You may have heard your friends or even your advisor talk about it: a backdoor Roth IRA conversion. What is it, and how do you know whether it’s right for you?

First, let’s talk about what a Roth IRA is and how it compares to a so-called “traditional” IRA. The biggest difference is the tax treatment. A Roth IRA, named for Delaware senator William Roth, is an individual retirement account that lets you contribute after-tax dollars toward retirement. Since you would have already paid taxes on the money you contribute, your investment grows tax free, and you can make qualified withdrawals tax-free starting at age 59 ½. Also, with a Roth IRA, you won’t have to take required minimum distributions (RMDs) each year. Traditional IRA contributions, on the other hand, are pre-tax, meaning you can usually take a tax deduction in the year you contribute, but you’ll pay income taxes on withdrawals when you retire. In addition, you do have to start taking RMDs at age 72 (or 70 ½ if you reached that age before Jan. 1, 2020).

Each type of IRA has advantages and disadvantages depending on your circumstances, and many people prefer having some money in a Roth IRA to offset their taxable income when they retire. However, not everyone can contribute to a Roth IRA. Contributions to Roth IRAs are only available to people who meet the IRS’s income restrictions. In 2022, single tax filers must have a modified adjusted gross income, or MAGI, of $144,000 or less, while couples who are married and filing jointly must have a combined MAGI of $214,000 or less. The amount you can contribute each year is limited based on your filing status and your MAGI. Income phase-out ranges for 2022 are $129,000 to $144,000 for single taxpayers and heads of household, $204,000 to $214,000 for those married filing jointly, and $0 to $10,000 for people who are married but file separately.

If your income is too high to be able to contribute to a Roth IRA, a backdoor Roth conversion can be the workaround you need to save to a Roth IRA and help reduce your taxes in retirement. Here’s how it works: If you have a traditional, SEP or SIMPLE IRA, or a 401(k), you can roll over funds from these accounts into a Roth IRA. You will have to pay taxes on the amount you withdraw and submit IRS Form 8606 to notify the IRS of your Roth conversion. Once you convert the funds, you must wait five years before accessing the money, or you may be charged taxes or penalties on any funds you withdraw.

Advantages of a Roth Conversion

When does it make sense to do a Roth conversion? Here are a few situations in which a Roth conversion could be a good idea:

  1. You are over the Roth IRA income limit. As mentioned earlier, one way around it is to convert other pre-tax retirement accounts to a Roth IRA so they can grow tax-free, and you can withdraw them tax-free in retirement. This could be especially helpful if you’re planning a major family trip in retirement. The money you would withdraw from your Roth IRA to pay for it would not increase your taxable income.
  2. You want to leave a legacy for your heirs. If you intend to leave money to someone other than your spouse, a Roth conversion could be a good way to accomplish it, although the rules can be confusing. Under the SECURE Act, if you leave your traditional IRA to someone other than your spouse, the person would be required to withdraw all of the funds in the account within 10 years, which could cause a significant tax burden if the amount of money in the account is sizeable. Beneficiary Roth IRA distributions must also be taken over 10 years, similar to Beneficiary IRAs for non-qualified designated beneficiaries (basically anyone who is a non-spouse, non-minor, or who does not have special needs).
  3. You anticipate higher taxes in retirement. This can be difficult to predict in some cases, but if you anticipate your Federal tax rate will be higher, or if you are moving to a state with higher taxes when you retire, a Roth conversion now might be a good move.
  4. You expect your income for the year to be low. If you’re one of the millions of Americans who decided to quit their jobs in 2022 (or if your income was lower this year and you expect future increases), you may still be looking for work and could end the year with lower income than in previous years. Since you would need to pay taxes on a Roth conversion, a good time to do it would be when your taxable income is lower.
  5. You won’t need the money right away. The Roth IRA five-year rule enables you to withdraw an amount equal to your contributions to your Roth IRA tax- and penalty-free. However, account earnings – such as interest or capital gains – must remain in your account for at least five years before you can withdraw them. If you’re under 59 ½, you’ll not only pay taxes, but also a 10% early withdrawal penalty. (There are exceptions, however.)

Roth conversions can be complicated, and they aren’t for everybody. Mistakes could expose you to penalties and/or higher taxes, or have other unintended consequences. If you aren’t sure, consult a financial advisor or tax professional who understands your particular situation and how the rules might apply to you. Then, make your decision based on your goals, tax situation, time horizon, and any other considerations important to you.

This is intended for informational purposes only and any discussion or information provided should not be construed as personalized investment advice from Savant.

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