Income taxes drive many personal finance decisions, including saving for retirement. For higher income earners, Roth IRA conversions may be a clever way to minimize the tax burden during your golden years, which means more funds free to support you in your hard-earned time of rest.

But when it comes to this unique financial tactic, also sometimes known as the “backdoor Roth,” there are both pros and cons to consider.

Read on to learn more about how this strategy might help you meet your retirement goals — as well as some downsides to beware of.

How Does a Roth IRA Conversion Work?

Let’s start with the basics: how does a Roth IRA conversion work? First, we have to understand the difference between Roth and traditional accounts.

Many people invest in Roth IRAs to minimize taxes while in retirement. By contributing after-tax dollars, you can withdraw any earnings in retirement tax-free. In contrast, if you utilize a traditional IRA, you can get a tax deduction based on your contributions in the year they’re made, and your money grows tax-free — but your withdrawals in retirement will be taxed at ordinary income rates.

Obviously, Roth IRAs offer a better tax incentive at the time of retirement (though don’t forget, you’ll still pay taxes before contribution). For many earners, Roths seem like the best possible option. There’s a catch, however: Roth accounts come with strict income limits, and those who earn more than these caps are ineligible to contribute to a Roth — directly, that is.

Enter the Roth IRA conversion.

A Roth IRA conversion is exactly what it sounds like; converting funds held inside a traditional IRA to a Roth IRA. Many people choose to do this because their income exceeds the limit for Roth IRAs. For example, in 2022, the modified adjusted gross income needs to be less than $129,000 for single filers and $204,000 for married & joint fliers to be eligible for the entire contribution. However, there is no income limit on conversions, making the conversion very desirable for high earners looking to minimize their tax burden at retirement time.

Benefits of a Roth IRA Conversion

If you know or believe that your taxable income in retirement will be higher than today, then you should think seriously about a Roth IRA. While there is no tax break now, having your contributions and earnings grow tax-free over time is advantageous in a variety of ways.

For one thing, this strategy may allow you to pay less in taxes long term, depending on what your tax brackets look like at different points along your career. Because they don’t have RMDs, or required minimum distributions, Roth accounts can also be excellent tools for passing along funds as an inheritance. (The IRS enforces required minimum distributions, which force you to begin withdrawing money from your traditional retirement accounts on an annual basis once you have reached a certain age — currently 70 ½ or 72.)

In addition, lower than normal portfolio valuations (due to market corrections, for instance), expiring tax carryforwards (losses from previous tax years that carry over to the next year), tax credits, and higher than normal itemized deductions could provide additional incentives to do a Roth conversion.

Another benefit to Roth IRA conversions is the ability to withdraw funds tax and penalty-free.

With a Roth IRA, you can withdraw your contributions (but not earnings) at any point in time, for any reason, tax-free — after all, you already paid income taxes on your contributions before you made them. And while we don’t recommend our clients use their Roth retirement accounts as emergency reserves, in a real catastrophe, this rule could be helpful.

Downsides of a Roth IRA Conversion

Like any sound financial strategy, execution is vital, and there are always pitfalls along the way. When implementing a Roth IRA conversion, you must be mindful of the potential larger-than-expected tax bill that may occur.

The funds you transfer from a traditional IRA to a Roth IRA will be added on top of your current income and taxed at an ordinary income tax rate.

Converting the right amount is essential as too much could push you into a much higher income tax bracket.

Even if you calculate that implementing the Roth IRA conversion will lower taxes long-term, ensuring that you have funds available for the tax bill at the time of conversion is critical, too. Ideally, funds from outside of your retirement account are best, so you can maintain the full value of your Roth IRA conversion.

While you have the opportunity to withdraw your contributions at any time for any reason from a Roth IRA, you do have to wait five years and be age 59½ so as not to incur any withdrawal penalties. In addition, you can be charged taxes and a 10% early withdrawal penalty on any earnings you take from the account unless you have a qualifying reason to do so (such as becoming totally and permanently disabled or buying your first home).

Will Roth Conversions Go Away?

With the Roth IRA conversion becoming more popular amongst high-income earners, it has recently drawn a lot of attention from Congress. In fact, President Biden’s Build Back Better Act (passed by the House) sought to end the abuse of Roth accounts by the wealthy.

It’s easy to understand the controversy. For example, Paypal’s co-founder Peter Thiel had a Roth IRA balance of less than $2,000 in 1999, and by the end of 2019, it was worth over $5 billion! But, and here is the kicker, Peter made no Roth IRA contributions after 1999. So Peter would only need to wait until he turns 59 1/2 to withdraw $5 billion tax-free.

Therefore, with the legislative crosshairs on this retirement strategy darling, you don’t want to wait to contact your trusted financial professionals to see if this is a good strategy for you.

If you’re still unsure about utilizing a Roth IRA conversion, contact us at Felton & Peel Wealth Management, and we will be able to walk you through your options so you can choose what works best for your needs. So please call us today to get started!