To Convert or Not To Convert

With the abundance of financial information now accessible online, the interest in Roth conversions has increased substantially in recent years, and for good reason. Roth IRAs are largely considered to be one of the most appealing retirement savings vehicles available. Coupled with declining tax rates and a proliferation of newly retired baby boomers – an estimated 29 million in 2020 – more and more people are left wondering, “Does a Roth conversion make sense for me?”

Roth conversions, unlike contributions, can be done by almost anyone. While the basics of a Roth conversion are understood by many, determining when, if, and how much to convert is often a complicated question to answer. Before deciding if a Roth conversion is right for you, it’s important first to understand the differences between the types of IRAs, the types of conversions, and the pros and cons.

TRADITIONAL IRAS VS. ROTH IRA

Traditional IRA

• A Traditional IRA is an individual retirement account that allows your money to grow tax deferred. Generally, balances in your traditional IRA, including earnings, are not taxed until you take a distribution. Once you reach age 59 ½, you can withdraw funds from your IRA without restrictions or penalties. Contributions are made with after-tax dollars and may be fully or partially deductible, depending on your filing status, income, and participation in a qualified retirement plan at work. Once you reach age 72, you must begin taking required minimum distributions each year. If you expect to be in a lower tax bracket during retirement, a traditional IRA is likely the best option. 

Roth IRA

• A Roth IRA is an individual retirement account that allows your money to grow tax free. Contributions are also made with after tax dollars; however, they are not eligible to be deducted from your income. If you’ve owned the account for 5 years, and your age 59 ½ or older, you can withdraw funds from the IRA without any tax liability. It doesn’t matter if you’re covered by a defined contribution plan with your employer like a 401(k), 403(b) etc. As long you have earned income, up to the limit set by the IRS, you can contribute to a Roth. Unlike the Traditional IRA, if you think you’ll be in a higher tax bracket during retirement, a Roth IRA may be a better choice.

TYPES OF CONVERSIONS

Roth IRA Conversion

A Roth IRA conversion is the process of moving funds from a traditional, SEP, or Simple IRA – or a defined contribution plan like a 401(k) – into a Roth IRA. Anyone can convert eligible IRA assets to a Roth, regardless of income. Income tax is owed on the conversion in the year you convert. Assuming the contributions you made to the IRA account were deductible, you’ll owe income tax on every dollar. If the contributions were non-deductible, you’ll owe income tax only on your earnings. There’s no requirement on the amount of dollars you can convert each year, you can choose to do partial conversions of any amount. ​

Backdoor Roth Conversion

A backdoor Roth conversion is a strategy used by high-income earners to circumvent the income limits that apply to Roth IRA contributions. This strategy is possible because there are no income thresholds limiting who can make non-deductible traditional IRA contributions or Roth conversions. Whether or not you can make the maximum Roth IRA contribution annually depends on your tax filing status and modified adjusted gross income (MAGI). For ’23, as a single filer, you may contribute up to the annual limit if your MAGI is less than $153,000. As a joint filer, your MAGI must be less than $228,000 to contribute the maximum amount allowed. A backdoor Roth conversion is a process whereby you establish a traditional IRA account (or contribute to an existing account), make a non-deductible contribution, and then convert it to a Roth. Calculating the taxes on a back door conversion is further complicated by the pro-rata taxation rules. The pro-rata rule influences the taxation, calculating liability proportionally to the fraction of after-tax vs. before-tax contributions. Let’s look at two examples to help demonstrate the difference between these two circumstances.
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Example 1: Paul earns over $228,000 per year as a joint filer, participates in his employers 401(k), and would like to make a Roth IRA contribution. Because his income is over the threshold, he cannot make a direct contribution. As an alternative he opens a Traditional IRA, makes a non-deductible contribution, and then converts those funds into a Roth IRA. Because his contribution was after-tax and non-deductible – and because he does not have other pre-tax IRA accounts – no taxes are due on the principal amount converted. Any earnings on the deposit would be subject to income tax at the time of conversion. If this is done is succession, earnings will be negligible.  

Example 2 (pro-rate rule): Paul earns over $228,000 per year as a joint filer, participates in his employers 401(k), and would like to make a Roth IRA contribution but has a Traditional IRA that was funded with strictly deductible/pre-tax contributions. Again, because his income is over the threshold, he cannot make a direct contribution. He can, however, contribute to his existing Traditional IRA and then convert those funds to a Roth IRA. The tax consequences of this transaction will be much different because of the pro rata rule. The pro rata rule prevents you from converting only the after-tax funds, it must be proportionate to the fraction of pre vs. post tax contributions.

