Roth Conversion Rules
July 14th, 2023
Owners of a traditional IRA may consider converting their retirement account to a Roth IRA. If a possible Roth conversion has been on your mind, you may wonder if it makes sense at this time, and what the pros and cons of a conversion. In this blog post, we’ll consider the advantages and disadvantages, as well as the rules of making the change if you decide that this is right for you.
Should I Do a Roth Conversion?
There are many reasons you might want to convert your traditional IRA to a Roth IRA. Chief among them is the opportunity for tax-free withdrawals. Unlike a traditional IRA, for which contributions are deductible from income, contributions to a Roth IRA are made with after-tax dollars. Accordingly, distributions from a traditional IRA are taxable income, but growth and withdrawals from a Roth IRA are tax-free. (However, funds converted from a traditional IRA to a Roth are taxed as income upon the transfer.)
Another advantage of converting some traditional IRA funds to a Roth IRA allows you to have a mix of both taxable and tax-free income in retirement. That allows you flexibility and control over what your taxable income might be in a given year. Also, if you expect to be in a higher tax bracket in the future, it might make more sense to pay taxes on the conversion now, and enjoy withdrawals tax-free later.
One more consideration is that holders of traditional IRAS are required to take required minimum distributions at a certain age (currently 73), whether they need the income or not. A Roth conversion may allow you to reduce, or potentially eliminate RMDs; Roth IRAs do not require distributions until after the owner’s death.
If you are unsure whether this makes sense for you, there are numerous online Roth calculators, but you’ll get a more comprehensive picture of what to do from an experienced tax planning attorney.
What is a “Backdoor” Roth Conversion?
This allows people who might not be eligible to contribute directly to a Roth IRA because of income limits to do so indirectly. This strategy involves a two-step process. The first step involves making a non-deductible contribution to a traditional IRA; unlike with tax-deductible IRA contributions, there is no income limit for non-deductible contributions.
Then, the traditional IRA is converted to a Roth IRA, with the funds being transferred directly from the custodian of the IRA to the Roth. Be aware that because of the “pro-rata” rule, the conversion will still be a taxable event if you have IRAs containing pre-tax contributions. The tax is calculated using the ratio of post-tax to pre-tax dollars in all of your traditional IRAs.
Even if you only have non-deductible contributions in your IRA, be aware that unlike contributions made directly to a Roth IRA, earnings on those contributions will not be tax-free. Also, if you have a 401(k) or other employer-sponsored retirement plan, something called the “IRA aggregation rule” could have an impact on the taxation of a conversion.
If all of this sounds complicated, that’s because it is. It’s important to speak with a knowledgeable advisor about your potential tax liability before attempting a backdoor Roth conversion.
Are There Roth Conversion Limits?
While there are no direct limits imposed on the amount you can convert from a traditional IRA to a Roth, there are some factors to think about when considering a Roth conversion. First and foremost, remember that whatever amount you convert will be taxable to you as income in the year in which it is converted. Whatever your current tax rate is, you will need to pay income tax on the converted funds at that rate.
Because the amount of money that you convert from a traditional IRA to a Roth IRA is considered taxable income, you also need to consider the possibility that this increase in your taxable income will push you into a higher tax bracket, leading to even greater tax liability. In addition, increasing your taxable income for the year through a Roth conversion could negatively affect your eligibility for certain tax deductions or credits.
Is There a Roth Conversion Deadline?
Yes. If you want to do a Roth in a particular tax year, the conversion must be completed by December 31 of that year. Accordingly, since the conversion process takes time, you will want to put the wheels in motion well before the deadline so that there is enough time to complete any necessary documents and processing.
One more note: in the past, it was possible to “recharacterize”essentially undoing a conversion completed in a previous year. Under current tax law, recharacterization is no longer an option. In other words, if you commit to doing this, it cannot be reversed once completed.
A Roth can be advantageous, but they are not something to undertake lightly or hastily. To learn more about IRA planning and whether a Roth conversion is right for you, contact Gudorf Law Group to schedule a consultation to discuss your circumstances and explore your options.