“Back Door” Roth Conversions: Should You Convert Your Traditional IRA into a Roth IRA?

Q. My husband and I are hoping to retire in five years, and we’re finally ready to do our retirement planning and estate planning. We both have significant amounts in traditional IRAs and are wondering if we should consider converting some or all of that money to a Roth IRA now, while the income tax rates are still historically low, as I understand that these rates are expected to go up in 2026, or possibly sooner. But we’re also confused about the rules, because we’ve always earned too much income to contribute to a Roth IRA, so are we even eligible to convert?

A. Many who are saving for retirement have large traditional IRAs, and many, like you, are confused about the rules to be able to convert traditional IRA accounts into a Roth IRA accounts. It is very important to understand that the rules for Roth IRA contributions simply do not apply to Roth IRA conversions. There are many complex rules governing whether you can contribute your income to a Roth IRA while you are working. But you can convert traditional IRA funds to a Roth IRA at any time without regard to the Roth IRA contribution rules. Let’s first take a look at the pros and cons of Roth IRAs versus traditional IRAs, and then we’ll examine the rules regarding whether you can contribute your income to a Roth IRA. Finally, we’ll examine the benefits of converting from a traditional IRA to a Roth IRA.

Advantages of a Roth IRA

A Roth IRA is an individual retirement account (IRA) that allows certain distributions or withdrawals to be made on a tax-free basis, assuming specific conditions have been met. Here are some things you should know about Roth IRAs compared to traditional IRAs:

• Two of the most important features of a Roth IRA are tax-free growth and no required minimum distributions during retirement. In comparison, a traditional IRA also provides tax-free growth, but requires annual minimum distributions starting at age 72.
• A Roth IRA allows you the flexibility to make early withdrawals without penalty under certain circumstances.
• Roth IRAs do not provide a tax deduction in the years they’re funded, meaning they’re funded with after-tax dollars. This means that contributing your income to a Roth IRA allows you to later take tax-free withdrawals. In other words, withdrawals from a Roth IRA are generally not subject to tax because you funded the plan with money that was already taxed. In comparison, with a traditional IRA, contributions are generally fully deductible (meaning that you are contributing pretax income), earnings grow tax deferred, you pay income tax on all withdrawals, and you pay a 10 percent penalty if you take a withdrawal before age 59 1/2 under most circumstances.
• Although there is no age limit to open a Roth IRA, there are income and contribution limits that you must be aware of before opening and contributing your income to a Roth IRA.
• No matter when you open a Roth IRA, you have to wait five years to withdraw the earnings tax-free.
• Roth IRAs are ideal if you want to avoid required minimum distributions and/or leave tax-free funds to your heirs.

Back Door Roth Conversions

It is vitally important to understand that the income limitation rules and the contribution limitation rules explained above apply only to Roth IRA contributions; they do not apply to Roth conversions. If you have a traditional IRA, you can always convert some or all of that money to a Roth IRA regardless of whether you have countable income, and regardless of whether you were prohibited from establishing a Roth IRA while you were working because of the income limits and/or contribution limits discussed above. There is never any limit on how much you can convert from an existing traditional IRA to a Roth IRA. Because of this, Roth IRA conversions are sometimes referred to as funding a “back door” Roth IRA.  Please note that when using this “back door” Roth IRA strategy to do Roth conversions, you still can’t withdraw the converted funds for five years without incurring a penalty.

One reason people do Roth IRA conversions is to take advantage of the many benefits already mentioned. But one of the biggest potential benefits of doing a Roth conversion this year (and perhaps every year until 2026) is taking advantage of the extremely low tax rates that exist right now. Keep in mind that when you withdraw that money from your traditional IRA, the withdrawn amount is 100 percent subject to income tax at whatever the prevailing income tax rates are at that time.

In 2017, the top income tax rate fell from 39.6 percent to 37 percent, while the 33 percent bracket dropped to 32 percent, the 28 percent bracket to 24 percent, the 25 percent bracket to 22 percent, and the 15 percent bracket to 12 percent. The lowest bracket remained at 10 percent, and the 35 percent bracket was also unchanged. However, these changes are temporary, set to sunset at the end of 2025, and might increase as early as 2022. Click here for a copy of the current Federal income tax tables.

When Can You “Contribute” to a Roth IRA?

