In the world of retirement planning, Roth IRA conversions are a standout strategy with huge potential tax savings! But here’s the thing: changes in legislation may be around the corner, potentially putting these opportunities at risk. The market’s ups and downs also play a big role in timing your move.
So, what’s the best play?
We’re here to help you figure that out. Together we’ll review everything you need to know about how these conversions work, the best time to consider them, and how to take action if you decide one may be right for you.
Table of Contents
- WHAT’S THE DIFFERENCE BETWEEN A TRADITIONAL IRA AND A ROTH IRA?
- ROTH CONVERSION RULES
- WAYS TO MAKE A CONVERSION
- WHAT ABOUT AN INHERITED ROTH IRA CONVERSION?
- OTHER ROTH IRA RULES YOU SHOULD BE AWARE OF
- THE BACKDOOR ROTH IRA: THE STRATEGY FOR HIGH-INCOME EARNERS:
- THE TAX IMPLICATIONS OF A ROTH IRA
- WHEN ARE TAXES DUE ON A ROTH CONVERSION?
- CAN YOU REVERSE A ROTH CONVERSION?
- WHEN IS THE BEST TIME FOR A ROTH CONVERSION?
- IS TIME RUNNING OUT FOR FUTURE ROTH CONVERSIONS?
WHAT’S THE DIFFERENCE BETWEEN A TRADITIONAL IRA AND A ROTH IRA?
While both offer tax savings, they differ in the timing of those savings. Where traditional IRAs utilize pre-tax money for contributions and are taxed upon withdrawal in retirement, Roth contributions are funded with post-tax dollars, but retirement withdrawals are tax-free.
Additionally, Roth IRAs have no Required Minimum Distributions (RMDs), allowing you to withdraw your money when you want to – making them great for anyone who isn’t fully retired. Traditional IRAs require account holders to take RMDs once they’ve reached the age of 72 (or 73 if you turn 72 after December 31st, 2022) – regardless of their income needs. And, if you’re a high-income earner, Roth IRAs have notoriously been off the table.
ROTH CONVERSION RULES
If you’re considering taking the leap from a traditional IRA to a Roth IRA, you’re embarking on a journey filled with important rules. Understanding the ins and outs of Roth IRA conversions is crucial whether you’re looking to better your tax situation or simply adapt to new circumstances.
We’ll now dive into the different ways to make a conversion, what you can do with an inherited IRA, and what other considerations come into play when making your decision.
WAYS TO MAKE A CONVERSION
Diving into the nuts and bolts of Roth IRA conversions, it’s important to understand the “how” of the process. It’s not as daunting as it sounds – in fact, it’s pretty straightforward.
The IRS outlines three primary methods to make this switch:
- An Indirect Rollover: You receive a check from your traditional IRA, and then, within a 60-day window, you deposit this into your Roth account.
- Same-Trustee Transfer: If your traditional and Roth IRAs are with the same institution, just ask them to transfer the funds internally.
- Trustee-to-Trustee Transfer: This one is a bit more direct. You get in touch with your traditional IRA’s financial institution and instruct them to send your funds straight to your Roth account at a different institution.
WHAT ABOUT AN INHERITED ROTH IRA CONVERSION?
If you’ve inherited an IRA from someone other than your spouse, transforming it into a Roth IRA isn’t an option. Most of the time, you’ll need to clear out the account within a span of five to ten years, with a few exceptions.
Now, if it’s your spouse’s IRA you’ve inherited, things are a bit different. You can keep the IRA as it was, with you stepping into the beneficiary’s shoes. You’ll just have to deal with the required minimum distributions (RMDs) and the taxes that come along with them.
However, the IRS also gives you the green light to make the IRA your own. After putting your name on the account, you can make the same decisions as you would normally be able to make, including making a conversion to a Roth IRA.
OTHER ROTH IRA RULES YOU SHOULD BE AWARE OF
If you’re considering a Roth IRA conversion, there’s a few other things you should know. The IRS doesn’t put a cap on the number or size of Roth conversions from a traditional IRA. You can convert a portion or the entirety of your traditional IRA to a Roth IRA.
Theoretically, you could convert your entire tax-deferred savings in one swift change. But, and it’s a big “but”, this could place you into a higher tax bracket.
You also may not want to rush to withdraw your converted funds. The IRS has a rule where you cannot touch your converted funds before five years without getting a 10% early withdrawal penalty slapped on top of your conversion year’s income taxes. However, if you’re 59½ or older, that penalty doesn’t apply to you.
Understand that each conversion you make has its own 5-year clock. However, the 5-year countdown starts on January 1st of the year you make the conversion, regardless of whether it’s January or December. So, if you convert in December, in reality, you’re looking at just over 4 years of waiting, not a full five.
