Although Roth IRA accounts were first established over 20 years ago, the way Roth accounts work is not as well-known as it should be. Roth conversions are even less well-known than Roth contributions, yet they can be even more beneficial than a direct contribution to a Roth account. And the holy grail in the Roth world of a back-door Roth is the most misunderstood, yet the biggest bang for the buck in the right situation. Significant changes may be coming soon to Roth accounts, depending on what the final version of The Build Back Better legislation looks like. Now is a good time to figure out if a Roth conversion or one of the other Roth transactions is right for you.
What is a Roth Account?:
In general, a Roth account means you don’t get a tax deduction when the money is put into the Roth account. However, the money in the Roth account grows tax-deferred over time and most distributions are tax-free when they come out of the account. A Roth account can be an IRA or another type of defined contribution retirement account such as a 401(k) or 403(b).
Contributions made to a Roth account can with withdrawn at any time penalty and tax-free. You’ve already paid taxes on that money. Earnings on the contributions can be withdawn penalty and tax-free as long as you’ve held the account at least five years and are age 59 1/2 or older. Heirs receiving an inheritied Roth IRA also receive tax-free distributions. There are no required minimum distributions (RMD’s) for Roth accounts if you are the original owner of the Roth account.
Traditional IRA Account:
Contributions to a traditional IRA can be made either with pre-tax dollars or with after-tax dollars. A contribution made with pre-tax dollars provides an immediate tax benefit, however the ability to make a pre-tax contribution is subject to income limits. You can make a non-deductible contribution to an IRA with after-tax dollars even if your income is above the limits for pre-tax contribution. In either case, you need to have earned income to make a contribution to any IRA with the exception of a spousal IRA which allows a non-working spouse to make a contribution based on their married filing jointly income tax return earnings.
Traditional IRA’s are subject to required minimum distributions (RMD’s) which generally begin at age 72, unless you reached 70 1/2 years of age before January 1, 2020. The money in a traditional IRA grows tax-deferred and you pay ordinary income taxes on the withdrawals. The contribution limit for a traditional IRA is $6,000 in 2021 and 2022. If you are 50 years old or older you can add an additional $1,000 as a catch-up contribution.
Why Do A Roth Conversion?
The primary advantage of having money invested in a Roth tax-qualified account rather than a traditional tax-qualified account is the ability to withdraw money tax-free in retirement. This allows you to manage the tax impact of creating your own source of income in retirement. Being in retirement doesn’t necessarily mean you will be in a lower tax bracket. If you have a sizable traditional 401(k) account or traditional pre-tax IRA you could be in the same income tax rate bracket or even a higher income tax bracket in retirement. There also is the unknown about where tax rates will be headed in the future.
If you use Roth withdrawals to pay for your living expenses, then you can withdraw assets income tax free when needed and not impact your taxable income. Staying in a lower tax bracket has benefits besides paying less in income taxes. The additional benefits are the ability to recognize capital gains from your taxable investments at a lower tax bracket, having lower income for the calculation of the expenses associated with Medicare for higher income retirees, and potentially having Social Security Income taxed at lower rate. There are no RMD’s for Roth assets belonging to the original owner of the Roth account which gives the owner flexibililty for timing the withdrawals from the account.
How A Roth Conversion Works
In a nutshell, a Roth conversion gets around the income limits for making a direct contribution to a Roth account. This is done by paying taxes on traditional pre-tax assets and moving the assets to a Roth account or by moving a non-deductible, post-tax traditional IRA contribution into a Roth account before it has any earnings. The allows the future withdrawals and growth on the assets to be tax-free.
Roth Account Income Limitations
The income limit for making a contribution to a Roth IRA depends on your income tax filing status and whether you are covered by a retirement plan at work or not. As an example, for someone who is married filing jointly and covered by a retirement plan at work, if you make more than $129,000 then you cannot make a contribution to a Roth IRA. There is no income limit to make a Roth contribution to a 401(k) if your employer’s plan allows Roth contributions, but you are subject to the annual salary deferral limits. The lilmits for 2021 are $19,500 up to age 50 and $26,000 if you are over 50 years old. For 2022 the limits are $20,500 up to age 50 and $27,000 if you are over 50.
Currently there are no income limitations to do a Roth conversion and you can convert an unlimited amount of assets, but this may change in the future so if it’s something you are interested in doing now is the time to work through the details to see if makes sense for your situation.
Roth Conversion Process
Roth conversions can be done at any time during the year. The process itself is simple in that you request the custodian, or company who is holding the assets, to open a Roth IRA and to transfer the traditional assets to the Roth account. In order for a Roth conversion to qualify for a 2021 conversion the funds must leave the IRA or retirement plan in 2021. It’s OK if the funds don’t end up in the Roth account until after the end of the year as long as they are converted within 60 days. It’s best to do a direct rollover from the original account to the new account to avoid any problems with a potential taxable distribution.
Tax Reporting For Roth Conversion
You will report the Roth conversion on IRS Form 8606. This will direct the income incurred on the conversion to be recorded on your 1040, where it will become part of your taxable income. You will receive a Form 1099-R from the custodian showing that an IRA rollover occured. It will provide details on the amount converted, the amount that is taxable and any federal or state taxes that were withheld. This is the information your tax preparer will need to complete the IRS Form 8606.