First of all, please note that “contributing” to a Roth IRA is completely different from rolling over an existing traditional IRA into a Roth IRA using the “Back Door” method mentioned above. To contribute non-IRA funds to a Roth IRA, you must be working and you must meet certain income limits, as explained below:

• You must be working: The first requirement for contributing to a Roth IRA at any age is having earned income. As long as you’re working —whether part-time or full-time, for yourself or someone else — you can contribute to a Roth. However, you can’t contribute more than the amount you’ve earned that year.
• Income Limits for Roth IRA Contributions: Regardless of your age, your earned income must be below a certain level for you to be eligible to contribute your earned income to a Roth IRA. These limits depend on your tax filing status (i.e., single or married) and how much income you earn. It is extremely important to understand that these income limits apply only to contributions of your earned income to a Roth IRA; these income limits do not apply to Roth conversions, where you take money from an existing traditional IRA and convert it to a Roth IRA.
• Income Limits for Single People: In 2021, contributions from individuals with single tax-filing status cannot be made to a Roth if your income exceeds $140,000. Contributions for single individuals begin to get phased out — or are limited — if you earn in the range of $125,000 to $140,000 in 2021.
• Income Limits for Married People: For those who are married and file their taxes jointly, the Roth income phaseout range for 2021 is $198,000 to $208,000.
• Contribution Limits for Roth IRAs: The annual contribution limit for Roth IRAs is $6,000 for 2021. For individuals aged 50 and over, they can contribute an additional $1,000 as a catch-up contribution for a total of $7,000 per year. If you and your spouse are married filing jointly, and you both establish Roth IRAs, one spouse can contribute up to the maximum for both spouses. In other words, the spouse can contribute a maximum of $14,000 if both spouses are 50 or older.
• The Roth Five-Year Rule and Older Investors: When you turn 59 ½, you can withdraw earnings from your Roth IRA without the 10 percent early withdrawal penalty. But you can’t open your first Roth IRA at age 58 and start withdrawing earnings penalty-free a year and a half later. This is because Roth IRAs have what’s called a five-year rule. Any money you put into a Roth IRA has to stay there for five tax years if you want the earnings generated by that contribution to be tax-free when you withdraw them (and you do). Once you make your first Roth IRA contribution and five tax years go by, any earnings you withdraw will pass the five-year test.

Roth IRAs and Social Security and Medicare

Another benefit of contributing to a Roth IRA is that no matter how late you contribute, Roth withdrawals aren’t considered income for the purposes of determining whether you’ll have to pay taxes on your Social Security benefits, unlike traditional IRA and 401(k) withdrawals. They also don’t count toward determining whether your income is high enough to charge you higher Medicare premiums.

Advantages of a Roth IRA Conversion

Many people are at their top earning years later in their careers so have too much income to contribute to a Roth IRA. In fact many people earn too much income even in their early working years to ever contribute to a Roth IRA. However, as mentioned above, you can always, at any time, do a Roth IRA conversion, regardless of your age and regardless of your income.

Tax Bracket Management

Based on the current tax tables, with optimal tax bracket management, a married couple currently earning $81,051 per year (ignoring RMDs) is in the 22 percent tax bracket, meaning that all income withdrawn from a qualified retirement account such as an IRA or 401(k) will be taxed at a minimum rate of 22 percent. Optimal tax bracket management would involve withdrawing an additional $248,800 in order to bring your income to the top of the 24 percent tax bracket, thus locking in the extremely low 24 percent tax rate. The money withdrawn could then be used to fund a Roth IRA as discussed in this article, or could be used to fund a Living Trust Plus® Asset Protection Trust.

How to Convert a Traditional IRA to a Roth IRA

There are three different ways to convert all or part of your traditional IRA to a Roth IRA. The first two options explained below are the easiest and the cleanest:

Option 1: An in-house transfer, in which you tell the financial institution that holds your traditional IRA (typically called the IRA custodian or sometimes the IRA trustee) to transfer the money into a Roth account at that same financial institution.

Option 2: An outside transfer, in which you direct the financial institution that holds your traditional IRA to transfer the money to a Roth account at another financial institution.

Option 3 (not recommended): A rollover, where you take a distribution from your traditional IRA, typically in the form of a check, and then deposit that money into a Roth account within 60 days. This option is not recommended because if you take a rollover and for some reason you don’t deposit the money into a Roth IRA within the required 60 days, you will owe income taxes on the full amount of the distribution, and you will be subject to a 10 percent penalty tax on early distributions if you are under age 59 ½.

Why You Should Consider a Roth IRA Conversion

Converting to a Roth IRA in your later years can be a good choice when:

• You no longer have earned income from work so you cannot contribute income to a Roth IRA.
• Your income is too high to contribute to a Roth through normal channels.
• You want to avoid RMDs.
• You want to leave tax-free money to your children.
• You don’t want your children to be forced to take full IRA distributions within 10 years after your death, which is required under the current law if you die owning a traditional IRA.

Hire a Professional to Help You Prioritize Planning for Retirement and Saving Money

No matter where you are in your retirement planning, you may have made mistakes along the way. If you don’t have enough saved, try to save more starting now. As many of you know, besides being a Certified Elder Law Attorney, I am also an experienced retirement planning advisor and long-term care financial advisor through my affiliation with Protection Point Advisors. Be sure to seek advice from a trusted financial adviser, such as myself and my team, to help you stay or get back on track.

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