SEP IRA to Roth IRA Conversion

Tax Strategy
|
Retirement
|
Updated
2/18/2023

How It Works

Using this strategy, an individual receives contributions in a SEP IRA from their employer and then transfers the contributions plus any earnings to a Roth IRA. Because the transfer is from a pre-tax to an after-tax retirement account, it is taxable income for the individual and subject to early withdrawal penalties in some scenarios.

Transfer funds from SEP IRA to a Roth IRA

The transfer, called a conversion, can be completed in one of three ways:

  1. Rollover - A transfer from the financial institution to the taxpayer who then transfers the funds to another financial institution.
  2. Trustee-to-trustee transfer - A transfer from one financial institution to another; or
  3. Same trustee transfer - A transfer from one account to another in the same financial institution.

Avoid early-withdrawal penalties

Same-trustee or trustee-to-trustee transfer aren’t subject to early withdrawal penalties since the trustee doesn’t distribute any funds to the taxpayer through these methods. The converted amount would still be taxable but the 10% early withdrawal penalty wouldn’t apply

A rollover, however, involves the trustee distributing funds to the taxpayer who must then deposit the distribution into a Roth IRA. Under this method, the taxpayer needs to mindful of the 60-day rollover and tax withholding requirements to avoid early withdrawal penalties.

Complete the rollover within 60 days

Once you receive the SEP IRA distribution during the rollover process, you’ll need to deposit the funds into the Roth IRA within 60 days to avoid a 10% early withdrawal penalty. The 60-day timer begins on the day that you receive the distribution. The IRS may waive the 60-day limit in certain cases.

Tax withholdings count as early distributions; subject to penalties

A mandatory income tax withholding rate of 20% applies to SEP IRA to Roth IRA rollover distributions that aren’t completed as a same-trustee or trustee-to-trustee conversion. The trustee sends the withheld taxes to the IRS and you’ll apply the withholdings as a credit against your annual tax liability.

However, because the tax withholdings are amounts not rolled over into the Roth IRA, the 10% early withdrawal penalty would apply to the amount withheld for taxes. To avoid early withdrawal penalties, the taxpayer can deposit funds from other sources equal to the amount withheld into the Roth IRA.

Check for non-deductible contributions held in other IRAs

Rolling over funds from a SEP IRA to a Roth IRA is typically a taxable event, since the funds are converted from a pre-tax account to an after-tax account.

However, a portion of the converted amount might be non-taxable if the taxpayer has previously made non-deductible contributions to a traditional IRA. Non-deductible contributions are atypical, but they might have been made as the first step of a back-door Roth strategy.

Non-deductible contributions to other IRAs must be allocated to the converted amount. The allocable amount is equal to the amount of non-deductible contributions to traditional IRAs divided by the total contributions to traditional IRAs as of December 31st of the conversion year.

The allocation of non-deductible contributions to the converted amount reduces the extent to which the conversion is taxable. This could have unintended consequences, especially in cases where the taxpayer has made non-deductible contributions to a traditional IRA but only intends to convert the amounts held in a SEP IRA. In that case a portion of the pre-tax amount would remain un-converted at year-end.

Report the conversion on Form 1040

At year-end, the individual will receive Form 1099-R from the financial institution that administers the SEP IRA. Form 1099-R includes the amount converted from a SEP IRA to a Roth IRA and the taxable amount that the individual must report on their tax return.

SECURE 2.0 Act of 2022

Beginning in 2023, SEP IRA contributions can be designated as Roth IRA contributions. The SECURE Act provides that the employee must elect for the employer contributions to be treated as though they were made to a Roth IRA.

After-tax contributions to a Roth SEP IRA are a potential alternative to rolling over pre-tax SEP IRA contributions to a Roth IRA. After-tax contributions to a SEP IRA could bypass the rollover process and potentially avoid the taxes and early withdrawal penalties often triggered by Traditional to Roth IRA conversions.

The implementation of the SECURE Act is still unfolding and many employers and financial institutions don’t yet offer a Roth IRA option. Therefore, it’s important to confirm whether it’s available before pursuing this alternative.

Eligibility

Confirm the following before using this strategy:

  • The taxpayer has pre-tax funds held in a SEP IRA.

Action Items

Follow these steps to use this strategy

  • Confirm that the Roth IRA will accept rollover contributions
  • Review for non-deductible contributions held in other IRAs
  • Initiate rollover through financial institution
  • File tax return using Form 1099-R
  • Track basis in Roth IRA on Form 8606
  • Report early withdrawal penalties on Form 5329

Limits (2023)

Contributions to a SEP IRA are limited to 25% of an employee’s compensation. For self-employed taxpayers who file on Schedule C, the contributions are limited to 20% of net business income.

This content is for informational purposes only and does not constitute legal, business, or tax advice. You should consult your own attorney, business advisor, or tax advisor regarding matters mentioned in this post. We take no responsibility for actions taken based on the information provided.

Get your free custom quote.

It takes less than a minute to start.

© 2022 Putnam CPA Group, PLLC
Made in Virginia