Roth conversions and backdoor Roth contributions are on the chopping block in congress. It is too early to know what will happen for sure, but there are some indications that this year may be the last chance to move money from a Traditional IRA to a Roth IRA. This type of transfer, a Roth conversion, is a taxable event but can be a great way to optimize taxes depending on your situation. After December 31st it may be removed as an option.
Why Transfer it?
If you have $100 in a Roth IRA and $100 in a Traditional IRA, they don’t have the same spending power. Obviously, they have the same amount of top-line dollars, but if you want to take money out of a Traditional IRA you have to pay taxes first. If your effective tax rate is 30%, then for every hundred dollars in your Traditional IRA it somewhat like you are just holding onto $30 for the government. Regardless of how big or small the account grows, if you tax rate is 30% then you can only spend about 70% of the account value overtime.
If you use a Roth properly you don’t have to pay any taxes to withdraw money! It can all be yours! Plus, there are more ways to spend out of a Roth before retirement than there are in a Traditional IRA. So why not just move all Traditional IRA money to a Roth IRA?
Cost to Move
If you move $100 from a Traditional to a Roth IRA the government wants its share back. So, it is advantages to try and time conversions for years that you have lower tax rates. Remember your tax rate can be much lower some years with no change in the law. For example, if you donate to charity, take a year off from work, or have losses in investments you may have a lower tax rate than an average year. If you expect your income to only increase, it may be worth converting even when it isn’t a particularly low-income year. Plus, Roth IRA’s have some great bonus features!
When you contribute to a Roth (deposit money) you can withdraw that money without tax or penalty before retirement. If you deposit the money to a Roth via a conversion (transfer from Traditional IRA) it can be withdrawn after five years even if you aren’t retirement age. Any profits you make off the deposits need to typically remain in the account until retirement, but the funds can grow tax free each year until you withdraw them.
Another big benefit is that Roth IRAs do not have required minimum distributions. That means regardless of your age, you can keep the funds in the Roth where they can grow tax free as long as you live!
increase your after-tax balance
Taking the example from above, you may think that you can only move $70 of the $100 into the Roth because of the 30% tax. However, the IRS allows you to pay the $30 to them from other accounts such as your checking, savings, or taxable brokerage accounts. If you transfer the full $100, it is like getting to stuff an additional $30 of after-tax money into the Roth, and it can earn profits tax free.
$5 Billion Tax Free
Roth conversions have only been around for about a decade. When Roth IRAs were first introduced in 1997, they were aimed at helping middle and lower income families save for retirement. One of the founders of PayPal, Peter Thiel, has made roughly $5 billion dollars 100% tax free in a Roth IRA using current rules. What he did is not something most people have access to do. In 1999, before PayPal was publicly traded, he purchased shares for the artificially low price of $0.001 inside a Roth IRA. Keep in mind that PayPal did not trade publicly at the time. This is called “stuffing” and one of the many things that the bill aims to curb. Stuffing and conversions are items that will potentially be taken away to return Roth IRAs to the original purpose of helping middle- and lower-income families.
For my clients, I do whatever I can to help them reduce taxes legally. That is why I want to do everything I can to help clients take advantage of this while it is allowed, but I think the tax code will be fairer if conversions and a few other items on the chopping block get the axe. This doesn’t mean I agree with all things in the bill, but this part makes sense to me. There is always the potential for further law changes to Roth and Traditional IRAs, but in my opinion the changes being proposed are well within the realm of reasonable.
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