Let’s say Paul has a $100,000 Traditional IRA balance, $7,500 of which came from a non-deductible contribution (’23 maximum allowed for those over 50). If Paul chooses to convert the $7,500 contribution, he will need to calculate how much of the conversion will be subject to taxes; the steps are as follows:

• $7,500 non-deductible amount/$100,000 total IRA balance = 0.075 non-taxable percentage
• $7,500 amount to be converted x 0.075 non-taxable percentage = $562.50 non-taxable amount 
• $7,500 amount to be converted – $562.50 non-taxable amount = $6,937.50 amount of conversion subject to tax 

Mega Backdoor Roth Conversion

A mega backdoor Roth conversion is a specific type of backdoor conversion where you contribute after-tax dollars to a 401(k) that you hold with your employer and then immediately roll those contributions into a Roth IRA or Roth 401(k). This strategy is only made possible if your companies plan document allows after-tax contributions and has an in-service withdrawal provision. For ’23, the pre-tax annual contribution limit for employer sponsored retirement plans is $22,500. Individuals above the age of 50 are eligible for a “catch-up” contribution, bringing the total to $30,000. However, if your plan allows after-tax contributions, the combined pre- and post-tax limit is much higher. In that instance, total employee and employer contributions of up to $66,000, or $73,500 for employees who are 50 or older, are allowed (for ’23). The after-tax dollars would then rollover, or convert, into a Roth IRA or Roth 401(k). The principal amount is not taxable; however, any earnings will be considered pre-tax and subject to taxation at the time of the conversion.

​Example: Paul works for XYZ Co. and contributes to their 401(k) plan. XYZ Co’s plan documents allow after-tax contributions and In-Plan Roth conversions. To carry out the Mega backdoor Roth strategy, Paul must follow these three steps (see chart below for a detailed breakdown): (1) max out individual contributions to the 401(k), (2) make after-tax, non-Roth contributions up to the annual maximum (combined employee & employer), and (3) elect an in-plan Roth 401(k) conversion of the “remaining after-tax contribution allowed.” Alternatively, if the plan does not have a Roth 401(k) component, after-tax contributions can be moved into a Roth IRA, assuming plan the documents allow for in-service non-hardship withdrawals. 

PROS

Tax-free Withdrawals

If you have met the five-year rule and are at least age 59 ½, Roth IRA withdrawals are completely tax-free. Tax-free withdrawals offer tremendous advantages in retirement, particularly in years when you have higher than normal income or want to realize capital gains without triggering additional tax liabilities.

Minimum Required Distributions

Unlike traditional IRAs, 401(k)’s etc., Roth IRAs do not have distribution requirements beginning at age 72. You can continue letting the funds grow tax-free for as long as you’d like. Minimum distributions can increase your income significantly later in life, especially when considering other means tested benefits, such as Medicare premiums and social security. The ability to leave Roth funds intact, without a withdrawal requirement, is a major advantage over other retirement vehicles. ​

Tax Diversification

Having a wide variety of account types in retirement provides you with the ability to pull funds in the most tax efficient manner possible. Maintaining diversity among IRAs, Roth IRAs, and Non-qualified (taxable), helps contribute to that efficiency. 
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​Example: For tax year ’23, the marginal income tax brackets are as follows:

Paul, who is retired, has total taxable income of $89,450 filing jointly (after adjusting for deductions), putting him at the tail end of the 12% marginal income tax bracket. Any additional income he realizes this year, will put him in the 22% marginal income bracket. He has done a very good job of saving for retirement, but never contributed or converted funds to a Roth IRA. All of his retirement savings accumulated in 401(k) and traditional IRA accounts. Let’s say, for example, that Paul booked a vacation to spend some time with his family in Hawaii, at a total cost of $10,000. When he withdraws funds from the IRA to pay for the trip, he’ll pay tax on that distribution at a rate of 22%, nearly a 50% increase from his previous bracket. Because his only source of funds is IRA and 401(k) assets, he has no other option. 

If he had Roth IRA and/or non-qualified taxable assets to withdraw from, he would have much more control over his tax liability. The option of pulling assets from those account types could have saved him $2,200 in additional federal income taxes ($10,000 * 22%). Maintaining a Roth IRA account in retirement can help prevent a situation like this. 

