You may have already figured this out about me, but ROTH is one of my favorite things to talk about. The word itself was a contender for naming our firstborn, but my husband didn’t feel the same way.
ROTH conversions are a really great benefit offered by the IRS.
Before I get into it, I will quickly review ROTH contributions and the benefits of having a ROTH account. ROTH contributions are made with after-tax dollars and the account grows tax-free as long as you take qualified distributions*. The IRS caps the amount you can contribute each year and it also caps the income you can earn in order to be eligible, so for high earners ROTH contributions are not an option. To expand on why ROTH is a great benefit, it gives you access to future tax-free money. Contributions for 2021 (and forecast for 2022) is $6,000 (or $7,000 if over age 50) or 100% of earned income, whichever is less.
Unlike ROTH contributions, income limits do not apply to ROTH conversions, thus giving the latter the nickname “backdoor ROTH IRA.” There is also no cap for the amount you can convert.
If you have pre-tax money saved in a retirement account, (historically this was the only way money was saved for retirement), you may be able to pay the taxes on it and convert it to a ROTH account.
If your pre-tax money is in a Traditional IRA, you may benefit from paying the taxes on it now, converting it to a ROTH IRA, and letting it start to grow tax-free.
If your pre-tax money is in an employer-sponsored plan like a 401k or 403b, you may be able to convert it to a ROTH IRA once you’ve left the company or meet the requirements for an in-plan conversion (that’s if the plan offers the ROTH conversion feature).
Reason #1: You may be in a lower tax bracket due to the Tax Cuts and Jobs Act or other factors. This means you would pay less in taxes on the amount you convert than you would in a year that tax rates have gone up.
Reason #2: If your balance is decreased due to market fluctuations, the math works in your favor to implement this retirement strategy because you’re taxed on a lower dollar amount. Let me go consult my crystal ball to find out the best timing for this. Oh, wait, it’s not real.
Reason #3: You can do it in chunks (that’s a technical term). You can choose an amount that aligns with your tax strategy for this year, and do an additional amount again another year (it’s limited to one per year). Working with a tax expert can benefit you in implementing this strategy because they could model various scenarios and the associated implications for your taxes.
Reason #4: You are paying your future tax expense ahead of time. If you’re working you are paying some of your retirement expenses while you still have earned income. I recommend paying the taxes out of current income.
If you’re considering this in retirement, the strategy can still benefit you by reducing future withdrawals from your portfolio. I recommend paying the taxes from a non-qualified source of cash. Note that if a Traditional IRA has already started Required Minimum Contributions (RMDs) that the RMD must be taken before the conversion can occur.
Either way, by reducing your future taxable income, you could possibly reduce Social Security taxes and Medicare premiums in addition to your income taxes.
Reason #5: ROTH IRAs are not subject to RMDs during the owner’s lifetime, and therefore provide more flexibility by allowing for more time for potentially growth and the possibility of leaving a legacy.
Reason #6: The SECURE Act changed the RMDs for non-spouse inherited retirement accounts to 10 years, whereas those beneficiaries used to have the option to take payments over their lifetime. Those beneficiaries have less flexibility and may end up with taxable income they don’t need or want, or simply that they spend instead of save. Inherited ROTH IRAs have the flexibility to spread RMDs over the beneficiary’s lifetime.
Reason #7: Now is better than later for ROTH to benefit you. This approach applies to a lot of things about money, like saving early. The benefit of the ROTH – tax-free potential growth – increases with time.
Most of us do not delay gratification. Take me for example, I nearly always pull into a parking spot nose first, even though it’s so enjoyable to have backed in when I return to my car and can pull straight out. The same can be said about spending versus saving. There is no calculator tool to answer if a ROTH conversion is right for you because there are too many variables – market performance, future tax rates, and life expectancy are all unknown. Just imagine that your future self will likely have no regrets about your present self making this choice.
Here are some careful considerations now that I’ve listed 7 reasons to consider a ROTH conversion. The amount of a ROTH conversion is likely to add to your income and could therefore push you into a higher tax bracket for the year in which you make the transaction. You could push yourself above the threshold to incur a Medicare premium surtax as well. You want to consider very carefully if a ROTH conversion, and how much, is right for you. I can’t emphasize enough the value of working with your tax professional to calculate your scenario.
You will have a larger tax bill and it’s best to pay this out of cash. If you use your account balance to cover the taxes you take away from the value of the investment and could face a 10% penalty if you’re under age 59.5.
If you think you need the money sooner than 5 years, then a ROTH conversion may not be right for you.*
If you do pursue a ROTH conversion, elect a trustee-to-trustee transfer if it’s moving from one financial institution to another or a same-trustee transfer if the conversion happens within the same institution. The other option is a rollover but that involves an actual check to you in the mail and a 60-day window to make sure it gets deposited. Then file a Form 8606 with your income taxes or let your tax preparer know the details.
*I wouldn’t utter the word ROTH without mentioning some very important rules to keep in mind. Your first contribution or conversion into an account starts a 5-year clock. For an account with just contributions, you can’t access the earnings on those contributions without a penalty until you have had the account for at least 5 years AND you are either 59½ years old, permanently disabled, taking withdrawals from an inherited account, or taking out up to $10,000 as a first-time homebuyer. You can access your contributions any time for any reason. Money that was converted into a Roth IRA cannot be taken out penalty-free until at least five years after the conversion, even if it was contributed to an existing ROTH IRA. Each conversion is subject to its own separate 5-year clock.
On a personal note, I made my first ROTH conversion in 1998, the year ROTH was established. Shoutout to my Mom, who read those newspapery 1040 instructions that you used to pick up at the Post Office lobby, because she advised me to do so. If you know a teenager with earned income, be that influence on them.
