A Roth individual retirement account (IRA) provides tax advantages that a traditional IRA does not. Qualified Roth IRA withdrawals are always federal income tax-free and usually state income tax-free as well, depending on the state (they are tax-free in Georgia). Taxpayers can convert all or a portion of a traditional IRA to a Roth IRA by paying the tax now. This allows high earners to bypass the income limits for yearly Roth IRA contributions – this is also known as a “backdoor Roth.”
This may seem counterintuitive, but there are several good reasons for Roth conversions. Current federal tax rates are probably as low as they will ever be. The Tax Cuts and Jobs Act of 2017 reduced the average federal income tax rate from 20.8% to 19.3%, but tax rates are increasing slightly each year due to inflation and new legislation passed by Congress that could raise individual tax rates significantly in the next few years. Additionally, the conflict in Europe has affected the stock market and prices are down. Essentially, this means that an investment that was worth $100,000 at the end of 2021 might be worth $75,000 now. If you convert that $75,000 and later your investments regain their value, you have avoided tax on $25,000. Another advantage of Roth IRAs is that there is no required minimum distribution, making them a great asset for higher income individuals to leave to their heirs.
There are also some potential disadvantages to Roth conversions that taxpayers should be aware of. First, there is a “five-year rule.” Generally, Roth IRAs allow tax and penalty-free withdrawals after the age of 59½. For Roth conversions, there is a 10% penalty on withdrawals made before the account is five years old. The clock starts on January 1st of the year that the first conversion occurs. Another consideration for retired taxpayers is Medicare Part B: the monthly premium is based on your modified adjust gross income (MAGI) for the prior two years, and a Roth conversion could cause the premium to increase for some taxpayers.
Of course, this only summarizes some of the advantages and disadvantages of a Roth conversion. There are many other factors that must be considered. Please contact us if you would like to discuss a Roth conversion. We would be happy to speak to you about the process in more detail and help you decide if this is a good tax strategy for you.
