How to Convert a SEP IRA to a Roth IRA

If you have a simplified employee pension individual retirement account, either through an employer or from setting it up yourself, you can convert it to a Roth IRA to avoid having to pay taxes on the distributions in retirement. However, you have to pay taxes in the year of the conversion, so it usually makes sense only if you expect to pay a higher rate at retirement.

Methods

You can convert a SEP IRA to a Roth IRA with either a rollover or a transfer. With a rollover, you take a distribution from the SEP IRA and, within 60 days, redeposit the money in a Roth IRA. With a transfer, you tell the trustee of your SEP IRA to move the money directly to your Roth IRA. In addition to avoiding the risk of missing the 60-day deadline, by using a transfer you don't have to worry about income tax withholding.

Resulting Taxes

Converting from a SEP to a Roth results in the amount of the conversion counting as taxable income in the year of the conversion. Money contributed to a SEP IRA wasn't taxable when you put it in, so when you convert it to a Roth IRA, which is an after-tax account, you have to pay taxes on it. The money is taxed as ordinary income, so the more income you have, the higher your tax rate on the conversion.

Tax Reporting

When you file your tax return, you must report the conversion with either Form 1040 or Form 1040A. You have to show the entire amount as a nontaxable IRA distribution and then complete Form 8606 to figure the taxable portion. Then you report the taxable amount — generally the entire conversion — as a taxable IRA distribution.

Future Distributions

Whenever you convert money into a Roth IRA, you have to wait at least five years from the date of the rollover before you can take qualified distributions of the money and any earnings on it. This requirement is separate from the normal requirements for taking qualified distributions. For example, if you convert the SEP to a Roth IRA in 2014, even if you're 59 1/2 in 2016, you must wait until 2019 to take qualified distributions.

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About the Author

Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."

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