A Financial Advisor Explains IRA's and Roth IRA Conversions
IRA's individual retirement accounts are tax-advantaged accounts that can help play a huge role in a families wealth management. At their heart, they can help you boost your retirement savings and help meet financial goals in a tax smart way.
The most common IRAs you’ll choose from are traditional and Roth IRAs. Both are designed for long-term growth, but there are some key differences that can impact financial planning, including how your contributions are taxed and when you can withdraw funds. Let's break out some advice from a financial advisor on the two accounts and a look at how to choose the one that’s right for you.
Traditional IRAs
Anyone age 18 and older with an earned income can make contributions to a traditional IRA of up to $6,000 a year in 2022. Those age 50 and older can contribute up to $7,000.
Contributions are tax-deductible, and your savings grow tax-deferred. You may begin making withdrawals at age 59 ½, and you must take required minimum distributions at age 72. Withdrawals are subject to income tax, and early withdrawals before age 59 ½ may be subject to a 10% penalty.
Your ability to deduct contributions to a traditional IRA is dependent on your income. Married couples filing jointly with a modified adjusted gross income (MAGI) of up to $204,000 can deduct the full amount, as can single filers with a MAGI of up to $129,000.
Roth IRAs
Contributions to a Roth IRA are made with after-tax dollars, and money inside the account grows tax-free. The annual contribution limit for a Roth IRA is also $6,000, or $7,000 for those age 50 and older.
If you are over age 59 ½, you can withdraw funds at any time and there are no minimum distribution requirements. Regardless of age, you can withdraw your contributions at any time without paying penalties or taxes. However, if you withdraw earnings before you reach age 59 ½, you may have to pay penalties and taxes. You may also need to pay taxes and penalties on withdrawals if you’ve been making contributions to your Roth IRA for less than five years.
Only those with incomes less than $204,000 for couples and $129,000 for a single person can contribute to a Roth IRA. If you earn more than that, you can still make partial contributions if your income is $144,000 or less for a single person and $214,000 for married couples.
What Is a Roth IRA Conversion?
A Roth IRA conversion occurs when you move funds from a traditional IRA, simplified employee pension (SEP) IRA, or savings incentive match for employees (SIMPLE) IRA into a Roth IRA.
In general, people can invest in a Roth IRA only if their modified adjusted gross income (MAGI) falls below a certain limit. For example, if you’re married filing jointly and earn more than $214,000 a year in 2022, you can’t invest in a Roth IRA; single and head of household filers have a cutoff of $144,000.
Advantages of a Roth IRA Conversion
A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. While there’s no up-front tax break with Roth IRAs, your contributions and earnings grow tax free.
In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided that you take a qualified distribution. While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money and, therefore, be in a higher bracket.
Another perk to a Roth IRA is that you can withdraw contributions (not earnings) at any time, for any reason, tax free. Still, you shouldn’t use your Roth IRA like a bank account. Any money that you take out now will never get the opportunity to grow. Even a small withdrawal today can have a big impact on the size of your nest egg in the future.
Moving to a Roth IRA also means that you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. If you don’t need the money, you can keep your money intact and pass it to your heirs.
Disadvantages of a Roth IRA Conversion
The largest disadvantage of converting to a Roth IRA is the whopping tax bill. If, for example, you have $100,000 in a traditional IRA and convert that amount to a Roth IRA, you would owe $24,000 in taxes (assuming your effective tax rate is 24%). Convert enough and it could even push you into a higher tax bracket.
Of course, when you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. While you can make some educated guesses, there’s no way to know for sure what tax rates (and your income) will be in the future.
Yet another common issue that many taxpayers face is contributing the full amount and then converting it when they have other traditional IRA, SEP IRA, or SIMPLE IRA balances elsewhere. When this happens, you’re required to compute a ratio of the monies in these accounts that have been taxed already vs. the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you deducted your contributions vs. those for which you didn’t).
This percentage is counted as taxable income. Yeah, it’s complicated. Definitely get a financial advisor to help.
Another drawback: If you’re younger, you have to keep the funds in your new Roth IRA for five years and make sure that you’ve reached age 59½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings but also a 10% early distribution penalty—unless you qualify for a few exceptions.
Misconceptions of Roth IRA Conversions
As Roth IRA conversions become more popular, questions and misconceptions abound. In no particular order, here are a dozen Roth IRA conversion facts to be aware of:
Anyone with an IRA can do a Roth conversion. There are no income limits. You can have $0 earned income and do a Roth conversion. You can make a million dollars and convert.
There is no limit on the amount that can be converted. If you have an IRA worth $3 million and want to convert the whole thing – go for it.
Inherited (beneficiary) IRAs cannot be converted.
There is no penalty on a Roth conversion, regardless of age. Understandably, IRA owners get a little gun-shy when they complete any transaction before the age of 59 ½. Rest assured that there is no 10% penalty on a Roth conversion, no matter how old you are.
Beware, however, that if you are under 59 ½ and have the taxes on the conversion withheld (paid) from the IRA, there can be a 10% penalty on the amount withheld. Why? Because the taxes withheld never get converted. They are essentially an early withdrawal that is sent to the IRS. As such, it is highly recommended that if you are under 59 ½, you pay the taxes due on a Roth conversion from a source other than the IRA.
Speaking of the taxes – they are not due immediately upon conversion. The amount of the Roth conversion is added to your income for the year, and you can settle up with the IRS next April. (Keep an eye out for IRS Form 1099-R showing the conversion amount.)
Partial conversions are allowed. Implementing a strategy of partial Roth conversions specific to your financial situation can help manage taxes and mitigate risk.
A Roth conversion must be initiated by the end of the calendar year (December 31) to qualify for that same tax year. (The funds being converted must be withdrawn from the traditional IRA by year end.) There is no such thing as a “prior-year conversion.”
For IRA owners taking lifetime required minimum distributions (RMDs), i.e., they are older than 70 ½ or 72, the RMD must be taken before any Roth conversion can be done.
Each Roth conversion will start its own 5-year clock which must be satisfied (or you turn 59 ½) before the converted dollars can be withdrawn penalty-free. Once you have held any Roth IRA for five years and are 59 ½ or older, earnings on converted dollars can come out tax- and penalty-free.
Roth IRAs have favorable ordering rules for distributions. It does not matter how many Roth IRAs you have, nor does it matter if you segregate your “contributory Roth IRA” from your “conversion Roth IRA.” The IRS only sees one big bucket of Roth IRA money under your name. Regardless of which Roth IRA you take a distribution from, Roth ordering rules dictate that contributions come out first, then converted dollars, then earnings.
Be careful! Roth conversions are added to adjusted gross income (AGI). This can impact “stealth taxes” on items tied to AGI such as IRMAA surcharges, financial aid, and taxability of Social Security.
Copyright © 2021, Ed Slott and Company, LLC Reprinted from The Slott Report, November 8,2021, with permission. Clarifying Some Roth Conversion Misconceptions | Ed Slott and Company, LLC (irahelp.com) Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article.
Internal Revenue Service. “Traditional and Roth IRAs.”
Internal Revenue Service. “IRS Nationwide 2010 Tax Forum: Roth Conversions.”
Internal Revenue Service. “2022 Limitations Adjusted as Provided in Section 415(d), etc.,” Page 4.
Internal Revenue Service. “Publication 590-A: Contributions to Individual
https://www.irs.gov/retirement-plans/traditional-and-roth-iras
These are the views of the author, not Olde Raleigh Financial Group, a Member of Advisory Service Network, LLC or Advisory Services Network, LLC, and should not be construed as investment advice. Neither Olde Raleigh Financial Group nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.
