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Now May Be a Good Time to Consider a Roth Conversion by Rick Bazzani, CPA

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Posted on May 26, 2021 by Rick Bazzani

When it comes to retirement savings, taxpayers generally have a choice: pay taxes on their contributions today or pay taxes on their withdrawals in retirement. For high-net-worth taxpayers, this decision is already determined by the U.S. tax code. However, with the prospect of higher taxes under the Biden Administration, wealthy individuals have a small window of opportunity to take advantage of today’s low tax rates and convert a traditional IRA funded with pre-tax dollars to a Roth IRA that provides tax-free distributions of income in the future.

The Basics: Traditional IRA Vs. Roth IRA 

One of the primary differences between traditional IRAs and Roth IRAs is the timing of the tax benefits and liabilities. Contributions to traditional IRAs receive an immediate tax break in the form of a deduction that can lower your taxable income in the years you contribute. Earnings grow tax-deferred until you reach age 59½, at which point your withdrawals will be subject to ordinary income taxes. Distributions taken from traditional IRAs before this age will also incur early withdrawal penalties. Once you turn 72, the IRS generally requires you take taxable required minimum distributions (RMDs) each year, regardless of whether you need those dollars to fund your retirement years.

Conversely, with a Roth IRA, you pay taxes up-front on your contributions and take future withdrawals in retirement tax-free. Over the years, your contributions, combined with compounding interest and market gains can grow exponentially free of tax, which is ideal if you expect to be in a higher income bracket during your retirement. Moreover, there is no requirement that you take withdrawals from a Roth IRA when you reach a particular age. However, not all taxpayers qualify to contribute to a Roth IRA during their prime earning years. For example, in 2021, single taxpayers with annual modified adjusted gross income (MAGI) above $140,000 are not eligible to contribute to a Roth IRA. For married couples filing joint tax returns, household MAGI may not exceed $208,000.

Roth IRA Conversions  

To work around the Roth IRA contribution limits and receive the benefit of tax-free withdrawals in retirement, wealthy individuals have the option to convert a traditional IRA to a Roth or to complete a legal back-door IRA with the knowledge that doing so will have immediate tax implications.

If you choose to convert a traditional IRA to a Roth IRA and yield tax-free future growth, you must immediately pay tax on the amount you convert. This means you would need to pay back to the federal government any tax deductions you took on your original contributions as well as taxes on any investment gains you earned in the traditional IRA up to the point of the conversion. It is important to also remember that the IRS will treat the converted amount as taxable income, which may bump you into a higher income tax bracket with higher tax rates. Consequently, while you may have a substantial tax liability in the year of the conversion, the amount you would pay at today’s record-low rates are far less than you would pay in the future on taxable withdrawals taken in retirement when rates are expected to increase.

Although the Biden administration has not formally laid out its plans for tax reform, some of the proposals on the table include increasing the top income tax rate to 39.6 (from 37 percent) for taxpayers making more than $400,000 annually, increasing the capital gains rate for households making more than $1 million a year to 39.6 percent (from 23.8 percent) and changing the deduction currently available for contributions to traditional IRAs and 401(K) plans to a tax credit equal to a portion of the contributed amount. The good news for taxpayers at every income level is that you can plan today for the prospect of higher taxes in the future.

The advisors and CPAs with Berkowitz Pollack Brant have deep experience helping clients project out future tax liabilities under various scenarios and ensuring the chosen paths align with your unique financial needs and estate planning goals.

About the Author: Rick D. Bazzani, CPA, is a senior manager in the Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs, where he provides individuals and business owners with a broad range of tax-efficient estate, trust and gift-planning services.  He can be reached in the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or at info@bpbcpa.com.