Most people recognize that Roth IRAs offer some significant tax advantages over traditional IRAs. For example, qualified Roth IRA withdrawals are free from federal income tax. In addition, unlike with traditional IRAs, there is no need to start taking required minimum distributions (RMDs) from Roth IRAs after reaching age 70½. This allows the assets held in the Roth IRA to grow tax-free for the foreseeable future. (Nonspouse beneficiaries, however, are required to take RMDs when they inherit a Roth IRA.)
The fastest and easiest way to fund a Roth IRA with a significant sum is by converting a traditional IRA to a Roth IRA. But these conversions aren’t beneficial for everyone. Also, a provision of the Tax Cuts and Jobs Act (TCJA) may make Roth IRA conversions riskier from a tax perspective.
A contribution solution
For 2018, the annual Roth contribution limit is $5,500 or $6,500 if the taxpayers is age 50 or older as of year-end. Eligibility to make annual contributions is phased out if modified adjusted gross income (MAGI) is between $120,000 and $135,000 for singles and between $189,000 and $199,000 for married couples filing jointly.
These contribution limits don’t apply to Roth IRA conversions. That’s why a conversion is a fast, easy way to fund a large Roth IRA. It’s one of the limited funding options for higher-income taxpayers. Some taxpayers avail themselves of what’s called a “back door” Roth contribution. This option involves making a nondeductible contribution to a traditional IRA and then converting the traditional IRA to a Roth IRA. This achieves the same result as if the taxpayer had contributed directly to a Roth IRA. Those using this procedure should exercise caution when they already have assets in a traditional IRA as it may result in adverse tax consequences ― the facts and circumstances will determine whether it is worthwhile.
A Roth IRA conversion is treated as a taxable distribution from your traditional IRA. So converting your IRA will generate a bigger federal income tax bill for the year of conversion — and maybe a bigger state income tax bill, too. But the conversion amount won’t be subject to a 10% early IRA withdrawal penalty tax even if you’re under age 59½.
As federal tax rates are now lower under the TCJA, 2018 may be a good year for a conversion. You’ll likely pay less tax on the income from a conversion than you would have paid in the past. And, if you expect to be in a higher tax bracket in the future, you’ll avoid any possible higher tax on any post-conversion income earned in your new Roth account.
But you shouldn’t initiate a Roth conversion without running the numbers first. Converting a traditional IRA with a large balance could push you into a higher tax bracket.
For example, if you’re single and expect your 2018 taxable income to be about $100,000, your marginal federal income tax bracket is 24%. Converting a $100,000 traditional IRA to a Roth IRA in 2018 would cause a fair amount of the extra income from the conversion to be taxed at 32%.
You may be able to mitigate the effect of the higher bracket by spreading the $100,000 conversion equally between 2018 and 2019. Then the extra income from converting would be taxed at 24%.
Conversions in 2018 and beyond can’t be reversed
Why would someone want to undo a Roth conversion? Sometimes, due to volatile market conditions, a converted Roth IRA account declines in value after the conversion. If your Roth IRA value drops, you could end up owing taxes partially on money you no longer have.
Under prior law, you generally had the ability to wait until October 15 of the year after a conversion to “recharacterize” it back to a traditional account to avoid the tax associated with the conversion. But under the TCJA, for conversions in 2018 through 2025, you can no longer undo the conversion with a recharacterization.
(You can still recharacterize new Roth IRA contributions as traditional contributions if you do it by the applicable deadline and meet all other rules.)
Is a Roth Conversion right for you?
A Roth conversion strategy may make sense for those who believe that their tax rates during retirement will be the same or higher than their current tax rates. Your tax and financial advisors can help you determine the best retirement planning strategies for your particular situation.