With President Biden and Congress looking at a federal tax increase in 2021, this may be the time to consider converting savings from a traditional IRA into a Roth account for tax-friendly features that benefit retirees and their families.
Roth IRAs were created by Congress as part of the Taxpayer Relief Act of 1997, allowing people to deposit after-tax income into retirement accounts. In return for paying taxes up-front, savers see fewer restrictions and there are no taxes on growth or withdrawals.
But Roth accounts were not created for everyone. Income limits have prohibited high-earning retirement savers from opening Roth accounts, but there is a loophole in the tax code that allows higher earners to benefit from the retirement savings option.
This backdoor Roth IRA strategy allows investors to convert money from a traditional IRA to a Roth IRA. Of course, investors who take advantage of this loophole must pay taxes on the money they move from the traditional IRA, but if the traditional IRA money is moved directly into a Roth, there are no penalties. Once a traditional IRA is entirely converted to a Roth, another part of the loophole opens. Savers can deposit up to $6,000 per year into their nondeductible traditional IRA, then convert that contribution into their Roth and pay no income taxes.
With a potential tax increase looming, this may be a good time to consider a backdoor conversion to avoid paying a higher tax rate on traditional IRA withdrawals. In addition to Roth investments growing tax free, people enjoy other benefits as well.
There are no minimum distribution requirements for Roth accounts. That means the government cannot force investors to withdraw their money at age 72, like it can with traditional IRAs. Because Roth IRAs have no required minimum distribution age, a person can convert traditional IRA savings to a Roth account and leave the money for their children to draw from tax-free for up to 10 years.
Also, a saver can withdraw contributions from a Roth account without paying income taxes or a penalty regardless of their age. However, there are restrictions on withdrawing investment earnings for those younger than 59½. But those taxes and penalties are waived if the money is used for certain purposes, such as the down payment of up to $10,000 on a first home, or if the saver becomes permanently and totally disabled.
Earnings also can be withdrawn to help pay for the birth or adoption of a child, or to pay for qualified education expenses, such as tuition, fees, books, and housing, but, in this instance, the saver would have to pay income taxes. The 10% penalty would be waived, however.
Each investor’s situation is different, so it is always a good idea to consult with a financial fiduciary, but generally, Roth accounts are the best type of retirement savings vehicle, by far, and this may be a good time to make the move.