roth IRAs, or inside a Rocket Dollar account, two bank accounts numbers tied to the same IRA LLC or two Roth Trusts and Trust bank accounts for a Rocket Dollar Solo 401(k). If you are commingling Roth conversions in the same account, the 5-year rule still applies to each conversion. This can get very messy to track the growth of each conversion! Save yourself the trouble of tax reporting by keeping the conversions separate.
What about with a Solo 401(k)?
You can do a Roth Conversion with your Traditional and Roth Bank accounts tied to your solo 401(k). If you need extra assistance and tax reporting, we typically require our solo 401(k) customers to buy or upgrade to a Gold account. You can, however, self-service between Traditional, Roth, and after-tax bank accounts.
What about a backdoor Roth?
A backdoor Roth involves doing non-deductible contributions to a Traditional IRA, and then converting that money by moving it to a Roth IRA. This a popular and perfectly legal way to circumvent the income limits placed on Roth IRAs, barring out many high earners for a full contribution.
- Making a non-deductible contribution to a traditional IRA
- Letting the money sit inside the traditional IRA. The amount of time a backdoor contribution should remain is debatable and you should research or talk with your tax accountant.
- Ask your provider (whether another custodian or Rocket Dollar) to convert the money you contributed, with no tax withholding. Remember, at Rocket Dollar you will have to pay for both a Traditional
- File your taxes using Form 8606. Report your non-deductible conversion to the Traditional IRA and your conversion to the Roth account in the same year. Converting in the same tax year is incredibly important and central to the backdoor Roth IRA strategy.
Take extra care to review your choices on rollovers and transfers
Types of transfers.
The conversion needs to be one of the following to do a backdoor Roth with a Rocket Dollar account.
- A trustee-to-trustee transfer, where the IRA provider sends the money directly to Rocket Dollar for your Self-Directed Roth IRA
- “same trustee transfer,” where your money goes from the IRA to the Roth at the same financial institution. (Reminder you will need a fully paid Traditional IRA and Roth IRA at Rocket Dollar)
The pro-rata rule. The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro-rata. Here’s how it works: When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your traditional IRA accounts combined. If all of your traditional IRAs combined consist of, say, 70% pre-tax money and 30% after-tax money, that ratio determines what percentage of the money you convert to a Roth is going to be taxable. In this example, no matter how much money you convert or which IRA account you pull the money from, 70% of the amount you convert to the Roth will be taxable. You can’t choose to convert only after-tax money; the IRS won’t allow it. And a word about timing: the IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion.
The above is not meant to be tax advice. Weigh all decisions and consult a tax professional or financial advisor before making a financial decision.