Things to Know About Roth Conversions

People who make up to a certain amount of money can open a Roth IRA; however, if your income exceeds that level, you cannot open a Roth IRA. When you eventually retire, you're stuck paying taxes on withdrawals from your retirement account. Or perhaps you're not.

Many retirees who are ineligible for a Roth IRA convert their funds from a regular IRA to a Roth one in order to lower their retirement taxes. A Roth conversion is the name for this method. Because it enables persons who would not typically be eligible for a Roth IRA owing to their income to set up a Roth, it is also known as a backdoor Roth IRA conversion.

Here are 6 things to know about the Roth conversions:

1. Who can contribute to a Roth IRA?

If your modified adjusted gross income (MAGI) is $138,000 for single filers and $218,000 for married couples filing jointly in 2023, you are not eligible to contribute to a Roth IRA. However, there is a workaround. Regardless of your income level, a Roth IRA conversion enables you to transfer all or a portion of your current conventional IRA funds to a Roth IRA.

2. Roth conversions aren't right for everyone

Consider a Roth conversion as a way to prepay your income taxes in retirement. Only if you believe your tax rate today is lower than it would be in retirement would you take this action.

For instance, you might currently be paying taxes at 12% of your income. But you anticipate being in the 22% tax bracket when you retire because of your diligent saving. Or, you might strongly believe that future tax rates will increase overall, raising the 12% tax band to 15%. The conversion would enable you to pay a reduced tax rate today rather than a greater tax rate in either scenario.

A Roth conversion is not the best course of action, however, if you anticipate having a reduced tax rate in retirement for whatever reason. When you may pay less in the future, why pay more today?

3. If your income exceeds the Roth IRA income limits, you can still convert it to a Roth.

The IRS establishes annual income caps for Roth IRA contributions. These restrictions may reduce the amount you are able to contribute or forbid Roth IRA contributions altogether.

Strangely, Roth conversions are not subject to income restrictions on Roth IRAs. Therefore, even if your income is too high to contribute directly to a Roth IRA, you can still make a traditional IRA contribution and convert it later. This is a so-called backdoor Roth IRA. The outcome is the same as a direct contribution, but there are a few extra steps required to get there.

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