In this article, we will discuss whether you should consider a Roth conversion or not. We will cover the tax and investment implications of this decision and the factors to consider when making it. We will also provide a comparison between Roth accounts and tax-deferred accounts and explain what a Roth conversion is and how taxes on the conversion are determined. We will also discuss the financial significance of this decision and the potential advantages and disadvantages of a Roth conversion. Finally, we will answer some common questions regarding this topic.
Roth Accounts vs. Tax-Deferred Accounts
To understand a Roth conversion, you must grasp the difference between a Roth retirement account and a tax-deferred account like a traditional IRA. In a traditional IRA, contributions are deposited with pre-tax dollars. In the tax years 2021 and 2022, you can claim a tax deduction for the amount you invest, up to $6,000 (or $7,000 if you are age 50 or older). You might have a taxable income of $50,000, but if you invest $6,000 of that in a traditional IRA, only $44,000 of your income will be taxed, assuming you do not claim any other tax deductions. However, these contributions become taxable when you withdraw them from the account at retirement.
For a Roth account, you cannot claim a tax deduction for the contributions you make. Your contributions will not reduce your taxable income in the year you make them, but they will not be taxed when you withdraw money from the Roth account. Withdrawals from a Roth account are tax-free because you have already paid taxes on the amount you contributed in the year you deposited it in your account.
The growth and earnings of the tax-deferred account are also taxable in the year they are withdrawn, but you can withdraw earnings from a Roth account without paying taxes if they are “qualified.” This means you must have had the account for at least five years and be at least 59 and a half years old, or the withdrawal is due to disability, death, or for purchasing a first home.
What is a Roth Conversion?
A Roth conversion involves taking money from a tax-deferred account and transferring it to a Roth account where it will grow without tax obligations. Taxes will be due on the amount you convert to a Roth account in that tax year, just as if you had withdrawn the money at retirement.
The tax authorities do not care whether you reinvest the amount converted from the tax-deferred account or spend it on retirement enjoyment when it is withdrawn from the traditional IRA. This amount was not taxed when you contributed to it, so it is taxable now.
Note: Taxes are due for the tax year in which the withdrawal occurs. For example, you will report the revenue on your tax return for the year 2021, submitted in 2022, if you withdrew the conversion at any time from January 1 to December 31, 2021.
What if I Made Non-Deductible Contributions?
A portion of the amount you convert to a Roth account may not be taxable if you made non-deductible contributions to your traditional IRA or 401(k) account – meaning you did not claim a tax deduction for that money in the year you made the deposit. Unfortunately, you cannot take only the non-taxable portion from the traditional IRA or 401(k) and consider it equivalent. The law requires that every dollar you convert be divided between non-taxable contributions and taxable contributions, based on the ratio that non-taxable contributions represent of your total retirement account balances.
Note:
The use of non-deductible IRA contributions to transfer money to a Roth IRA is sometimes referred to as the “backdoor Roth IRA” strategy.
For example, let’s assume you made non-deductible contributions to your IRA of $8,000 and the total value of your traditional IRA account is $80,000. If you decide to convert $10,000, then 10% (derived from the $8,000 contribution representing 10% of the total balance) of your IRA account, which is $1,000 ($10,000 × 10% = $1,000), will not be taxable. You will pay taxes on the remaining amount of the conversion, which is $9,000.
Am I Eligible for a Roth Conversion?
First, income limits may prevent you from making contributions to a Roth IRA. You may be able to…
Source: https://www.thebalancemoney.com/should-you-do-a-roth-conversion-2894481
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