It has been a tough year for the market. The S&P 500 index so far in 2022 has taken somewhat of a nosedive, at one point dropping 20.6 percent, the NASDAQ dropping nearly 30 percent[i], and as a nation, we have experienced massive inflation especially noticeable with gas and energy, and food prices. But for those of you saving for retirement, the reduction in the value of your portfolios can be potentially beneficial. A sound financial plan may help to alleviate stress in the future when it comes to your retirement.
What is a Roth IRA?
A Roth IRA is a tax-advantaged individual retirement account to which you can contribute after-tax dollars[ii]. A Roth conversion is when you take earned income from another retirement account and put it into a Roth IRA or a series of Roth IRA accounts.
Benefits of a Roth IRA
Tax-free growth and no required minimum distribution at retirement ageThe benefits of a Roth IRA are tax-free growth of your money, no required minimum distribution at age 72 (or 70 ½ if you reached that age before January 1, 2020), like with a Traditional IRA, and with a Roth IRA, the money eventually can be passed to your beneficiaries tax-free. What concerns people is that to convert to a Roth IRA requires you to pay taxes on that money upfront. But this isn’t necessarily an impediment, especially if you are in a lower tax bracket and think that you may be in a higher one in the future. Also, your wealth within the account may be higher, so the taxes upon distribution in the future, if you were to keep a Traditional IRA, could be steeper.
A Roth IRA conversion has no contribution limits.Another benefit is if you do a conversion, there are no limits to how much you can put into the Roth IRA. When you convert, you take the money from the Traditional IRA and reposition it into the Roth IRA. The limitations occur when you make a general contribution. You can contribute to a Traditional IRA and a Roth IRA (subject to eligibility) up to $6,000 ($7,000 if you are age 50 and over) for the tax year. Nobody knows why these contribution limits exist, but they do.
Taking advantage of the Tax Cuts and Jobs Act of 2017The Tax Cuts and Jobs Act established in 2017, effectively lowered income tax brackets for most people. The top rate fell from 39.6% to 37%, the 33% bracket reduced to 32%, the 28% bracket dropped to 24%, the 25% to 22%, and the 15% to 12%. The lowest bracket remained unchanged at 10%[iii]. This has the potential to be beneficial if you convert your funds from the Traditional IRA to the Roth IRA at today’s lower tax bracket because the Act is set to expire on January 1, 2026. Then, if the tax brackets return to their previous levels or higher than today, had you converted, you would have already paid the lower tax and wouldn’t be subject to the higher tax burden.
How the conversion works and the Roth IRA income ceiling
If you are eligible for a Roth IRA to contribute without converting, there is an income ceiling. If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) has to be under $144,000 for the tax year (2022), and if you are married filing jointly, your MAGI has to be less than $214,000 for the tax year (2022)[iv]. If you already have money in the Traditional IRA you can convert it to the Roth IRA as much as you want, albeit, again, it will be taxed. But it is that simple. If you find that your MAGI is over the threshold but still want to put money into a Roth IRA, you can use the conversion to do it. First, you put your money into a Traditional IRA and then convert it to the Roth IRA (called a “Backdoor” conversion).
Let’s say you converted all your money in your Traditional IRA to a Roth IRA but then decided that the tax bill is too much or wasn’t for you for whatever reason. You have until October 15 of the following year to fix what you did to the way it was before without experiencing a tax consequence. This is called “recharacterization.”
When and when not to convert
The younger you are, the more the Roth IRA makes sense. A young person is potentially in a lower tax bracket, and they have time on their side, and a Roth is typically a long-term financial instrument. If you think you want to take the money out in a few years, you may want to reconsider the conversion. A young person would hesitate to withdraw early due to being penalized (see below). Suppose you are over 70, for example; in that case, you may want to be careful converting to a Roth IRA because if your income is near the qualifying threshold for IRMAA (Income-related monthly adjustment amount), you could end up paying additional costs. What that means is beneficiaries who earn over $87,000 a year and are enrolled in Medicare Part B and/or Part D pay a surcharge that’s added to their Part B and Part D premiums. This is determined from your income tax return two years prior. The Social Security Administration will send notice if you are being assessed IRMAA[v].
It would be best if you had enough cash to cover the tax bill
As mentioned above, the caveat to converting your funds to a Roth IRA is that you have enough cash to cover the tax bill. Some people consider converting their funds from a Traditional IRA to a Roth IRA with multiple contributions instead of all at once. You would claim each contribution on your tax return as income because doing so in multiple stages might keep you from bumping into a higher tax bracket, so you may want to pay attention to that.
Is my Roth IRA deductible
A Roth IRA is not deductible
Withdrawing the funds early
Also, if you liquidate early before age 59 ½, are not disabled, have to pay medical insurance premium after a job loss, or are not a first-time homebuyer, there is a 10 percent penalty.
Figuring out where you stand
To begin, you may want to calculate how much you want to convert and figure out the tax to analyze whether the conversion may potentially benefit you. A financial professional can help you work through the numbers.