IRA to Roth Conversion – So, What’s the Big Deal?

What is an IRA to Roth Conversion, also known as the Backdoor IRA?

Put your money into a traditional IRA, then convert your contributed funds into a Roth IRA. You’ll pay taxes on this. But that’s it. Even though you did not qualify to contribute to a Roth, you get to make a contribution any way.

The so-called “backdoor Roth” allows individuals with high incomes to sidestep the Roth’s income limits.

The conversion makes sense when you expect to be in a higher tax bracket in retirement.

What are the Steps?

1. Put your money into a traditional IRA account.

2. Convert your contribution to a Roth IRA. You can get the necessary instructions from your IRA administrator.

3. Prepare to pay taxes. Remember that only post-tax dollars go into a Roth IRA. Your traditional IRA contributions were tax deductible, so you’ll need to give that tax deduction back. The pro-rata rule, will play a big part in determining your tax bill.

4. Prepare to pay taxes on income gains in your traditional IRA. If the money in your traditional IRA has made investment gains, you’ll also owe taxes on those gains at tax time.

What are the Benefits of a ROTH Conversion?

As an investor, you’ll enjoy tax-free withdrawals in retirement.

Further, you can watch your money grow tax-free for longer. Roth IRAs do not have RMDs so your money can stay in the account and keep growing tax-free. Traditional IRAs force you to take RMDs every year after you reach age 72.

You can leave a tax-free inheritance to your heirs. The individual(s) that inherit your Roth IRA will be required to take RMDs, but the won’t have to pay any federal income tax on their withdrawals, the caveat being the account needs to be opened for at least five years.

Watch Out for Penalties

The conversion needs to be one of the following:
– a rollover, where you receive the money from your IRA and deposit it into the Roth within 60 days
– a trustee-to-trustee transfer, where the IRA provider sends the money directly to your ROTH IRA provider, or
– a “same trustee transfer,” where the same financial institution is responsible for the move.

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Questions to Consider

1. Will you need the money in five years or later?

2. Will you end up in a higher tax bracket?

3. Where will you get the money to pay the conversion taxes?

Legislative Threat for IRA to Roth Conversions

Backdoor conversions of traditional IRAs and 401(k)s to Roth IRAs and designated Roth accounts are routinely used by high-income taxpayers to shelter retirement savings from taxation.

Over time the tax-free status of investments held in Roth IRAs can produce large tax savings and net greater returns for owners or their heirs. Recent media stories have identified uber wealthy individuals who have used Roth accounts to create tax-free investment portfolios. Now, the IRA to Roth Conversion seem to be in the cross hairs.

The Build Back Better Bill has the potential to limit high-income savers’ options to convert their savings into Roth IRAs and Roth 401ks. This restriction could start as early as 2022. In that case, converting after-tax contributions is no longer an option. Included in this is converting from a non-deductible IRA into a Roth IRA.

After December 31, 2031, the BBB bill would eliminate Roth IRA and Roth 401(k) conversions entirely for high-income taxpayers. High-income taxpayers are defined as individuals having modified adjusted gross incomes that exceed $400,000 for single taxpayers and married persons filing separately, $450,000 for married individuals filing joint returns.

In 2029, caps would apply to high-income taxpayers’ aggregate retirement accounts balances and RMDs would be mandated, regardless of the owners’ age.

After 2031, if the BBB retirement account changes are enacted, high-income taxpayers would not be allowed to make backdoor IRA and 401(k) conversions into Roth accounts.

Generally only taxpayers whose modified adjusted gross income are below $208,000 (for married couples) and $140,0000 (for single taxpayers) in 2021—are permitted to create a Roth IRA.

For more in-depth articles to help you navigate your financial journey, check our Personal Finance page out!


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