Roth Conversion Ending – Tax Considerations

For many individuals, a Roth conversion is a tax-deferred way to take advantage of tax-free withdrawals. But a new proposal in the House could end this strategy for high earners.

The proposed legislation, dubbed the Build Back Better Act would prohibit IRA and 401(k) plan Roth conversions for people earning more than $400,000 a year. It would also eliminate so-called “mega backdoor Roth” conversions, which allow investors to convert up to $38,500 in extra after-tax contributions into a Roth account.

Taxes

Several different tax considerations can impact your Roth conversion ending. Ultimately, you should consult with a qualified tax professional to determine the best strategy for your situation.

One factor to consider is your taxable account profile. If you have a lot of taxable assets in a brokerage account, you may need to liquidate them to pay the tax due on your conversion.

Another factor is your income. If you have a lower tax rate this year than usual, you can save some of the taxes that would otherwise be due by doing a Roth conversion.

Lastly, it would help if you also considered the timing of your Roth conversion. You should wait until a few years before taking Social Security benefits. This will help avoid having your Roth conversion money count toward your Medicare premiums or Social Security taxes.

Investments

Investments refer to putting your hard-earned money into something that can generate income or appreciate over time. They can include stocks, bonds, real estate, alternative assets, or commodities investments.

Investing is essential to meeting long-term goals such as retirement, child education, or paying off debts. It also helps you beat inflation and preserve wealth over time.

However, investors should be aware of liquidity restrictions. Some investments, such as government bonds and fixed deposits, can be challenging to sell, especially if the account is locked in for some time.

The best place to park your hard-earned money is in a taxable brokerage account, where you can earn tax-free capital gains. If you must pay a conversion tax with IRA funds, be sure to liquidate enough to cover the tax and then reinvest the remaining money in another account that is a better fit.

Roth conversions could be an excellent way to recoup some of the lost capital from a down market, but they also have significant downsides. For example, they can increase Medicare premiums and Social Security taxes.

Re-characterization

Roth conversion endings can be tricky, especially when your income increases or your tax rates change. In these cases, it can be more prudent to re-characterize your contribution to a different type of IRA rather than paying taxes on the conversion amount and losing the benefits.

If you re-characterize your contributions, you must transfer the total amount of the original gift, plus any attributable earnings, to another IRA account. You can use a trustee-to-trustee transfer to accomplish this, but you must notify the custodian of your new IRA about the transaction.

This can be complicated, but it can also be a great way to fix any mistakes you made during a Roth conversion. For example, if you had a mistaken belief about the income limits of a Roth IRA and ended up contributing more than allowed.

Tax-free withdrawals

In a Roth IRA, earnings can be withdrawn tax-free as long as you are at least 59 1/2. You can also exit contributions to your IRA without penalty at any age.

In contrast, withdrawals from your taxable account are subject to ordinary income taxes and capital gains taxes on profits from securities. Moreover, returns can also be taxed at a lower rate for heirs.

A Roth conversion ending occurs when you reposition a Traditional or other qualified retirement plan asset into a Roth account. This is commonly done through in-plan rollovers from an employer-sponsored 401(k), 403(b), or 457(b) plan to a designated Roth account.

However, there are essential considerations for taxpayers executing a Roth conversion. One of these is the IRS’s five-year holding period requirement, which begins when you make your first contribution to a Roth IRA.