Finally, don’t think you can’t make Roth contributions even if you exceed the income limits for opening a Roth IRA. You still can via a conversion by using a neat trick commonly referred to as a “backdoor Roth IRA.”
THE BACKDOOR ROTH IRA: THE STRATEGY FOR HIGH-INCOME EARNERS:
Traditionally, high-income earners cannot open Roth-style accounts due to regulatory income caps. In 2024, those are $161,000 for individuals and $240,000 for married couples. However, Roth Conversions offer a workaround – the backdoor Roth IRA. Most high-income earners can contribute to traditional IRAs and then perform Roth IRA conversions throughout their lifetime to continue taking advantage of tax-free growth. Remember that this is a legal loophole to get around income limits; it is not a tax dodge. You may incur higher taxes upon establishment, but you’ll gain the future tax savings of a Roth account.
There are three ways to create a Backdoor Roth IRA:
- Fund a traditional IRA and then roll over whatever funds you choose to a Roth
- Convert your entire traditional IRA to a Roth
- If your plan allows conversions, roll over your 401(k) to a Roth IRA
THE TAX IMPLICATIONS OF A ROTH IRA
The most significant caveat to a Roth conversion is the tax bill due upon the rollover. Because contributions to traditional IRAs are made with pre-tax dollars, all transferred funds are eligible to be taxed at ordinary income tax rates. To prevent a sizable tax event, spread the conversion over several years.
If you’re confident you’ll be in a higher tax bracket in retirement, it might make the most sense to foot the higher bill now to enjoy the tax-free withdrawals down the road. But be careful about the funds you use to cover your conversion taxes – it makes more sense to pay with cash from savings than to pull it from your retirement account (potentially costing thousands in growth over the long term). Reach out to an expert if you’re unsure.
WHEN ARE TAXES DUE ON A ROTH CONVERSION?
When you switch funds from a traditional IRA to a Roth IRA, the big date to remember is December 31st because that’s when the converted amount counts as income for the year. So, if you convert in 2024, the IRS will expect taxes on that extra income come April 2025.
CAN YOU REVERSE A ROTH CONVERSION?
Okay, you’ve converted your traditional IRA to a Roth IRA. But what if you have a change of heart? Maybe the tax bill looks scarier than you thought, or your financial situation took a turn. Here’s the deal: back in the day, you could do a nifty little thing called a “recharacterization” to reverse your conversion, no harm, no foul.
However, since 2018, the IRS has said ‘no more’ to that option. So, if you make a Roth conversion today, you won’t be able to reverse your decision. That’s why it’s always a good idea to think it through and chat with a financial advisor before taking the now-irreversible plunge.
WHEN IS THE BEST TIME FOR A ROTH CONVERSION?
A great time to consider making a Roth Conversion is while the market is down. Not too long ago, we gave you some advice about staying calm in a market downturn – don’t time the market, stay invested, and control what you can. While waiting for the market to work through its cycles, why not convert your traditional IRA portfolio (while its value is down) to one that offers more flexibility and tax-free investment growth in retirement?
While a sluggish economy can be unsettling, it’s the perfect opportunity to take advantage of the circumstances and control what you can control – the goals of your long-term investment plan. Why not do so by minimizing the tax liability generated by a Roth conversion now? If the value of your traditional IRA portfolio has declined, convert your assets at the lower value and take advantage of lower tax liability. Once the market rebounds, the gain on your rolled-over assets will be tax-free!
Please Note: While a down market presents a prime opportunity for Roth conversions due to potentially lower tax liabilities, the “best time” might still lean towards acting sooner rather than later—even if there isn’t a dip in the market (see next section).
IS TIME RUNNING OUT FOR FUTURE ROTH CONVERSIONS?
While it doesn’t look like they’ll be eliminated in 2024, the future of the Backdoor Roth IRA remains a target of proposed legislation. Some legislative efforts have already been taken to limit Roth IRAs or to change tax brackets and RMDs in the future. With that said, this is one of those times we don’t suggest waiting to find out.
And since we still can’t predict the future, today’s benefits – the lack of required RMDs coupled with relatively low tax rates – could make now as good a time as any for a Roth IRA conversion. As always, we recommend weighing all up-front costs and consequences and consulting with a financial expert before making any substantial changes to your plan. Not everyone who considers Roth conversions takes action after all variables are considered. If you’re looking for help with your investments and financial future, we encourage you to schedule your 15-minute complimentary call today!
Editor’s Note: This article was originally published in October 2022 as Time is Running Out on Roth Conversions for 2022. It has been updated with 2024 data.
