A Simple Guide to Roth IRA Conversion

Oct 17, 2022

Cartoon of an older man holding a coin next to an oversized computer screen saying Roth IRA.

As the Baby Boomer and Gen X generations reach retirement age, many are taking another look at their retirement savings plans hoping to identify opportunities for tax reductions. For those with tax-deferred plans like traditional IRAs and 401(k)s, Roth conversion has become an increasingly popular method for locking in future savings in exchange for paying an upfront tax bill.

A Roth IRA conversion won’t make sense for everyone, so knowing how they work, the pitfalls they entail, and how best to execute them is crucial to mapping out your individual retirement strategy. To help you understand the basics, here’s a brief guide to Roth IRA conversion.

What is a Roth IRA Conversion?

A Roth conversion is the process of moving—or “rolling over”—funds from a traditional IRA or another retirement plan, such as a 401(k), to a Roth account. While a Roth IRA can enable you to protect your retirement income from future tax increases, it also means you’ll be paying more taxes upfront. Let’s take a closer look at the differences between these types of retirement plans.

What makes Roth IRAs special?

With a traditional IRA or 401(k), you make contributions with pre-tax dollars (these contributions entitle you to an income tax deduction) and you pay your tax obligation down the road when you start taking distributions. This is essentially reversed in the case of the Roth IRA; your contributions are made with after-tax dollars, but your investments get to grow tax-free over time. With a Roth, you pay your tax obligation upfront and, in exchange, you get to enjoy tax-free income in retirement.

Additionally, Roth IRAs afford investors superior flexibility when it comes to deploying the funds within their accounts. You can withdraw contributions—but not the earnings on these contributions—at any time should a sudden cash need arise, so your money isn’t “locked up” as it would be with a traditional IRA or 401(k). Roth IRAs also don’t entail required minimum distributions (RMDs) as other retirement plans do. That means that you won’t need to take out a certain amount of money each year after turning 72, which allows you to save unused money to potentially share with your beneficiaries. Roth IRAs can make great inheritance vehicles, too, because your heirs won’t have to pay taxes on their withdrawals in most cases.

Potential Pitfalls of Conversion

While Roth IRA conversions represent a pillar of many retirement saving strategies, they aren’t without risks or restrictions and they may not make sense for every investor. For instance, getting to pay your taxes today is only a boon if your tax rate is higher in retirement. If this isn’t the case and your future tax rate ends up being lower than it is today, you may ultimately surrender less in taxes by sticking with your tax-deferred account over opting for a Roth. Be sure to account for both your state taxes and your income tax bracket when trying to predict what your future tax obligations will be.

Even if you determine that using a Roth IRA will reduce your total tax obligation, having to pay a potentially large sum at the time of conversion may not work for you. Assuming a relatively low effective tax rate of 24%, making a $200,000 conversion would result in you owing $48,000 in taxes. That’s not an insignificant check to write.

Another wrinkle to consider is that Roth accounts necessitate a five-year holding period following contributions. Once you convert your funds, you can’t use the earnings on those funds for five years without subjecting yourself to costly early withdrawal penalties.

Utilizing a Roth Conversion

The IRS imposes a $6,000 (or $7,000 for those over 50) annual limit on the amount that can be directly contributed to a Roth IRA for the year 2022, but there’s no such limit on the amount that can be indirectly contributed via rollover. Simply reach out to your financial institution or plan provider to initiate the process.

Moreover, if your income exceeds a certain amount—$144,000 for individuals and $214,000 for married couples filing jointly in 2022—you won’t be eligible to make contributions to a Roth IRA directly. However, if you’d like to, you can still get money from your IRA or 401(k) into a Roth by leveraging a popular financial loophole: the so-called “backdoor Roth IRA.”

Backdoor Roth IRA

A backdoor Roth IRA is an informal name for a method used by high-income taxpayers to create a permanently tax-free Roth IRA, even if their incomes exceed the limits that tax law prescribes for regular Roth ownership. This tax mitigation strategy helps you if your income is too high to contribute to a Roth IRA directly, whereby you can still get your money into the account by adding a few steps to the process:

  1. Contribute to a traditional IRA or 401(k). Ensure that the contributions you make are non-deductible (i.e., post-tax funds) and that you’ve accounted for those contributions in your submission of IRS Form 8606. Alternatively, you can roll money into an IRA from a traditional 401(k) account.
  1. Convert your contributions to a Roth IRA. It’s important that you convert your traditional IRA to a Roth IRA as soon as possible. Failing to do so could allow your non-deductible contributions to accumulate investment gains while within the traditional IRA, which you would be responsible for paying taxes on upon conversion.
  1. Enjoy the tax protection of a Roth IRA. If you’ve executed it properly, all the taxes you owe will be paid upfront. From here onward, the funds within your Roth will grow tax-free until you’re ready to start making withdrawals in retirement.

Similarly, you’re able to contribute after-tax income to your 401(k) and then make an in-service distribution of those funds into a Roth IRA. This is what’s known as the “Mega Backdoor Roth IRA” and it’s another potential tax savings strategy for high-earners to consider.

Is a Roth IRA Conversion Right for You?

In general, Roth IRAs are best for people who envision having to pay more taxes later in life than they do currently, whether from an increase in income, a change in state residency, or higher expected tax rates. Rather than go the traditional IRA or 401(k) route and defer taxes until retirement, paying tax obligations now—while taxes are lower—means that you’ll ultimately get to hold onto more of your money and enjoy tax-free income later in life.

When Should You Convert?

Though a Roth IRA conversion might sound like a great long-term investment strategy, starting earlier isn’t always better. When you convert funds from a tax-deferred account like a traditional IRA or 401(k), you’ll need to pay taxes on all of the money that would have been taxed had you withdrawn it, including tax-deductible contributions and tax-deferred earnings. To make the most of your conversion, it’s best to time it strategically.

Here are a few scenarios you may find yourself in that could make a Roth conversion beneficial to you:

  • You’ve just retired and have enough to sustain yourself for five years on a relatively-lower income.
  • You’re a young person who’s looking to convert your traditional IRA during a short-term income reduction.
  • You’re likely to be in a higher tax bracket or moving to a state with higher income taxes in the future.
  • You want to save your Roth IRA as a tax-free inheritance for your beneficiaries.

If you meet any of these criteria, and you wouldn’t mind footing a larger tax bill upfront in order to potentially save money down the road, think about reaching out to a financial advisor today to discuss your rollover options. A professional can help you determine whether or not moving your money into a Roth makes sense for you, as well as help you navigate the rollover process.

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