Roth Conversions Are Permanent
Roth conversions can no longer be undone once completed, so it’s important to understand the tax impact of making a Roth conversion and to be able to pay the taxed owed due to the conversion. It’s generally more tax efficient to pay the tax due from assets outside of the IRA rather than take a distribution from the IRA to pay the tax due. It’s also usually helpful to make a Roth conversion toward the end of a year so that your tax preparer can estimate with a greater degree of accuracy the tax impact of the conversion.
Beware Of The Roth Conversion Five-Year Rule
The IRS charges a 10% penalty on any money you withdraw from a converted Roth IRA within the first five years. But if you decide to do multiple Roth conversions over several years, you need to understand that each Roth conversion has its own five-year clock. If you were to convert a 401(k) balance to a Roth IRA in 2021, 2022, and 2023, for example, you would have three different five-year rules to keep track of. The clock for the five-year rule starts on January 1 of the year you make a conversion. So if you were to convert money in December of 2021, the IRS considers your five-year clock to have started on January 1, 2021, For that December conversion, you would essentially have just four years left before the penalty expires.
When To Do A Roth Conversion
The ideal Roth conversion planning strategy is to convert when tax rates will be the lowest, which varies from person to person. If conversions are deferred, then the IRA will continue to grow and the larger the balance, the higher the tax bill will likely be in future years. However, if you are nearing retirement age and you expect your income will drop substaintially, it may be more advantageous to wait until you are in a lower tax bracket.
The trade-off between doing a conversion earlier and paying the taxes sooner vs. waiting and paying the taxes later on a larger balance was analyzed by Michael Kitces. It was determined that mathematically, the outcome of the Roth vs. traditional IRA decision will actually be the same, regardless of growth rates and time horizon, as long as both accounts remain intact and tax rates don’t change. To cope with the uncertainties around future tax rates, one popular approach is to tax-diversify between the two types of accounts and have some assets in each type. However, what Kitces found was the reality is that the outcomes are correlated to each other and the net result is that tax diversification doesn’t actually diversify the risk, it simply neutralizes the opportunity altogether. The better approach is to identify specific life events such as retirement or the beginning of a career when you will be in a lower tax bracket, and do Roth conversions at that time to fill up your taxable income up to the marginal tax bracket which you want to stay below.
RMD’s And Roth Conversions
A Roth conversion will not satisfy your RMD (required minimum distribution) because it is considered a rollover and not a withdrawal from your IRA. If you are subject to RMD’s, your taxable income will include both the RMD and the amount of a Roth conversion.
Qualifed Charitable Distributions
An alternative for satisfying RMD’s without increasing your taxable income if you are 72 years old or older is to donate to a qualifed charity from your traditional IRA through a QCD, or Qualified Charitable Distribution. A QCD is a direct transfer of funds from your IRA to the charity. The limit is $100,000 per year and the QCD is excluded from your taxable income. Certain charities are not eligible to receive QCD’s including Donor Advised Funds and private foundations.
Back Door Roth Conversions
Back door Roth conversions is a term used to describe the techniques used to side-step the Roth account’s income limitations for making a direct contribution to a Roth account.
The current draft of The Build Back Better bill has provisions in it which limit the ability to use Roth conversions as well as back door Roth conversions. If the bill passes in its current form, starting in 2022 then regardless of income level you’d no longer be able to convert after-tax contributions made to a 401(k) or traditional IRA to a Roth IRA. An additional rule would prevent Roth conversions of any kind made by anyone making more than $400,000 or any couple making more than $450,000 beginning in the year 2032. Back door refers to making a contribution to a traditional IRA and then converting it to Roth, or getting the assets to be Roth assets through a back door and side-stepping the Roth limitations.
Mega Back Door Roth Conversions
A mega back door Roth conversion is a way to contribute a higher amount to a Roth account using the provisions of a 401(k) plan. For details on the difference between a Roth IRA and a Roth option in an employer’s retirement plan is here.
The IRS allows employees to put up to $58,000 into a 401(k) account in 2021 for those under 50 and $64,500 for those 50 and older. The employee can defer up to $19,500 of their salary if under 50 or up to $26,000 if 50 or older. The remainder of the 401(k) limit can be filled with employer contributions or additional after-tax contributions from the employee if the 401(k) plan allows it. If the employee makes an after-tax contribution to the 401(k) plan and they are allowed to convert it immediately to Roth assets it’s a way for the employee to potentially make a $38,500 Roth contribution each year. A growing number of companies now allow mega back door Roth conversions in their 401(k) plans. Under the proposed legislation, employees would still be allowed to make after-tax contrubutions to 401(k)s. But they would no longer be permitted to convert that money to a Roth, where the growth on the assets would be tax-free. Instead they would pay income tax on their investment gains when they withdraw the money.
Summary For A Roth Conversion
A Roth conversion can be a very powerful tool for your retirement. The backdoor strategy opens the door to Roths for even high-earners who normally would be ineligible for a Roth. But it’s not a slam-dunk decision. Your financial situation now and in the future needs to be taken into consideration to determine if a Roth conversion is right for you, when the conversion is most appropriate for you, and how much to convert in which year.
Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.