Roth conversions are here to stay (for now), so here’s what they are, how they work, and how high-earners can consider leveraging them throughout their careers.
What Is A Roth Conversion?
A Roth conversion is a strategy that allows you to convert all (or a portion) of your pre-tax retirement accounts (IRA, 401k, etc.) into a Roth IRA.
It’s an excellent way for high-earners to access this advantageous account.
What Makes A Roth IRA Unique?
Roth IRAs come with several benefits.
Let’s explore three of the most important ones below.
- Qualified distributions in retirement are tax-free. Tax-free dollars in retirement can be an incredible tool for high-earners because distributions won’t count toward your annual taxable income, giving you more options in your withdrawal and income plan.
- It’s the only retirement account that doesn’t have Required Minimum Distributions (even Roth 401(k)s have them), during the Roth IRA owner’s lifetime.
- Roth IRAs are efficient estate planning tools. Distributions for your heirs are tax-free if you follow all the rules. (Read IRS distribution rules for Roth heirs)
If a Roth IRA offers so many benefits, why not contribute directly? Once you earn a certain amount of money, the IRS phases out your ability to make contributions; below are the tax-year 2022 IRS income limits:
- If Modified Adjusted Gross Income (MAGI) > $144,000, Not eligible
Married Filing Jointly (MFJ)
- If Modified Adjusted Gross Income (MAGI) > $214,000, Not eligible
Married Filing Separately (MFS)
- If Modified Adjusted Gross Income (MAGI) > $10,000, Not eligible
But just because your income exceeds these levels doesn’t mean you’re barred from Roth IRAs for good.
If you find yourself above these income thresholds, considering a Roth Conversion could make sense.
3 Common Roth Conversion Strategies
You may come across Roth conversions at different stages of your life and career. Here are a couple of strategies to familiarize yourself with.
1. Consistent Smaller Conversions
If you want to add funds to a Roth IRA throughout your career, you can contribute the maximum amount to a non-deductible IRA ($6,000 in 2022 if below age 50), then convert the funds to the Roth IRA. While you’re limited to a smaller annual contribution, it could be an excellent way to consistently build a Roth IRA bucket.
There are, of course, some caveats to consider. It’s not always practical if you already have a Rollover IRA due to the pro-rata rule because it can make calculating the taxes on your withdrawals a bit more complex.
2. Lump-Sum Conversions
You can also convert a larger lump sum to a Roth IRA. While there are limits on how much you can contribute, there aren’t limits on how much you can convert, assuming you have the cash to pay any tax liabilities.
For example, if you wanted to convert $20,000 from a traditional IRA into a Roth, you could, even though you could only contribute $6,000.
An excellent way to take advantage of a lump sum Roth conversion is after you retire. Early retirement, before you enroll in Social Security and take Required Minimum Distributions (RMDs), can be an ideal climate for more substantial Roth conversions. Since your income is likely lower, meaning you’re in a lower tax bracket, you can convert a larger lump sum at a lower effective tax rate.
Mind the five-year rule when converting large sums. You must wait at least five years since the conversion to access the money, and every new conversion restarts the clock. So, if you plan to access the funds sooner, this might not be an appropriate strategy.
3. Mega Backdoor Roth Conversions
Mega Backdoor Roth Conversion strategy enables you to contribute “after-tax” money into your employer plan (401(k), for example) and convert those after-tax funds into your Roth 401(k) within your employer plan.
Keep in mind that not every plan allows you to do this, so make sure to check with your benefits administrator.
Remember, not every Roth conversion strategy will be most appropriate for you. We would be happy to help run the numbers to see if and when a particular strategy could be right for you.
When Does A Roth Conversion Make Sense?
Roth conversions aren’t always suitable for everyone. Even more, they could be a smart decision in one year but not in another.
Below is a short list of situations where you could benefit from a Roth conversion.
- You anticipate being in a higher income tax bracket in retirement.
- You think tax rates may be higher in the future.
- You’re having a lower-income year than usual and thus find yourself in a lower-income tax bracket.
- You’re a new retiree who hasn’t yet started taking Required Minimum Distributions (RMDs).
- You are looking for income (and tax) diversification in retirement.
- You want a tax-efficient vehicle for leaving money to heirs.
Bonus Tip: Roth IRAs are a great savings vehicle to leave tax-free money to heirs.
Before You Convert, Consider This
While Roth conversions can offer many benefits, there are some scenarios where it may be best to hold off.
- You’re in the highest tax bracket.
- You anticipate a significant withdrawal from your pre-tax retirement account(s) and may pay more in taxes.
- You want to make charitable donations with your traditional IRA (via QCD).
- You’re concerned that a conversion could tip you into a higher tax bracket. Your tax bracket affects so much more than your tax rate, and it can spill over into several other areas, notably Medicare IRMAA. Even if you’re in a reasonable tax bracket, you could be hit with consistent IRMMA charges. Tapering your conversions enough to limit your IRMMA could save you thousands of dollars a year in Medicare premiums.
When it comes to Roth Conversions, the devil is in the details. You should not pursue any of these strategies without first consulting with a financial planner and/or tax professional as there are many ways to make mistakes that could prove very costly. Our goal is to help clients not only navigate complex strategies but see their full picture and guide them in taking steps that optimize their long-term goals.