Doing a Roth conversion — also known as a “backdoor Roth IRA” – is perhaps still appealing in 2022. Why? Low 2022 tax rates.
What is a Roth Conversion? Backdoor IRA?
A Roth Conversion is when you convert money that you have in a traditional IRA to a Roth IRA.
This is sometimes called a backdoor Roth IRA because instead of investing money in a Roth, you are converting money. With a conversion, you can get around both the income and contribution limits. It’s a “backdoor” way to get money into a Roth.
What’s the Catch?
While there are not any income or contribution limits for a Roth conversion, there are very important tax considerations.
- When you do a Roth conversion you need to pay taxes on the money you convert
- The conversion could also push you into a higher tax bracket
How is a Roth IRA Different from a Traditional IRA?
The key difference between a Roth IRA and a traditional IRA has to do with how and when you are taxed.
Money in a traditional 401k or IRA grows tax deferred, meaning that you pay taxes on the money when you withdraw the funds (and no taxes at all when you invest the money).
Contributions to this account are made with after-tax earnings — you must pay taxes now on the money you are investing. However, there are some big benefits to a Roth IRA:
- Tax Free Withdrawals: All future withdrawals from your Roth IRA are tax free.
- Tax Free Investment Returns: Investment growth in your Roth account is tax free no matter how much your account grows.
- Exempt from Required Minimum Distributions (RMDs): Roth IRAs do not have RMD rules. You can keep money in the Roth account for as long as you like. And, tax and penalty free withdrawals can be made as soon as you have had at least one Roth IRA open for over five years and you have already reached the age of 59.5.With a traditional IRA, you must start withdrawing a specified amount of money — RMDs — as soon as you turn 72. This can increase your tax rate and force you to sell investments at inopportune times.
Reasons to Do a Roth Conversion Right Now
So, Roth conversions give you tax free withdrawals and growth with fewer rules.
However, you pay for these benefits upfront. Remember, when you do a Roth Conversion you must pay taxes on all of the money you convert.
However, due to the Trump tax cuts — formally known as the Tax Cuts and Jobs Act of 2017 (TCJA) — your federal tax rate is likely still relatively low — making a Roth conversion more affordable now than years ago.
Other Advantages to a Roth Conversion
Besides the reasons listed above, here are a few additional advantages to doing a Roth conversion:
Your Estate: In many cases, your beneficiaries will pay less in taxes if the money is in a Roth account instead of a traditional account.
Rate of Return: Another situation when a Roth conversion could reduce taxes is when you think that the money in your retirement account will likely earn a relatively high rate of return or otherwise grow significantly before you need to withdraw the funds. If you do a Roth conversion before you see these big gains, then you will be paying taxes on a lower dollar amount and all growth in that account will be tax free.
Timing of Withdrawals: If you are a long way off from needing to withdraw from your traditional 401k or IRA, then a Roth conversion may be a good idea since you are likely to see gains on that money.
Beware of a Roth Conversion in These Instances
Can You Afford the Short Term Taxes?: When you take money out of a traditional account and convert it to a Roth account, you will owe taxes on the amount you convert. You need to be sure that you can afford this expense — even if federal tax rates are at record lows.
NOTE: Many people convert small amounts one year at a time to spread out the tax burden. You do not need to convert an entire account.
You Have a Traditional 401k at Your Current Employer: You usually can not convert a traditional 401k you have with a current employer to a Roth IRA. You must wait until you have left the employer.
The Conversion Will Trigger Extra Taxes or Costs: When you do a Roth conversion, all of the money you convert from your traditional IRA or 401k will be taxed as income. However, it is not only the taxes that are costly, the extra income could impact other expenses:
- College Costs: if you are paying for college, the income could impact financial aid packages.
- Medicare: If you are 65 or older, the more money you earn (including withdrawals from IRAs and 401ks taxed as income), the more you might need to pay for Medicare.
You Withdraw the Funds Instead of Converting: If you withdraw money from a tax advantaged account before you are 59 1/2, then you will usually have to pay a 10% penalty in addition to the income taxes you owe.
This does not mean that you can’t convert the money, you just need to do the right kind of paperwork to transfer your funds from a traditional account to a Roth account.
How to Model a Roth Conversion as Part of Your Overall Retirement Plan
A financial advisor can make sure that your tax strategy is part of your overall retirement plan.
You can also do this on your own with the NewRetirement Planner, a rich and highly detailed tool. You can even model and plan for Roth conversions! In the Planner you can use the Roth Conversion Explorer to get a multi year strategy for conversions. You can also use the Roth Conversion Calculator to get ideas for how much to convert this year.