Since 2010 the federal government has allowed people to complete Roth conversions, which is simply moving money from a Traditional IRA to a Roth IRA. Because of contribution limits and income phaseout requirements, some tax payers simply don’t qualify to contribute to a Roth IRA.
The primary benefit of the Roth IRA is tax-free growth, versus the tax-deferred growth of accounts such as Traditional IRA or 401(k). The Roth conversion is a way to turn tax-deferred savings into tax-free savings.
IRAs have contribution limits. In 2022, the limit is $6,000, or $7,000 for those 50 or older). These limits increase to $6,500 and $7,500 for 50+ in 2023. Keep in mind these limits apply to total IRA contributions, whether Traditional or Roth, or any combination of the two.
Roth IRA contributions also come with income phaseouts. If you file taxes as a single person in 2022, your Modified Adjusted Gross Income (MAGI) must be under $144,000, or under $214,000 if married filing jointly.
The process is actually quite simple. Let’s talk about that first, then we’ll get into taxes and strategy.
If you have saved to a Traditional IRA or rolled over money from a 401(k), in theory you have a bucket full of tax-deferred dollars. I say in theory because it is possible to have after-tax dollars in a Traditional IRA.
Note: there are additional rules for distributions of after-tax dollars from Traditional IRAs, which will not be covered in the scope of this article.
A few reasons a Roth IRA might be more attractive include:
The catch is you will be subject to ordinary income tax when you move money from a Traditional IRA to a Roth IRA, regardless of age. As an example, say you have $50,000 in a Traditional IRA and would like to convert to a Roth IRA. When you complete the conversion, $50,000 is essentially added to your taxable income at your ordinary rate in the year of the conversion. If you earn $150,000 from employment you will also report an additional $50,000 of income.
If you’re a single filer, your $150,000 salary plus an extra $50,000 of income gives you a total of $200,000 taxable income. You will now move from the 24% tax bracket up to the 32%. If married filing joint, you will move from the 22% tax bracket up to the 24%. In marginal terms, your tax math if filing single in 2022 would have been:
$15,213.50 plus 24% of the amount over $89,075.
So, $15,213.50 + (($150,000-$89,075)*0.24) = $29,835.50 tax exposure
After completing a Roth Conversion and jumping up to the 32% tax bracket, your tax math now looks like this:
$34,647.50 plus 32% of the amount over $170,050.
So, $34,647.50 + (($200,000-$170,050)*0.32) = $44,231.50 tax exposure
Remember these are marginal dollars, which means deductions and credits have not yet been applied. Your effective tax rate may be lower; however, a difference of $14,378 in tax exposure may be a very important consideration.
You can see the full tax brackets here
Given the increased tax exposure, you may ask why someone might want to complete a Roth conversion. For those with higher IRA balances who are thinking about retirement, future tax exposure is the primary reason. Because RMDs begin at age 72, the tax burden in retirement can potentially eclipse that of the Roth conversion.
If you have a large IRA balance and have even moderate investment returns, your RMD amount – and the resulting tax bill – may increase every year. Not only that, but higher RMDs may trigger higher Medicare premiums and taxation on Social Security benefits.
As an illustration, let’s make the numbers a little larger. If my IRA balance at the end of 2021 was $500,000 and I have reached age 72 this year, I will need to withdraw $18,248.18 from my IRA by the end of 2022. Here’s what I’ll have to withdraw over the next 10 years:
According to the above table stretched out across my assumed life expectancy, my RMDs will increase every year until my age 97. The potential taxes I’ll pay from age 72 until 97 start to add up quickly.
Let’s go back to the tax exposure at the time of the conversion. For those with higher Traditional IRA balances, another factor to consider is how to pay for the taxes due from the conversion. You can withhold taxes when completing the conversion, or you can pay the taxes with other cash you may have saved.
Withholding taxes reduces your account value. If my IRA value is $500,000 and I expect to be in the 24% bracket this year, my account value after withholding for federal tax alone decreases by $120,000! If investment growth is your goal, that math will show that a Roth conversion would not be beneficial in this case.
in addition, there may be potential opportunity loss in using $120,000 cash to pay taxes rather than investing for growth.
In situations like this, a good strategy may be to convert smaller amounts over time to reduce the immediate large tax hit.
There is still time to complete a Roth conversion in 2022, or to begin planning for a potential conversion in 2023. While this article covered some of the tax considerations, other factors are at play when considering if a Roth conversion is right for you.
This article should not be relied upon for any tax, investment, or retirement planning decisions. Talk to your financial advisor and CPA to learn how this strategy might impact your long-term financial outcomes.
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