The threat of higher tax rates in the future emphasizes the importance of a tax-free source of income. For this reason, a Roth IRA can be a very effective planning tool. By preserving the Roth IRA for as long as possible, you are providing the opportunity for maximum growth to an account that can be income-tax-free.

Benefits of a Roth IRA

The benefit of a Roth IRA is that it is essentially an income-tax-free vehicle. While assets in a traditional IRA benefit from tax-deferred growth, future distributions are taxed at ordinary income rates. Alternatively, Roth IRA accounts not only grow on a tax-free basis while in the account, but distributions are also income-tax-free in the future. Further, there are no required minimum distributions (RMDs) from Roth accounts unless they are inherited accounts. This can be a significant advantage in terms of your estate plan and may be a good reason to consider converting funds. Inherited accounts may have RMDs, but the distributions are still tax free. From an estate planning perspective, Roth IRAs are a great way to leave tax-free money for heirs.

Given the long-term benefits that Roth IRAs can provide in planning, conversions from traditional IRAs to Roth IRAs should be evaluated in the scope of one’s overall income tax and estate planning. Although there is an upfront tax paid when the conversion takes place, in environments where markets are suppressed this tax could be less burdensome and the conversion more beneficial in the long run. Additionally, in a year when your taxable income is low, it might be beneficial to pay the tax on the traditional IRA funds at a lower tax rate than you might incur in the future.

There are no limits to the number of Roth IRA conversions you can make. Converting to a Roth IRA is a taxable event where the tax is based on the fair market value of the traditional IRA at the time of conversion. As mentioned earlier, if the traditional IRA is currently undervalued, then the resulting conversion tax would be lower as well. Additionally, once converted, any rebound of value inside the Roth IRA would be income-tax-free.

Considerations when converting an IRA

When you convert funds from a traditional IRA to a Roth IRA, you need to aggregate all traditional IRAs and Simplified Employee Pension (SEP) IRAs/SIMPLE IRAs you own (other than IRAs you’ve inherited) when you calculate the taxable portion of your conversion. If you have made only deductible contributions to your traditional IRAs, then the entire amount of any funds that you convert will be taxable. However, if you have ever made nondeductible contributions to your traditional IRA, then those contribution amounts will not be taxable when converted to a Roth IRA, since they have already been taxed. In this case, the amount that you convert to a Roth IRA will include a pro-rata amount of pre-tax and after-tax dollars.

You may also benefit from a Roth IRA if you are not eligible for deductible IRA contributions. For 2022, your total contributions to all of your traditional and Roth IRAs cannot be more than $6,000 ($7,000 if age 50 or older). However, if you are covered by a retirement plan at work, you may not be eligible to deduct your contribution to your traditional IRA if your modified AGI is too high (phased out over $78,000 for single or head of household, $129,000 for married filing jointly, or $10,000 for married filing separately). If you are not covered by a retirement plan at work, you may be eligible to contribute to a traditional IRA (deductible) or Roth IRA as long as you have earned income.

The conversion rules allow you to contribute to a Roth IRA if you wouldn’t otherwise be able to make regular annual contributions because of income limits. In 2022, you cannot contribute to a Roth IRA if you earn $214,000 or more (married filing joint) or $144,000 or more (single). Alternatively, you can simply make a nondeductible 2022 contribution to a traditional IRA and subsequently convert that traditional IRA to a Roth IRA. Also note that you can convert SEP IRAs and SIMPLE IRAs that are at least two years old to Roth IRAs.    

Remember, anyone can convert a traditional IRA to a Roth IRA. There are no income limits, or restrictions based on your tax filing status. Any nondeductible contributions you have made to your traditional IRA will not be taxed when you convert.

As with all tax strategies, there are many variables that factor into the decision to make the conversion, such as the expected future tax rate and investment growth, the age of the account holder, and aggregation rules. A detailed analysis of the various factors is highly recommended.

For more information about retirement plans, please read Understanding the Tax Treatment of Retirement Plans.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. There is no assurance that any investment, financial or estate planning strategy will be successful. These strategies require consideration for suitability of the individual, business or investor.

Wilmington Trust is not authorized to and does not provide legal or tax advice. Our advice and recommendations provided to you are illustrative only and subject to the opinions and advice of your own attorney, tax advisor or other professional advisor.