This question has become one of the most asked and contested tax topics since the Roth IRA was introduced back in 1998.

Should you convert your traditional IRA and pay the taxes now, to enjoy tax-free distributions in the future? Or should you hold on to your traditional IRA and foot the tax bill in retirement? After all these years and extensive research on this very subject, there must be a definitive answer to this by now – right?

Not exactly.

While there are plenty of advantages to a Roth conversion, there are a significant number of considerations to determine if it is the right move for you.

What is a Roth IRA? And how is it different from a Traditional IRA?

A traditional IRA is an individual retirement account that generally allows you to make a tax-deductible contribution. These contributions grow tax-free and, when withdrawn, are subject to income tax.

A Roth IRA is an individual retirement account funded with after-tax dollars, so you do not receive a tax deduction when you make a contribution. Like a traditional IRA, these contributions also grow tax-free. However, with a Roth IRA you have the ability to withdraw funds without incurring a tax liability.

The IRS has issued several rules and regulations regarding traditional and Roth IRAs. These include eligibility requirements, annual contribution limits as well as information related to distributions. To learn more about these two types of individual retirement accounts, feel free to check out our blog post on this topic, here.

What is a Roth conversion and how does it work?

A Roth conversion is simply a means of transferring funds from a traditional IRA to a Roth IRA and paying any taxes due on the transfer. When you complete this conversion, you are generally required to recognize the converted amount as taxable income, since you likely never paid taxes on those contributed dollars in the first place.

There are no annual income limitations to complete a Roth conversion, unlike a Roth contribution. There are also no limitations on the amount you may convert. However, once you complete a Roth conversion, it cannot be reversed or recharacterized. Therefore, it is important to understand all the potential tax consequences that could arise when completing a Roth conversion.

What are the benefits of a Roth conversion?

Some benefits include:

• Enjoy tax-free distributions later in life
• Grow the balance tax-free, as the investment income earned in the account is exempt from income tax (this is similar to a traditional IRA)
• A Roth conversion eliminates the required minimum distributions that are otherwise mandatory with traditional IRAs
• Enables you to leave the assets to your heirs completely tax-free

If you are planning on – or think you might be – in a higher tax bracket in the future, a Roth conversion can allow you to pay the taxes now, locking in a lower rate. The earlier on in life that you begin converting your IRA, the sooner you can get your account to work on growing tax-free for years to come. Even if you’re nearing retirement, a Roth conversion could still very well make sense for you.

You don’t need to convert the entire balance all at once. A good strategy to consider is to convert a portion of your IRA on a yearly basis, looking to stay within a tax bracket with which you are comfortable. This way, you can help manage your taxes effectively and help mitigate any risk.

Be sure to take into account any deductions you may be entitled to claim. These deductions can help offset the income from the conversion and lessen the tax burden. Some popular deductions may include charitable contributions, medical expenses, or business losses.

And finally, a Roth conversion now could impact your financial future. If you expect to owe any estate tax when you die, a Roth conversion now can help reduce your estate’s future tax liability. The tax dollars that you pay out of pocket on the conversion will reduce the size of your taxable estate. This, on top of being able to transfer the assets to your heirs income tax-free, makes a Roth conversion quite appealing.

What are the drawbacks to a Roth conversion?

Some drawbacks include:

• Loss on any growth potential on the dollars that are used to pay the taxes on the conversion
• The increase in income could make you ineligible to claim certain tax credits (ie: Educational Credits, Advanced Premium Tax Credit, & Recovery Rebate Credit)
• The increase in income could trigger additional taxes (ie: 3.8% net investment income tax & an increase in taxable Social Security)
• Additional income amounts may increase your Medicare premiums

If you plan on or think you might be in a lower tax bracket during your retirement years, perhaps a Roth IRA is not right for you. It may not make sense to pay the taxes now on the conversion at a higher rate if you are likely to be in a lower tax bracket later in life.

