When you transfer assets from a Traditional, SEP, or SIMPLE IRA (collectively referred to as a Traditional IRA in this article) or a qualified employer sponsored retirement plan (QRP) such as a 401(k), 403(b), or governmental 457(b) to a Roth IRA, it is known as a Roth conversion. When you convert your pre-tax savings into ordinary income, you avoid the IRS’s 10% additional tax for early or pre-59 1/2 withdrawals (10 percent additional tax) on your taxes now in exchange for the benefit of tax-free potential Roth IRA growth later.
What is the purpose of a Roth conversion?
Converting to a Roth IRA has the added benefit of potentially lowering your future taxes. While Roth IRAs don’t offer an immediate tax break, your contributions and gains grow tax-free. In other words, if you take a qualifying distribution after paying taxes on the money you put into a Roth IRA, you’re done paying taxes.
While it’s impossible to anticipate future tax rates, you can estimate whether you’ll earn more money and thus be in a higher tax band. In many circumstances, you’ll pay less taxes in the long term with a Roth IRA than you would with a standard IRA with the same amount of money.
Another advantage is that you can withdraw your contributions (not your earnings) tax-free at any time and for any reason. You shouldn’t, however, use your Roth IRA like a bank account. Any
What is the downside of Roth conversion?
- You anticipate a lower tax rate in retirement. Roth conversions aren’t a good idea if you’re in a high federal tax bracket now and expect your retirement income to be low enough that your tax rate will be lower as well. However, you still have to worry about what Congress will do with tax rates in the coming years.
- Taxes are paid in advance. Do you have enough free cash flow to handle the additional tax burden that a Roth conversion would entail? If you have high-interest credit card debt or a small emergency fund, you should address those issues before racking up a larger tax burden.
- Concerns about Social Security. If you’re already collecting Social Security, your income determines whether or not your benefit is taxable, as well as how much it will be taxed.
Your taxable income will increase the year you make a Roth conversion, which might result in a portion of your Social Security benefit being taxed or pushing you into a situation where more of your benefit is taxed.
- Monthly Medicare Part B and Part D rates are increasing. Once you’ve signed up for Medicare, the monthly Part B and Part D premiums you pay are determined by your modified adjusted gross income (MAGI) from two years ago. If you plan to enroll in Medicare at the age of 65, a Roth conversion at the age of 63 may result in higher starting Medicare premiums than the standard rates. Your premiums reset every year, based on your taxable income from the previous two years, so if your income doesn’t stay high, you’ll rapidly revert to lower rates.
- There is little protection from bankruptcy. A creditor cannot touch money in a 401(k), but the protection of IRA funds is limited. In 2021, the total amount of IRA assets protected from creditors is $1,362,800. The cap is reset every three years to account for inflation, with the next adjustment scheduled for April 2022.
How many years can you spread out a Roth conversion?
Each new conversion begins a five-year clock, and you’ll need to account for several conversions to avoid taking too much money out too soon. The five-year rule applies to both pre-tax and after-tax funds in a regular IRA when converting to a Roth.
Who should do a Roth conversion?
If you want to reduce your taxable income in retirement, a Roth IRA conversion may be perfect for you. If you believe your tax rate will be higher in retirement than it is today. If you want to avoid having to take required minimum distributions from a regular IRA at the age of 72, this is the way to go.
What is the difference between a Roth conversion and a Roth contribution?
A Roth conversion is the process of transferring money from a pre-tax retirement account (such as an IRA or 401k) to a Roth IRA. Unlike a Roth contribution, there are no earnings restrictions that may prevent you from converting your Roth account. Let’s say you want to convert $50,000 from a pre-tax IRA to a Roth IRA.
Are Roth conversions going away?
A high-profile provision of the Build Back Better bill would prevent the ultra-rich from benefiting from Roth IRAs, which were created in the late 1990s to help middle-class Americans save for retirement.
Roth IRA contributions are made after you’ve paid income taxes on the funds. To put it another way, whatever money you save is taxed “up front,” allowing you to get the most out of your Roth IRA: Withdrawals are tax-free in the future, regardless of how much your investments have grown.
“I believe that the American people are overtaxed. So I firmly endorse and have pushed for many years for lowering taxes on America’s working people,” stated Senator William Roth in 1998, whose work establishing Roth IRAs and later Roth 401(k)s earned the accounts his name.
Senator Roth, please accept my apologies, but backdoor Roth IRA workarounds have turned his blessing into a curse.
Proposed Rules for Wealthy Investors with Defined Contribution Accounts
High-income individuals and couples with balances of $10 million or more in any defined contribution retirement plans, such as IRAs and 401(k)s, would be required to make withdrawals under BBB.
Individuals earning more than $400,000 a year and married couples earning more than $450,000 a year would be unable to contribute to their accounts and would be obliged to withdraw half of any sum above the $10 million barrier. Let’s imagine at the end of 2029, you had $16 million in your IRA and 401(k). You’d have to take out $3 million under the new regulations. (The plan won’t take effect until December 31, 2028.)
A separate clause applies to Roth accounts, such as Roth IRAs and Roth 401(k)s. It applies to any couple or individual earning more than the aforementioned levels, with more than $20 million in 401(k) accounts, and any portion of that held in a 401(k) account.
BBB Would Tamp Down Roth Conversions
The BBB legislation includes a second double whammy for Roth accounts. The bill proposes to ban so-called non-deductible backdoor and giant backdoor Roth conversions beginning in 2022. You wouldn’t be able to transfer after-tax contributions to a 401(k) or regular IRA to a Roth IRA, regardless of your income level.
By 2032, a new rule would prohibit Roth conversions of any kind for anyone earning more than $400,000 or a couple earning more than $450,000.
What is the deadline for converting an IRA to a Roth IRA?
Yes, the current year’s deadline is December 31. Gross income does not include a translation of after-tax amounts. Any portion of the conversion that was made before taxes will be included in your gross income for the conversion tax year.
Should I Convert IRA to Roth after retirement?
It’s not a good idea to convert to a Roth if you’re nearing retirement or need your IRA money to live on. Converting to a Roth costs money since you have to pay taxes on your funds. The money you spend up front must be justified by the tax savings after a specific number of years.
How do backdoor Roth IRAs work?
A “backdoor Roth IRA” is a sort of conversion that permits high-income individuals to avoid the Roth’s income restrictions. Simply put, you contribute to a regular IRA, convert the funds to a Roth IRA, pay taxes, and you’re done.