ROTH IRAs and conversions from Traditional IRAs have been getting a lot of press recently. This discussion has clearly piqued the interest of our clients, as we have received many questions about the process and tax implications. This interest is exacerbated by pending legislation likely to curtail common strategies employed with ROTHs. Here are my thoughts on the current and possible state of ROTHs.
What is a ROTH IRA?
ROTH IRAs were first authorized in the late 1990’s as an alternative to traditional IRAs. Instead of taking a tax deduction for the ROTH IRA contribution, the taxpayer would fund the ROTH using after-tax funds. The primary benefit comes from not having to pay tax on the growth of those funds. So these vehicles made a ton of sense for taxpayers that were ineligible for traditional IRA contributions, were young, or felt that their tax rates would be higher in future years when they inevitably accessed the retirement accounts.
But there are limitations to who can contribute to a ROTH. The primary limitation is income based. Currently, a jointly filing couple with adjusted gross income (AGI) exceeding $208,000 is ineligible to make a ROTH contribution. That taxpayer is simply unable to make a standard contribution to a ROTH IRA. Enter a Backdoor ROTH IRA contribution.
What is a Backdoor ROTH IRA Contribution?
A Backdoor ROTH IRA contribution (technically a conversion) is a multi-step process that effectively allows taxpayers to still get money into a ROTH even if they exceed the income limit. Here is how it works:
- First make a non-deductible contribution to a Traditional IRA for a given year (assume $6,000 for this contribution amount)
- Because the contribution is non-deductible, the contribution creates $6,000 in basis in the Traditional IRA
- Convert the Traditional IRA into a ROTH IRA account shortly after
- Technically this is a taxable event, but since the taxpayer has $6,000 in basis, he or she would only pay tax on the amount exceeding the original $6,000
- Taxpayer now has the funds in his/her ROTH
There are some considerations that have to be dealt with before considering a Backdoor ROTH IRA conversion. The primary issue is that the non-deductible IRA needs to be the only IRA the taxpayer has. If that is NOT the case, a ROTH conversion becomes complicated by taxes. In that case, we are talking more generally about a ROTH IRA Conversion.
What is a ROTH IRA Conversion?
A ROTH conversion is just like it sounds: a conversion of Traditional IRA funds to a ROTH IRA. Once the account is converted into the ROTH, it has all of the benefits afforded all other ROTH accounts; namely, tax free growth. But at the point of the conversion, a taxable event has been created. Assuming no basis in the Traditional IRA being converted, the funds are fully taxable, and tax generally shouldn’t come from the conversion. An example might help.
- Taxpayer has $50,000 in an IRA (can be a rollover IRA or vanilla Traditional IRA)
- Taxpayer has no basis in that IRA
- Taxpayer is in the 30% tax bracket
- Taxpayer weighs the options and determines that converting the entire IRA to a ROTH is in their best interest
- Taxpayer converts the funds to the ROTH
- Taxpayer includes the $50,000 conversion amount on that year’s income tax and pays 30% on that conversion ($15,000)
So while the end result is particularly attractive, conversion decisions have to be made in the context of a taxpayer’s full financial picture, with taxes being an extremely important consideration.
Future of ROTH IRAs
Congress is currently considering the legacy of Backdoor ROTH contributions. As of now, the expectation is that Backdoor ROTHs will be shut down as an option beginning after Dec 31, 2021. In addition, there is discussion of limiting the ability of taxpayers to do ANY ROTH conversions, at least above a certain income level. There are additional limitations in debate related particularly to large ROTH balances and the types of investments permitted in ROTHs. All of these Congressional debates lead to increased interest in conversions prior to 12/31/21.
In addition, there is considerable debate about tax increases. While it’s impossible to read the tea leaves on future taxes, it seems reasonable to expect rates to generally increase as opposed to decrease. Given that, paying tax on conversions currently in a lower tax environment may be wiser than paying tax on IRA distributions in the future in a higher tax environment.
Should You Consider ROTH Conversions in 2021?
Historically, I have been fairly ambivalent on the value of conversions. Depending on the assumptions used in the analysis, conversions looked very attractive or very unattractive. But with the prospect of rising tax rates in the future and potential limitations on ROTH Conversions, 2021 is a critical year for this analysis.
Each taxpayer’s situation is unique, and there is no universal answer. But if you are considering a ROTH conversion and want to understand the full picture, please reach out to us for discussion BEFORE you make the decision. We are happy to frame up all the variables so that you can make the best decision for your unique situation.