Beneficiaries / Estate Planning

Roth IRAs are a particularly valuable estate planning tool. When inheriting a Roth, you are granted the same tax advantages as the original owner. Distributions are tax free, provided it’s been 5 years since the original account owner established the account (each conversion has its own 5-year requirement). The SECURE Act, which was passed in December 2019, changed the inherited IRA distribution rules. For those deaths that occurred in ’20 or later, non-spouse beneficiaries must establish an inherited Roth IRA account and withdraw the entire balance within a 10-year period or take a lump sum distribution. 

The new law also created a category of beneficiaries called “eligible designated beneficiaries”, who are still permitted to stretch distributions over their life expectancy. As a non-spouse beneficiary, you must fall into one the of the following categories to qualify; (1) a minor child of the decedent (only applicable until the minor reaches the age of majority) (2) disabled persons (3) chronically ill (4) not more than 10 years younger than the deceased and (5) certain types of trusts. 

​Spousal beneficiaries can treat the account as their own, stretch distributions over their lifetime, deplete the account over a 10-year period or take a lump sum distribution.

CONS

Increases Ordinary Income

Any amount you choose to convert will increase your ordinary income, which may push you into a higher marginal tax bracket. Conversions only make sense if the converted funds are taxed at a rate that is lower than what you expect to pay in the future. Without proper planning, it’s possible to pay more lifetime taxes with a Roth conversion than without. 

Conversions are Irrevocable

Many things can prompt your desire to reverse a conversion. Two of the more common reasons for doing so are: (1) poor investment performance and (2) underestimating your tax liability and/or marginal bracket. 

Remember, the amount you convert from an IRA to a Roth IRA, under most circumstances, is fully taxable. If you perform a conversion and subsequently loose money on the investments, you may want to reverse that transaction, in hopes of reconverting when the account has a lower balance to reduce the overall tax liability. 

Alternatively, you may underestimate your tax liability when planning for a conversion. Let’s say for example you convert $30,000 in October and then receive an unexpected bonus in December, pushing you into a higher marginal income tax bracket prior to year-end. Your total anticipated income, after receiving the bonus, may cause you to reconsider the prior conversion. Prior to 2018, you could have “recharacterized” the conversion, meaning you could move the converted funds back to the traditional IRA, eliminating taxes that would have otherwise been owed. Under current law, Roth conversions are irreversible. Once your conversion is complete, nothing can be done to reverse it.

Ordinary Income Tax Ripple Effect

It’s important to understand the interrelationship that exists between ordinary income, capital gains, social security and other taxes and surcharges; including net investment income tax and Medicare premium surcharges. Long-term capital gains stack on top of ordinary income, so an increase in ordinary income can trigger additional capital gains taxes. Ordinary income also plays a factor when calculating “provisional income,” which is used to determine how much, if any, of your social security benefit will be subject to tax. Lastly, more ordinary income can trigger Medicare premium surcharges and/or net investment income tax.

Beginning in ’07, government began reducing the subsidy for high-income individuals, causing them to pay higher monthly amounts for Part B and Part D Medicare premiums. These surcharges are referred to as “Income-Related Monthly Adjustment Amounts,” or IRMAA, which is determined by income on your tax return from two years prior. See the chart below for a breakdown of these surcharges based on income:

Net investment income tax is a 3.8% surtax paid in addition to regular income taxes. The surtax applies only if you have net investment income – capital gains and dividends, interest and annuity payments, passive business income and/or rents – and MAGI over a certain amount; $200,000 filing single and $250,000 filing jointly. The surtax applies to your net investment income or the portion of your MAGI that excess the threshold – whichever is less. For example, if you have $40,000 in net investment income and your MAGI goes over the threshold by $60,000, you’ll owe the 3.8% surtax. But you’ll owe only on the $40,000 since it’s the lower of the two amounts. Total tax would be $1,520 ($40,000 x 3.8%).

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The rules and tax implications of converting any amount from a traditional IRA to a Roth IRA – or as a backdoor or mega backdoor conversion – are very complex. We strongly recommend you consult with a tax advisor and/or financial planning professional to help properly determine if a conversion is right for you before executing any of the strategies discussed herein. 
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The decision to convert to a Roth should be made in the context of a comprehensive financial plan. If you have additional questions or would like to explore any of these strategies further, our team of advisors at Cairn Investment Group are available to assist. Contact us anytime for a complimentary consultation.

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Mark Farrelly CFP®, ChFC®, CDFA®
​Senior Advisor And Director Of  Financial Planning

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