LEVATUS Perspective | Important Considerations Around Roth Conversions
If you earn too much to contribute directly to a Roth IRA, there are still “backdoor” ways to move funds to this type of an account
Photo by Ibrahim Rifath
Roth IRAs can be a powerful savings and estate planning tool, and can add value within a broad retirement planning strategy. In the context of the today’s shifting tax backdrop, reviewing retirement account type diversification opportunities is particularly compelling.
The Roth shelters income and capital gains from taxes as does a traditional IRA, but the Roth does not require minimum distributions at retirement. Also unlike traditional IRAs, the Roth IRA has an income threshold for contributions. The ability to make a direct contribution to a Roth IRA in 2021 phases out for single filers with an adjusted gross income between $125,000 - $140,000, for 2021. For joint filers, it phases out between $198,000 and $208,000.
The good news is that there are ways to access the Roth IRA even if your income is over these limits. Following are a few factors to consider when evaluating whether diversifying your retirement account types to include some exposure to Roth makes sense.
Potential tax advantages of Roth IRAs
A Roth IRA is an individual retirement account similar to a traditional IRA in that it offers tax-free growth. But there is no tax whatsoever on withdrawals after you reach age 59 ½ which can be a very powerful tax planning tool. When taking withdrawals from a traditional IRA, you have to pay taxes on the money your investments earned—and on any contributions you originally deducted on your taxes. With a Roth IRA, as long as you meet certain requirements, all of your withdrawals are tax-free. Contributions to traditional IRAs are made with pre-tax dollars as opposed to contributions made to Roth IRAs which are post-tax dollars. Similarly, when converting assets to a Roth IRA, you pay taxes on the converted amount at the time of the conversion. If you believe that tax rates will increase in the future, you end up paying taxes up front at a lower rate.
No Required Minimum Distributions (RMDs)
With traditional IRAs it is necessary to take required minimum distributions (RMDs) every year after you reach age 72 (age 70½ if you attained age 70½ before 2020), regardless of whether you actually need the money. So you lose the tax-free growth on the money you had to withdraw and pay income taxes on the amount of the distribution.
On the other hand, Roth IRAs don't have RMDs during your lifetime, so your money can stay in the account and keep growing tax-free. The beneficiaries of your Roth IRA will have to take RMDs, but they won't have to pay any federal income tax on their withdrawals as long as the account's been open for at least 5 years.
The “backdoor” option to get your assets into a Roth
A Roth conversion can get some of your assets into a Roth IRA—even if your income is too high to make annual contributions. For new money the conversion is a 2-step process, often referred to as a "backdoor" strategy. First, place the allowed contribution in a traditional IRA—which can be made regardless of your income. Then, move the money into a Roth IRA using a Roth conversion.
If you have an existing traditional IRA you can also convert all or a portion of these assets. If you are within retirement years and already taking RMDs, you will have to take the entire amount of the RMD for the year before doing a conversion. You can decide whether to withhold taxes due on the conversion amount from the traditional IRA or pay them at the time of conversion. The amount you choose to convert will be taxed as ordinary income. This additional income, therefore, can push you into a higher marginal federal income tax bracket. The federal tax on a Roth IRA conversion will be collected by the IRS with the rest of your income taxes due on the return you file for the year of the conversion. The ordinary income generated by a Roth IRA conversion generally can be offset by losses and deductions reported on the same tax return.
Potential benefits of a conversion are powerful
Control of future tax liabilities
Your money grows tax free for future generations who won’t have to pay tax on withdrawals from Roth
Your children will pay less taxes on inherited traditional IRA
Avoiding RMDs from traditional IRA (important if RMDs are not being used to meet cash flow requirements)
Possibly lower tax bracket by reducing income
A few more considerations
You can save money on a Roth conversion by completing it during a market downturn. Because the value of your investments is lower during a decline in the market, you'll pay a smaller amount of taxes when you make the conversion. It is also a good strategy if your income is lower than it usually is in a given year.
Before doing a Roth conversion consider if you are leaving inheritance to charity you are actually paying taxes when none would be due. This wouldn’t be the best option if you plan to leave money to a charity.
If you are not passing down wealth inter-generationally the economics of conversion are not as compelling even if tax rates rise.
There are no more recharacterizations of Roth IRA conversions (you can’t undo them).
Finally, there are tax consequences to consider before using this strategy because any assets transferred into a Roth IRA must pay taxes upfront at the time of the conversion. Consulting your tax professional and financial advisor is always a good first step to see if this backdoor option is right for you.
Tax, estate, investment
Distilling complex topics down to their essence is a hallmark of the LEVATUS approach.
ABOUT THE AUTHOR
Liz Darling is a senior client advisor and founding member of LEVATUS. Her professional background includes several years working in the hospitality industry, institutional real estate investment management, and wealth planning. Coming from an institutional background, Liz’s favorite part of her day is interacting with her clients on the little things that she can do to make their lives and their financial situation simpler and clearer. Liz writes on topics from which she has years of experience such as real estate’s role in generational wealth building and various topics on how wealth can impact children.
August 2024 started with a swift drawdown in markets. As with many such corrections, a major contributor was leverage.