Elm3’s Guide to Roth Contributions and Conversions
Roth IRAs are popular savings vehicles because they could reduce your taxable income in retirement. You contribute after-tax dollars to a Roth IRA or 401(k), meaning that eventual distributions likely will not be taxed.
There are a number of reasons to contribute to a Roth IRA or 401(k):
- You can hedge against increased taxes. Taxes tend to increase each year, and if you assume that you will owe more taxes on your income down the line, you can contribute to a Roth IRA when you are in a lower income tax bracket.
- You can take advantage of years with lower earnings. There are years where one spouse in the household may not work, where an earning member of your household is unemployed for a portion of the year, where your capital gains are lower than expected, or where another event occurs that lowers your taxable income. Teenagers working their first job could also benefit from opening a Roth IRA, given that they are likely in the lowest income tax bracket that they will ever be in. Making a Roth conversion or contribution during those years can allow you to take advantage of being in a lower tax bracket, as long as you can afford the associated tax bill.
- Your earnings can grow tax-free. As long as you follow the Roth IRA withdrawal rules, your Roth IRA can grow, and you will not pay taxes on that growth. The Roth IRA withdrawal rules include…
- Withdrawing the funds after age 59 1/2 AND after a five-year holding period
- Withdrawing the funds for other qualified reasons, such as first-time home purchases or college expenses.
- You can leave your beneficiaries a tax-free inheritance. Non-spousal IRA and 401(k) beneficiaries will need to deplete tax-deferred IRA and 401(k)accounts within 10 years of inheritance, increasing their taxable income during those years. While non-spousal Roth IRA or 401(k) beneficiaries will also need to deplete the Roth account, they will not face taxes on these distributions.
How can you add funds to a Roth IRA or 401(k)?
You can either contribute directly to a Roth account or complete a Roth conversion. If your income disqualifies you from directly contributing to a Roth IRA, you may choose to do a Roth conversion. Additionally, there are limits on the amount of direct contributions you can make to a Roth IRA each year, but you can convert any amount of funds from an IRA to a Roth IRA, provided you are prepared for the tax bill. With a Roth 401(k), you can contribute as long as your employer offers a Roth 401(k) option and as long as your total 401(k) contributions remain below the limit for that year.
Direct Roth Contributions
You can contribute to a Roth IRA at any age, provided you have earned income during the year of contribution. You cannot contribute more than you earned in a year. In 2023, you can contribute up to $6,500, or up to $7,500 if you are 50 or older. Keep in mind that the $6,500 contribution limit includes both traditional and Roth IRA contributions. For example, if a 35 year-old contributes $4,000 to a traditional IRA in 2023, she can only contribute $2,500 to a Roth IRA in the same year.
In 2023, you can make a direct Roth contribution of up to $6,500 or $7,500 if your adjusted gross income falls at or below these thresholds:
- Single: $138,000
- Married Filing Jointly: $218,000
You can make a partial Roth contribution if your adjusted gross income is between the following thresholds:
- Single: $138,000-$153,000
- Married Filing Jointly: $218,000-$228,000
Above these thresholds, you cannot make a direct Roth IRA contribution. However, you could look into a Roth conversion.
With a 401(k) in 2023, you can contribute up to $22,500, or $30,000 if you are 50 or older. Similar to IRAs, there is a shared contribution limit for traditional and Roth 401(k) contributions.
Roth Conversions
You can convert any amount of your traditional IRA savings into a Roth IRA. However, a portion or all of your conversion will be taxable.
To calculate the tax-free portion of your conversion, you will add together the value of all of your IRA accounts after the conversion, the value of your conversions, and any annual distributions made from your IRA accounts. You will then divide this sum from the total nondeductible contributions within your IRA accounts.
For example, pretend you have a traditional IRA worth $6,000 and a rollover IRA worth $14,000. Your IRAs include $5,000 of nondeductible contributions. You plan to convert $5,000 of your rollover IRA into a Roth IRA. To calculate the tax-free portion of your conversion, add together the post-conversion value of all of your IRAs ($6,000 +$14,000 – $5,000) with the conversion value ($5,000). You would arrive at $20,000. You would then divide your nondeductible contributions ($5,000) by the above sum ($20,000). You would find that 25% of your conversion would be tax-free, and 75% of your conversion would be taxable.
Tax Considerations in Roth Conversions
Overall, it is best to work with a tax professional in deciding the right timing and amounts for Roth conversions. Doing so can help you avoid some common tax pitfalls.
You want to avoid bumping yourself into a higher tax bracket with a Roth conversion. Pretend you are a single filer with an adjusted gross income of $182,000 in 2021. You would fall into the 24% tax bracket. However, if you completed a Roth conversion that increased your adjusted gross income over $182,100, you would fall into the 32% tax bracket. It is best to consider your tax bracket when determining the size of your Roth IRA contributions or conversions.
You can plan Roth IRA contributions or conversions for years when your income is lower, such as during a year when you are unemployed. As long as you can afford the tax bill, doing so could allow you to take advantage of the lower tax rates during a lower earnings year. You may consider Roth conversions between the time when you retire and the time you turn 72. Your earnings tend to be lower during the years after retirement and before you take required minimum distributions (RMDs).
Be careful of the Medicare surcharge. In 2023, higher earners can end up paying anywhere from $230.80 to $560.50 for Part B, while the standard Part B premium is $164.90. An increase to your modified adjusted gross income could also increase your Part D premiums. Increasing your income through a Roth conversion could thus significantly increase your medical premiums. Keep in mind that Medicare surcharges are based on your tax return from two years ago. If you completed a Roth conversion in 2019, you wouldn’t experience the Medicare surcharge until 2021, and at that point, the increased medical premiums could take you by surprise.
You can use Roth IRA distributions to decrease or avoid Medicare surcharges. When you take a traditional IRA distribution, the distribution increases your taxable income and could result in a surcharge. However, Roth IRA distributions do not increase your taxable income or put you at any more risk of a surcharge. You could accordingly plan for higher Medicare costs from your conversion but lower Medicare costs when you take Roth distributions. Additionally, you could consider a Roth conversion at age 62. When you apply for Medicare at 65, your conversion would fall outside the two-year look-back window and would not be included in calculating your Medicare premiums.
Roth conversions could increase taxation on your Social Security benefits. Your Social Security tax bracket depends on your provisional income. Provisional income includes half of your Social Security benefits, tax-exempt interest earned during the year, and any non-Social Security income that would be included in your adjusted gross income. Up to 50% to 85% of your benefits are taxable if your provisional income falls between specific thresholds:
Roth conversions would increase your provisional income and could result in more of your benefits being taxed. You could avoid this by delaying claiming your Social Security benefits until after you complete a Roth conversion.
Roth conversions could increase your capital gains tax bill. Your long-term capital gains are taxed at a 0%, 15%, or 20% rate, depending on your taxable income. With the increase in taxable income from a Roth conversion, you could go from paying 0% on capital gains to 15% or even 20%.
Should you complete a Roth conversion?
I highly recommend speaking with a tax professional to determine the best decision for you and your family. A tax professional can project your expected taxable income and can help you make decisions about Roth conversions.
