If you make too much money to qualify for a Roth IRA and have considered doing a Roth conversion to save on taxes, 2022 may just be your year to do it!
Congress is currently trying to pass the Build Back Better (BBB) Bill, which focuses on limiting tax strategies for high-income families. One of these tax strategies is backdoor Roth and mega backdoor Roth conversions. If passed, affluent families who don’t qualify for a Roth IRA would no longer be able to get around the income limit by converting funds into a Roth IRA.
Here’s a closer look at how Roth conversions work and when you might want to consider one, so you can decide if it’s the right move for you.
What is a Roth Conversion?
A Roth conversion allows you to take money from your traditional 401(k) or IRA and convert it into a Roth IRA, potentially saving you taxes on distributions in retirement. It’s an effective strategy for anyone who wants to save money in a Roth IRA but makes too much to qualify for one.
Roth IRA conversions usually work like this:
- You open a traditional IRA if you don’t already have one.
- You transfer the account into a Roth IRA. (A financial advisor can help you complete this step.)
- You pay taxes on the amount you convert in that tax year.
Any money you convert into a Roth IRA counts as taxable income for the year, but moving forward, every single penny you earn in interest is 100% tax-free. And because there are no required minimum distributions (RMDs), you don’t have to start emptying the account when you turn age 72.
Benefits of a Roth Conversion
Roth conversions have a lot of advantages, such as
Flexible Withdrawal Rules
Unlike tax-deferred retirement accounts, there are ways you can tap into your Roth IRA before age 59 ½ without penalty. But as with all retirement accounts, there’s some fine print to watch out for.
The biggest one you need to know about is the five-year rule, which states you can’t touch any money inside your Roth IRA without penalty until it’s at least five years old. So, once you do a Roth conversion, you must wait five years before you can tap into it.
After that, you can withdraw any of your contributions without penalty (but your earnings are still off-limits). Then, once you reach age 59 ½, everything is fair game and you can take distributions however you’d like.
What does this mean for you?
Well, if you suspect you’ll need the money in your Roth IRA before age 59 ½ — maybe because you’re retiring early, for example — setting up a Roth conversion ladder in which you do one Roth conversion each year for a set number of years can be a great way to gain access to your money on a rolling basis without having to take a massive tax hit by transferring it all at once.
No Contribution Limit
For 2022, you can’t save more than $6,000 a year in a Roth IRA (or $7,000 if you’re 50 or older). But with a Roth conversion, you can transfer as much as you want at any one time. There’s no limit!
You’ll still want to keep your tax bracket in mind so you don’t rack up a large tax bill, but a Roth conversion can be an excellent way to get around the $6,000 yearly limit you’d typically face.
The IRS makes you take required minimum distributions from your tax-deferred retirement accounts (think 401(k)s, traditional IRAs, 403(b)s, etc.) as soon as you turn age 72. The amount you have to take depends on your account balance and life expectancy — but the goal is to effectively empty your account by the time you die.
If you’re looking to leave a legacy behind to your kids or simply don’t want to raise your taxable income that much in retirement, RMDs can be a big problem. Luckily, you don’t have to take RMDs on any Roth IRA distributions you make because you’ve already paid taxes on that money.
So, long story short, Roth conversions can be a great way to eliminate or lower the RMDs you would otherwise have to pay on traditional 401(k)s and IRAs.
Is It Right For You?
There are several reasons why you may want to consider a Roth conversion in 2022. This list isn’t exhaustive, but here are a few scenarios in which it may make sense for your situation:
- You want the flexibility of getting to withdraw your money before age 59 ½ without penalty if you need to.
- You have a large IRA and want to reduce the amount of RMDs you have to take when you reach age 72.
- You have a substantial amount of money in tax-deferred retirement accounts and want to lower your future income tax bracket in retirement.
- You want to leave all or part of your retirement account to your heirs and don’t want RMDs eating into your gift amount.
- Your income is unexpectedly low this year and you want to take advantage of the tax savings.
- You suspect the tax hit you’d take on a rollover now is less than what you’d pay on distributions in retirement.
When It May Not Be a Good Idea
There are also a couple of situations where a Roth IRA may not make sense for you:
- You don’t have enough funds on hand to cover the tax bill you’d need to pay on the conversion.
- You’d potentially pay more taxes on the conversion now than you would on distributions in retirement. (A financial advisor can help you figure this out.)
Is a Roth Conversion Right for me?
Find Out if You Should Execute a Roth Conversion Today
Roth conversions are an excellent tax planning tool to have at your disposal, but there are complications to watch out for. If you initiate a conversion when it doesn’t make sense for your situation, you could end up paying way more in taxes than you would have otherwise. Plus, there’s no way to undo the damage once it’s done.
It’s a smart idea to consult a financial advisor in Utah to see if a Roth conversion is right for you before you administer one.
At Rock House Financial, a fee-only financial advisor in Farmington, Utah, we are charitable giving tax mitigation specialists. We work with families, business owners, and individuals who wants to make an impact through giving. To learn more about Roth conversions or to get help executing one, contact the team at Rock House Financial today.
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