When moving forward with a Roth conversion, it is important to pay the taxes due with cash held outside of the IRA. Using your IRA funds to pay these taxes reduces your retirement account balance and therefore you will miss out on the opportunity for tax-deferred growth on the portion used to pay income tax.

Many benefits of the tax code depend on your adjusted gross income. As such, the more income that you realize, the more likely you are to be phased out from being able to claim certain tax deductions and credits. Make sure you keep this in mind when thinking about a Roth conversion.

SECURE Act of 2019 – A significant change for inherited IRAs 

The SECURE Act was signed into law on December 20, 2019 and changed the rules regarding inherited IRAs. Prior to enactment, a beneficiary of an IRA was allowed to “stretch” the distributions over their life expectancy. The SECURE Act did away with this provision and now requires that a non-exempt beneficiary withdraw all assets from the inherited account within 10 years of the decedent’s death. This applies only for those deaths occurring after December 31, 2019.

This strategy of ‘stretching’ the IRA over life expectancy allowed the beneficiary to maximize the tax-deferred growth potential and in the case of traditional IRAs, minimize taxable income over the years. By restricting the withdrawal period to 10-years, beneficiaries could be losing out on years of tax-deferred growth and potential tax savings.

This new provision alone makes a Roth conversion more compelling in that it helps limit the future tax liabilities of your heirs by paying the income tax dollars now. Plus, beneficiaries are not allowed to convert an inherited IRA themselves, so it is important to plan accordingly.

Build Back Better Act – A brand new crackdown on Roth conversions?

In October 2021, President Joe Biden introduced his latest piece of legislation, the Build Back Better Act. This bill was subsequently passed in the House of Representatives on November 19^th, 2021 and contains numerous changes to the tax code, including Roth conversions. The following provisions related to Roth accounts were included in this bill:

• Prohibit Roth conversions for high-income taxpayers with taxable income over $450,000 if filing jointly, or $400,000 for single filers. This would take effect for tax year 2032.

• Eliminate the backdoor Roth & Mega backdoor Roth by prohibiting the conversion of after-tax retirement contributions & after-tax funds held in plan accounts. This would be effective starting January 1, 2022.

• Prohibit contributions to individual retirement accounts for taxpayers with aggregate retirement account balances exceeding $10 million in the prior tax year. This would apply to married couples with taxable income over $450,000 & single filers with taxable income over $400,000, effective for the 2029 tax year.

• These same taxpayers must also withdraw at least 50% of the amount over $10 million, beginning with the 2029 tax year.
  • And for those taxpayers with more than $20 million in retirement accounts, they must withdraw the lesser of:
    • The amount needed to bring the total balance in all accounts down to $20 million, or
    • The total aggregate balance in Roth IRA and designated Roth accounts.

It’s a good idea to take the above proposals into consideration for year-end planning both now and in the future. As this bill is now being negotiated in the Senate, the above proposals could very well change or be eliminated completely before the final bill is signed into law by the President.

Regardless of what provisions make it into the bill, it is valuable to keep them in mind. Who knows – there is always a chance these proposals may re-emerge in the future under this or another administration.

So, is a Roth conversion right for you? 

During this time of historically low tax rates, Roth conversions have become much more appealing. Even if there were no other tax law changes in the next couple of years, the individual tax rates are anticipated to increase in 2026, as the provisions in the Tax Cuts and Jobs Act of 2017 are set to expire.

Nonetheless, with a new tax bill likely on the horizon and the potential tax rate increases that could come along with it, it’s more crucial than ever to take advantage of any tax savings opportunities available to you.

The end of the year will be here before you know it, so it is important to start planning for your taxes now. And while there are several benefits to doing a Roth conversion, bear in mind it may not always be in your best interest to do so.

Be sure to consult with a Wealth Advisor to determine if a Roth conversion is the right move for you. Our advisors at Domani Wealth are always available to start a conversation, and you can get in touch with us by calling 855-855-5455, or email [email protected].