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Surprising Tax Impact of Converting Your Traditional IRA to a Roth IRA

Written by Kohari Gonzalez Oneyear & Brown | Aug 28, 2024 12:10:00 PM

Article Highlights:

  • Understanding Traditional and Roth IRAs
  • The Conversion Process
  • Benefits of Converting
    • Tax-Free Withdrawals
    • No Required Minimum Distributions
    • Estate Planning Advantages
  • Pros and Cons of Converting
  • Age Considerations
  • Other Tax-Related Issues
    • Non-Deductible Traditional IRAs
    • Conversion Income
    • Net Investment Income Surtax
    • Paying the Tax on a Conversion
    • Tax Strategy

The yearly contribution amount that taxpayers can make to a Roth IRA is capped. The allowed 2024 contribution for joint-filing taxpayers phases out at an adjusted gross income (AGI) between $230,000 and $240,000 (or an AGI between $0 and $9,999 for married taxpayers filing separately). The maximum contribution for 2024 is $7,000 ($8,000 if age 50 or older). The phase-out for taxpayers who are single ranges from $146,000 to $161,000. Every year, the phase-out and contribution caps are modified for inflation.

Higher-income taxpayers can, however, get around the phase-out income restrictions by contributing to a regular IRA first, then converting it to a Roth IRA—a strategy known as a "back-door Roth IRA." However, if this technique is not planned for in advance, there are significant risks that might lead to unanticipated taxable revenue.

Many Americans, including those who do not pay higher taxes, are considering the possible long-term tax benefits of converting their regular Individual Retirement Account (IRA) to a Roth IRA. This choice, nevertheless, is not without complexity, therefore it must be made after carefully weighing the advantages, disadvantages, and ramifications. The process of converting a regular IRA to a Roth IRA will be covered in detail in this article, along with taxation, advantages, disadvantages, age concerns, and other tax-related topics.

Understanding Traditional and Roth IRAs

Understanding the key distinctions between regular and Roth IRAs is crucial before beginning the conversion process. With a conventional IRA, people can contribute before taxes are deducted, which lowers their taxable income in the year of the contribution. While withdrawals from the account are taxed like regular income, account balances grow tax-deferred.

In contrast, there is no tax deduction for contributions made to a Roth IRA as they are paid using after-tax money. But the big benefit of a Roth IRA is that you may take eligible withdrawals tax-free and your profits grow tax-free as well. Because of this feature, Roth IRAs are a desirable option for younger people opening Roth accounts and those who expect to be in a higher tax rate when they retire.

The Conversion Process

A conventional IRA's money can be transferred in part or in full to a Roth IRA in order to convert it. The amount you convert must be taxed as income for the year that you pay income taxes on it. This taxability is important to take into account since, depending on the amount converted and your existing tax rate, it may result in a substantial tax payment.

Benefits of Converting

Tax-Free Withdrawals

The biggest advantage of a Roth IRA is that you may take out your money tax-free in retirement, or even sooner in certain situations. This protects you against future rises in the federal income tax rate.

No Required minimal Distributions (RMDs)

Unlike regular IRAs, Roth IRA owners are not required to begin taking minimal distributions at the age of 73, which gives them greater flexibility when it comes to retirement planning.

Benefits for Estate Planning

Roth IRAs are a useful tool for estate planning since they may be bequeathed to heirs, who can also take advantage of tax-free withdrawals. The RMD requirements for inherited Roth IRA funds are the same as those for inherited conventional IRA accounts, but typically, the distributions are tax-free.

Pros and Cons of Converting

Pros:

  • Potential for tax-free growth and withdrawals.
  • No RMDs while the owner is alive, offering more control over your retirement funds.
  • Can provide tax diversification in retirement.

Cons:

  • Upfront tax bill on the converted amount.
  • Conversion could push you into a higher tax bracket for the year.
  • If you are a Medicare beneficiary, the conversion could cause an increase in your Medicare premiums two years later, as the premiums are based on income from the tax return two years prior.
  • Increased adjusted gross income for the year can trigger limitations on other tax benefits that are reduced or eliminated for higher income taxpayers.
  • No reversal - once converted to a Roth IRA, you cannot recharacterize back to a traditional IRA.

Age Considerations

When choosing whether to convert a regular IRA to a Roth IRA, age is a major factor. Younger people who anticipate rising incomes (and, thus, higher tax brackets) may gain more from conversion since the tax benefits of taking tax-free withdrawals from a Roth IRA may offset the initial tax burden. The choice becomes more complicated for elderly people who are getting near to retirement. They need to think about how long it will take for the advantages of tax-free development to outweigh the conversion tax liability.

Other Tax-Related Issues

Non-Deductible Traditional IRAs

You can make pre-tax (tax deductible) or post-tax (non-tax deductible) contributions to a traditional IRA. While nondeductible contributions are not taxable upon conversion, deductible contributions and gains are. Funds from both the taxable and nontaxable components of an IRA are deemed withdrawn ratably upon conversion. Furthermore, a taxpayer's conventional IRAs are all regarded as one, therefore it is not possible to convert the IRA with the highest number of nondeductible contributions. Thus, when deciding how much to convert, a thorough examination is needed beforehand to determine the taxable percentage.

Conversion Income

The amount converted is added to your annual taxable income, which may result in a larger tax obligation or perhaps place you in a higher tax category. The impact on different tax advantages resulting from raising AGI by the taxable conversion amount must be carefully evaluated when deciding whether to convert to a Roth IRA. For example, the taxpayer may forfeit all or a portion of the following tax benefits for the conversion year as a result of the conversion:

  • American Opportunity Tax Credit
  • Lifetime Learning Tax Credits
  • Earned Income Tax Credit (EIC)
  • Child Tax Credit
  • Saver's Credit
  • Adoption Credit
  • Higher Education Interest Deduction
  • Medicare B & D Premiums - 2 Years Later
  • Medical Itemized Deductions
  • Miscellaneous Itemized Deductions (in years after 2025)
  • Nontaxable Social Security
  • Favorable Tax Brackets
  • Capital Gains Rates
  • Loss Allowance for Rental Real Estate

Net Investment Income Surtax

The 3.8% net investment income surtax is imposed when modified AGI above specific thresholds, meaning that higher-income individuals may be subject to an extra tax as a result of the Affordable Care Act's health care provisions. The taxpayer could cross the barrier if their AGI increased as a result of converting to a Roth. Additionally, the extra revenue from a conversion can have a detrimental effect on taxpayers who would otherwise qualify for premium credits for health insurance.

Paying the Tax on a Conversion

How is the tax due on a conversion to a Roth account met? The taxpayer may use money from an IRA or other sources to cover the obligation. If IRA funds are used to pay the tax, they are not included in the rollover or conversion and are thus taxable. If the person is under 59½ at the time of the withdrawal, they may additionally be penalized 10% for early withdrawal.

Tax Strategy

To lessen the tax burden, strategically plan your taxes by spreading out the conversion over a number of years or scheduling it during years when your income is lower.

There are a lot of advantages to converting a regular IRA to a Roth IRA, especially if you desire flexibility or expect higher retirement tax rates. But making the decision to convert shouldn't be rushed. It necessitates a thorough examination of your long-term retirement objectives, tax consequences, and existing financial status. It is strongly advised that you consult with our office to help you understand the nuances of this choice and create a plan that is specifically tailored to meet your needs.