Roth IRA Conversions: What You Need To Know

Have you heard of Roth IRA conversions but are unsure if they are right for you? Below, we’ll explore Roth conversions, backdoor Roths, and mega backdoor Roths so you can understand the pros, cons, and specific rules of each. 

But first, let’s define some key terms.

What is a Roth IRA?

Roth IRA

Roth IRAs are individual retirement accounts that offer several advantages not found in other retirement plans, such as:

  • Tax benefits: You fund a Roth IRA with money you’ve already paid taxes on (after-tax dollars), so there is no immediate tax deduction. However, both your contributions and earnings grow tax-free. Once you reach retirement age (defined by the IRS as 59 ½ or older), you can withdraw your money tax-free.
  • No RMDs: You never have to take required minimum distributions (RMDs) from your Roth IRA. This differs from Traditional IRAs and other retirement plans that make you start taking withdrawals at age 72, even if you don’t need the money yet. 
  • Easy wealth transfer: A Roth IRA is a great way to transfer wealth to your heirs tax-free. You can name an individual or multiple people as beneficiaries of your Roth. That way, the account won’t have to go through probate and can instead pass directly to your heirs. Inherited Roth IRA rules are complex, so it’s best to speak with your financial planner or accountant.

Roth IRAs are a popular way to invest for retirement today. The benefits are so good that the government limits who can contribute to a Roth IRA, which brings us to the topic of Roth conversions.

What is a Roth conversion?

401k, IRA, Roth

People who earn over a certain amount ($144k for individuals and $214k for married couples in 2022) aren’t eligible to contribute to a Roth IRA, at least directly. That’s where Roth conversions come in.

A Roth conversion involves transferring money from a retirement account such as a Traditional IRA or 401(k) into a Roth IRA. Many high-income earners use this strategy to legally bypass the income limits to contribute to a Roth IRA, known as the “backdoor Roth” method.

You will have to pay income tax on the amount you convert to Roth, which is why this strategy makes sense for people looking to save on future tax bills. For example, if you believe you will be in a higher tax bracket in the future, paying taxes now versus later might save you money in the long run.

A crucial step investors often miss when completing Roth conversions is filing IRS form 8606. The 8606 form is required for those who make nondeductible contributions to a Traditional IRA as part of the backdoor Roth strategy.

What is a backdoor Roth IRA?

A backdoor Roth is another name for a Roth conversion. If your income exceeds the Roth limits, you can’t put money directly into a Roth IRA. However, you can contribute using the “back door” method. 

The drawbacks of doing a backdoor Roth are paying ordinary income taxes on the money you transfer into a Roth and aggregation rules. The IRS created aggregation rules to limit the ability to use a non-deductible IRA as a tax shelter. 

Recent legislation, specifically the Build Back Better plan, has threatened the existence of backdoor Roth IRAs. It’s a good time to consider the backdoor Roth strategy since its future is uncertain.

What about a mega backdoor Roth IRA?

The “mega backdoor Roth” strategy allows you to transfer a large amount of money from your employer-sponsored 401(k) into a Roth IRA. For 2022, the contribution limit is $40,500. A mega backdoor Roth is a highly complex strategy with many moving pieces. Therefore, it’s best to consult with your tax advisor before choosing this method.

One such complication is the aggregation rule. According to the IRS, if you have multiple IRAs, they will all be considered one for tax purposes. This creates a challenge for those looking to do a backdoor Roth if they already have existing IRAs.

You can only implement a mega backdoor Roth strategy under certain conditions. For example, you can only do it if your employer allows you to withdraw money from your 401(k) while still employed at the company, known as in-service distributions. 

The plan must also allow you to move funds from profit-sharing plans into a Roth IRA. This strategy is suitable for owner-only 401(k) profit-sharing plans since it’s easier to pass compliance testing.

Keep in mind, tax rules are constantly changing and there is no guarantee that the current tax landscape will remain the same. Before implementing any strategies presented, the services of an appropriate professional should be sought.

Next steps

Still not sure if a Roth conversion is right for you? It might be time to speak with a financial planner. Rex Behrashi, CFP®, has been helping business owners and individuals with retirement, investment, tax, and estate planning for over 15 years. 

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