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Is Now the Time for a  Roth Conversion?

Is Now the Time for a Roth Conversion?

October 03, 2022

Roth conversions, or a “Back Door Roth IRA,” is a suggestion that comes up fairly frequently when discussing retirement planning strategies, and it’s a scenario that certainly warrants a closer examination.

Before we can decide if it's the right move for you, we should discuss what's involved and what the implications are.

Roth IRAs are a great tool to utilize when investing, as they allow the investments within the account to grow tax free. The contributions made into this type of account are post-tax, so while there is no income deduction, no taxes are required to be paid at the time of withdrawal, assuming the account has been open for at least 5 years. This is a huge benefit! However, the IRS has set an income limit that you must be under in order to contribute. As of 2022, if you file single, you can only contribute to a Roth if your income is under $144,000. If you file as married filing jointly, the income limit is $204,000. So, what if you’d like to have a Roth, but your income is too high? Fortunately, doing a Roth conversion or back door Roth is still an option.

A Roth conversion is when you take a qualified account (or a portion of one), such as a 401(k) or an IRA, and, as the name suggests, convert it into a Roth IRA. There are a few advantages and disadvantages to completing this type of transfer. The most important disadvantage to consider is the tax increase that will be incurred. The entire conversion amount will be added on to your taxable income for the year, and depending on your income and tax bracket, this could result in a sizable tax bill when it comes time to file in April.

The advantages of a Roth conversion can be seen and felt in a few different ways. One key benefit is having access to an account in retirement that is completely tax free. Second, removing assets from qualified accounts will reduce the Required Minimum Distribution amount that will be required when reaching age 72. Upon reaching age 72, the IRS mandates that individuals withdraw a small percentage of his or her qualified accounts, and income tax be paid on it. This is required to be done every year and even requires a small increase in the withdrawal percentage.

Another potential benefit can be realized when the assets are transferred to the beneficiaries of the account when the account owner passes. At that point, an IRA becomes an Inherited IRA which is required to be liquidated within ten years1. Depending on the size of the account, the tax impact to the beneficiary could be quite significant. Roth IRAs are not subject to this rule since all contributions are made post-tax.

Hopefully, the risk-reward tradeoff has become clear. By completing the Roth Conversion, the investor is opting to pay income tax today instead of in future years or putting the burden upon their beneficiaries.

So, when is the right time to make this conversion?

After the analysis has been done, and it has been decided that a Roth Conversion makes sense, the next step would be to look to minimize the potential downside by limiting the tax impact. As of the end of the third quarter of 2022, the S&P 500 is down 25% for the year, and many investors have seen similar performance in their portfolio. The pullback, while certainly not enjoyable, has created several opportunities, one of which being the ability to complete a Roth Conversion with a reduced tax impact. In fact, market pullbacks are the optimal time to look at this type of transfer because of the decreased values. In other words, by doing a Roth Conversion during a pullback, you are reducing the increase in your taxable income compared to if you did so during market highs.

If you are wondering if a Roth Conversion makes sense for you, please reach out to us here at MWA so that we can begin to discuss if this will be beneficial for your specific plan!

1This is a new rule that became effective in 2020, and there are certain scenarios where the ten-year rule does not apply.