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Roth Accounts vs. Tax-Deferred Accounts

Understanding a Roth conversion begins with knowing the difference between a Roth retirement account and a tax-deferred account, such as a traditional IRA or 401(k).

Contributions into a traditional IRA or 401(k) are made with pre-tax dollars. For a traditional IRA you may be able to claim a tax deduction for the amount you invest. For example, you might have had $50,000 in taxable income, but if you contribute $6,000 of that to an IRA/401(k), you’re taxed on only $44,000 of your income, assuming you claim no other tax deductions. But that $6,000 plus any earnings becomes taxable income when you withdraw it from the account in retirement.

You can’t claim a tax deduction for amounts you contribute to a Roth IRA. Your contributions will not subtract from your taxable income in the year you make them, but they won’t be taxed when you withdraw the money from a Roth, either. Withdrawals from a Roth account aren’t taxable because you’ve already paid taxes on the money in the year you contributed it to your account.

Roth earnings can be withdrawn tax-free if they’re “qualified.” This means you’ve held the account for at least five years, you are age 591/2or older, or the distribution is being taken because you’ve become disabled, died, or are taking the money for a first-time home purchase.

What is a Roth Conversion?

A Roth conversion involves taking money from a tax-deferred account and moving it into a Roth account, where it will grow tax-free. A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. In other words, once you pay taxes on the money that goes into a Roth IRA, you will not pay taxes on the money you takeout. This may be especially beneficial based on the current tax rates and tax brackets. The Tax Cuts and Jobs Act of 2017 contains a “sunset,” or expiration, for many of its provisions. Unless otherwise changed, the tax rates and brackets will revert to 2017 levels. Converting to a Roth also means you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. If you don’t need the money, you can keep your money invested and pass it to your heirs.

You can convert a traditional IRA to a Roth IRA in2021. There are no income limits, or restrictions based on your tax filing status. Taxes will come due on the amount you move into a Roth in that tax year, just as they would if you took the funds out in retirement, but any nondeductible contributions you have made to your traditional IRA won't be taxed when you convert.

The conversion rules can also be used to allow you to contribute to a Roth IRA in 2021 if you wouldn't otherwise be able to make regular annual contributions because of the income limits (sometimes called a" back door" Roth IRA). In 2021, you can't contribute to a Roth IRA if you earn $208,000 or more and are married filing jointly, or if you're single and earn $140,000 or more. Instead, you can simply make a nondeductible 2021 contribution to a traditional IRA, and then convert that traditional IRA to a Roth IRA. You can contribute up to $6,000 to a traditional IRA in 2021, $7,000 if you're 50or older.

Remember that you can also convert SEP IRAs, and SIMPLE IRAs that are at least two years old, to Roth IRAs. And, if you're eligible for a distribution from your employer retirement plan [for example, a401(k) or403(b) plan], you may be eligible to transfer or roll those distributions over to a Roth IRA as well.

The Bottom Line

A Roth IRA conversion can be a very powerful tool for your retirement. If your taxes rise because of changes in tax law—or because you earn more, putting you in a higher tax bracket—a Roth IRA conversion can save you money in taxes over the long term. And the backdoor strategy, well, opens the Roth door to high-earners who normally would be ineligible for this sort of IRA, or who are unable to move money into a tax-free account by other means.

Together, we can work to keep you on-track towards your financial goals. Request a consultation with me to learn more.

Read more articles by Robert Fix