Here’s What You Need To Know About Roth Conversions

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For retirement, specifically, individual retirement accounts (IRAs) are a widely popular savings vehicle. Roth IRAs, in particular, are excellent accounts to help retirees mitigate their tax liability in retirement. 

The main differentiator of a Roth IRA is that you contribute with after-tax dollars, and all qualified distributions are tax-free. This structure brings an important tax-efficient element to your savings journey. Roth IRAs also don’t have required minimum distributions (RMDs), bringing more flexibility to your retirement income plan. 

But income thresholds keep many high-earners from directly contributing to a Roth IRA. Luckily, there is a way around that known as a Roth Conversion or a backdoor Roth IRA. What is a Roth Conversion, and does it make sense for you? Let’s find out.

Building blocks of Roth Conversions

A Roth Conversion allows you to convert funds from a traditional IRA into a Roth IRA. It enables people to contribute to a Roth even if they exceed the income thresholds, which are $139,000 for those filing single and $206,000 for those married and filing jointly in 2020. If your modified adjusted gross income is above these numbers, you are unable to contribute to a Roth IRA.

A Roth Conversion is a wealth-building strategy for high-income earners to take advantage of the benefits of a Roth IRA even if they can’t directly contribute to it. There are a couple of ways to accomplish a Roth conversion:

  1. Take a distribution from your Traditional IRA and deposit it into your Roth IRA within 60 days.
  2. Trustee transfer. Financial institutions transfer the money on your behalf from one account into another, whether between different institutions or within the same one.

With a direct contribution to an IRA, the IRS sets contribution limits, which for 2020 are $6,000 and $7,000 if you are over 50. But with a Roth Conversion, you can convert more than the annual limit. So if you want to transfer $15,000 into a Roth IRA by way of a conversion, you can. You can also make multiple Roth conversions in a year, so you could transfer $8,000 in September and $7,000 in December. 

But Roth Conversions don’t get you off the hook for tax responsibilities.

What are your tax responsibilities?

The tax liabilities for Roth conversions can be complicated and depend on the tax-status of the contributions. Let’s break this down a bit further. 

Most contributions to a traditional IRA are pre-tax, which can either be deductible (pre-tax dollars) or non-deductible (after-tax dollars). This distinction depends on your income. Suppose you are converting money from a traditional IRA comprised of deductible assets. In that case, you will be responsible for paying ordinary income tax on the total amount of the contribution, including any amount that those contributions have earned. You will need to pay this at the time of the conversion. 

The next scenario is if you convert money with non-deductible assets. Since your original contributions were after-tax, you would only be responsible for taxes over your tax basis.

If you contribute with both deductible and non-deductible assets, it kicks the complexity up a notch, triggering the pro-rata rule. Under this rule, the total value of your IRAs dictates the taxes you owe. Say, for example, you had $100,000 split between 3 different IRAs and $20,000 of that was non-deductible. You can’t simply roll over the $20,000 non-deductible portion, as the IRS takes the full $100,000 balance into account when figuring your tax bill. 

Your financial advisor will be able to help you estimate your tax responsibility before making the transfer. 

When is a Roth conversion right for you?

Remember, Roth IRAs are most beneficial due to the way they are taxed. In general, people will start their careers in a lower tax bracket and work their way up as they near retirement. By converting when you are in a lower tax bracket, you can save yourself thousands of dollars in taxes throughout retirement. 

IRA distributions are considered ordinary income. So if you are in a higher income bracket, your tax bill could be up to 37% of all distributions. But by paying a lump sum tax bill now, you would be able to withdraw funds tax-free in retirement. 

Roth conversions can also make sense for those who experienced a dip in their income. Conversions in lower-income years can help keep some of the tax responsibilities at bay and set you up for the future.

When considering a Roth Conversion, there are a few things you want to look at:

  • Current and projected tax bracket
  • Cash flow (to determine if you can pay a lump sum of taxes required to make the conversion)
  • Tax planning strategy

Be sure that you think through all of your options because once you convert the money, it can’t go back.

Our team can help

Proactive tax planning is an integral part of any healthy financial plan, and a Roth Conversion can be a big part of that conversation. A seasoned financial planner can skillfully navigate the tax hurdles, income thresholds, and master the timing of a Roth Conversion. 

We have seen many clients find success with Roth Conversions and would love to talk to you to see if it makes sense for your financial situation. Ready to learn more? Set up a time to speak with us today.

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