First available in 1998, Roth retirement accounts have quickly become a popular way to save for retirement by allowing participants’ after-tax contributions to grow tax-free and, unlike traditional IRA accounts, not be subject to taxes upon withdrawal. As their popularity increased, employer-sponsored 401(k) plans with a Roth option quickly followed, becoming available for employers to offer to their employees in 2006. According to CNBC, the number of employers offering a 401(k) with a Roth option has nearly doubled to 88% in the past decade.
For younger people who have many years ahead of them to grow and accumulate retirement assets and those who anticipate being subject to higher taxes when they begin making withdrawals, Roth accounts are an especially attractive option. However, Roth accounts do have income limitations and thus not everyone who would like to contribute directly to a Roth is able to.
Those who have previously not had the opportunity to contribute to a Roth account, either due to income limits or lack of availability through their employer, still do have options to grow their retirement funds with the Roth benefits. These are called Roth conversions, and there are two types to be aware of.
A Roth conversion is exactly what it sounds like: pre-tax traditional IRA funds are moved to an after-tax Roth account, thereby converting the funds. The conversion process requires paying ordinary income taxes on the fair market value of the assets being converted so there is no immediate tax break. However, once the conversion is complete, the assets and future earnings will no longer be subject to taxes when withdrawn in retirement. In addition, at the time of the conversion there is no withdrawal penalty which usually applies when funds are withdrawn from a retirement account before a certain age.
Before 2010, Roth conversions, like Roth IRAs, had income restrictions but are now available to everyone regardless of income.
Back-door Roth Conversions
A back-door Roth conversion differs from a regular Roth conversion in that the funds being moved are after-tax IRA funds to an after-tax Roth IRA account. An individual may have after-tax funds in an IRA because they were/are unable to take a tax deduction for the contribution due to income limitations. Although taxes have been paid on the contributions, the earnings will accumulate tax-free but are subject to taxes upon withdrawal in retirement.
To circumvent the income limitations on Roth accounts, an individual can contribute to a nondeductible IRA and then complete a back-door Roth conversion and move the funds over to the Roth account. This should be done immediately after the first contribution is made to minimize the risk of achieving any gains that will inevitably trigger additional taxes being due when the conversion is complete.
In addition, it’s imperative to be aware that holding additional funds in other IRA accounts can also cause additional tax consequences. Called the pro-rata rule, all funds held in non-Roth IRA accounts are aggregated. If some of the assets are pre-tax and some are post-tax, the proportion of pre-tax to post- tax assets is applied to any amounts being converted and taxes will be due on the pre-tax percentage. Simply put, when you are completing the conversion, a portion of it can be considered pre-tax if there are pre-tax IRA funds being held elsewhere. You cannot dictate that only the post-tax IRA funds are the funds that will be converted.
While the thought of having tax-free funds available in retirement is enticing, Roth conversions are not ideal for everyone. For example, if you are performing a standard conversion and are in a high-income tax bracket, you may be required to pay a high amount of taxes on the converted amount that can make a conversion less beneficial. Another less suitable situation is being near retirement with less time to accumulate assets or expecting that your income will drop significantly in retirement and result in being in a lower income tax bracket.
Both of these strategies can have considerable tax advantages and consequences, so it is important to discuss a potential conversion with your Vision Capital Client Relationship Manager to fully understand the impact of any conversion as well as the cost versus benefit for your unique situation.