The impact of the pandemic along with low tax rates makes 2021 an opportune time to convert a traditional individual retirement account into a Roth IRA. But a Roth IRA conversion may not be the right financial move for everyone. A Roth IRA conversion makes sense when: Taxes are low.
If you're approaching retirement or need your IRA money to live on, it's unwise to convert to a Roth. Because you are paying taxes on your funds, converting to a Roth costs money. It takes a certain number of years before the money you pay upfront is justified by the tax savings.
On April 5, you could convert your traditional IRA to a Roth IRA. However, the conversion can't be reported on your 2021 taxes. Because IRA conversions are only reported during the calendar year, you should report it in 2022.
Is there a deadline to convert? Yes, the deadline is December 31 of the current year. A conversion of after-tax amounts is not included in gross income. Any before-tax portion converted will be included in your gross income for the conversion tax year.
When you convert tax-deferred money from the traditional IRA to the Roth IRA, you'd pay taxes on the amount converted as if it were taxable ordinary income. The taxable portion converted would be considered income for the tax year in which the conversion occurred.
How Much Tax Will You Owe on a Roth IRA Conversion? Say you're in the 22% tax bracket and convert $20,000. Your income for the tax year will increase by $20,000. Assuming that this doesn't push you into a higher tax bracket, you'll owe $4,400 in taxes on the conversion.
One key disadvantage: Roth IRA contributions are made with after-tax money, meaning that there's no tax deduction in the year of the contribution. Another drawback is that withdrawals of account earnings must not be made until at least five years have passed since the first contribution.
The backdoor Roth IRA strategy is still currently viable, but that may change at any time in 2022. Under the provisions of the Build Back Better bill, which passed the House of Representatives in 2021, high-income taxpayers would be prevented from making Roth conversions.
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The year you do a Roth conversion, your taxable income will rise, which could cause a portion of your Social Security benefit to be taxed or push you into a situation where more of your benefit is taxed.
Starting in 2022, the bill had proposed to end so-called non-deductible backdoor and mega backdoor Roth conversions. Regardless of income level, you'd no longer be able to convert after-tax contributions made to a 401(k) or a traditional IRA to a Roth IRA.
A Roth IRA conversion can be a very powerful tool for your retirement. If your taxes rise because of increases in marginal tax rates—or because you earn more, putting you in a higher tax bracket—then a Roth IRA conversion can save you considerable money in taxes over the long term.
You may not need a Backdoor Roth Conversion if you are able to meet your savings goals with the maximum retirement limit through your workplace retirement account and are not expecting a need for additional savings for your retirement plan.
You can make backdoor Roth IRA contributions each year. Keep an eye on the annual contribution limits. If your annual contribution limit is $6,000, that's the most you can put into all of your IRA accounts. You might put the entire amount into your backdoor Roth.
While the legislation has not become law, the Build Back Better Act was set to eliminate the backdoor Roth IRA strategy as of Jan. 1, 2022.
There Are Two Five-Year Rules for Backdoor Roth IRAs
You're usually allowed to withdraw contributions from your Roth IRA at any time, free of penalties or taxes. There is a second five-year rule, however, for backdoor Roth conversions.
Reduce adjusted gross income
If you're planning a Roth conversion, you may consider reducing adjusted gross income by contributing more to your pretax 401(k) plan, Lawrence suggested. You may also leverage so-called tax-loss harvesting, offsetting profits with losses, in a taxable account.
The Roth IRA five-year rule says you cannot withdraw earnings tax free until it's been at least five years since you first contributed to a Roth IRA account. 1 This rule applies to everyone who contributes to a Roth IRA, whether they're 59½ or 105 years old.
A "backdoor Roth IRA" is a type of conversion that allows people with high incomes to fund a Roth despite IRS income limits. Basically, you put money you've already paid taxes on in a traditional IRA, then convert your contributed funds into a Roth IRA and you're done.
Paying Your Taxes on a Roth Conversion
You may have to pay taxes on the conversion either at the time of conversion or as estimated tax payments during the tax year of the conversion. It is not wise to wait until the tax deadline for the year to pay the taxes because you may incur penalties.
Roth IRA - Conversion From an IRA Distribution Must be by End of Tax Year. The original conversion from a Traditional IRA to a Roth IRA must be completed within 60 days after the end of the tax year.
You'll be able to select whether you want to contribute for 2021 or 2022. In this case, you'll want to choose 2021 since you'll have until April 2023 to contribute for the 2022 tax year.
Like the Backdoor Roth IRA, the “Mega” Backdoor Roth also got a reprieve in 2021, but its future is uncertain. The Mega Backdoor Roth is a 401(k) plan version of the Backdoor Roth IRA. It only works if your 401(k) plan allows for after-tax contributions and in-service distributions of after-tax funds.
For taxpayers who anticipate a higher tax rate post-retirement, converting a regular IRA to a Roth IRA after age 60 can help to lower their total tax burden over time. Roth IRA conversions allow earnings to grow tax-free and avoid the need to make required withdrawals that increase post-retirement tax costs.
A Roth conversion may push your taxable income high enough to cause an income-adjusted surcharge in Medicare premiums. For example: A married couple with $100,000 of income would be paying the lowest Medicare rates of $170.10 (2022) for Part B and $0 for Part D.