For so many people, their incomes took a hit in 2020. Layoffs, furloughs, cut hours….almost every family was affected in some way. Now the year is wrapping up, you might be feeling anxious about going into another year of uncertainty.
One way to take advantage of the current climate and do something that will benefit you in the future is to convert your IRA to a Roth IRA before the year ends.
This is called a Roth conversion, and it can be very beneficial in the right situations.
What is a Roth Conversion?
A Roth conversion takes an IRA and converts all, or part, of it to a Roth IRA.
The difference between a traditional IRA and a Roth IRA is in the tax benefits.
With a traditional IRA, you contribute pre- or after-tax dollars so that your money grows tax-deferred, and your withdrawals are taxed as income after age 59 ½.
With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can make tax- and penalty-free withdrawals after age 59½ (with some exceptions.)
You can contribute to a Roth IRA as long as your modified adjusted gross income (MAGI) is equal or less than $139,000 for single filers and $206,000 for married couples filing jointly. But what if you want the tax benefits of a Roth IRA, but your income is too high? That’s where a Roth conversion comes in handy. You can convert the money in your traditional IRA to a Roth IRA regardless of income.
Why You Should Consider a Roth Conversion in 2020
What makes this year a prime opportunity for Roth conversions? Because the best time to take advantage of a Roth conversion is when you know you’ll be in a higher tax bracket in the future. What you’re doing is putting money away for retirement at a lower taxable income, so you ultimately save money.
And this year, so many people took a hit on their incomes that they have fallen to lower tax brackets. However, that might not be the case next year. Their income or hours could pick up again, and they’d be right back at their original tax bracket.
So if you made a lot less in 2020 than usual but are expecting your income to increase again next year, this is a prime time to put money into a Roth IRA.
How to Convert to a Roth
There are 3 steps to a typical Roth conversion:
1.Make sure the money is in an account that can be converted to a Roth IRA. Those include:
- Traditional IRA
- Simple IRA
- SEP IRA
- Annuity plan
- Tax-sheltered annuity plan (section 403(b) plan); or
- Governmental deferred compensation plan (section 457 plan)
- Employer’s qualified pension, profit-sharing, or stock bonus plan (including a 401(k) plan) [NOTE: If you’re still working at the company where your plan is kept, this in-plan conversion could make sense. But if you’ve left the company, not every plan offers that.]
- Open a Roth IRA, and move the money there.
3. Make the conversion and know that you will have to pay taxes on IRA contributions and gains at tax time.
It sounds simple, but there are some often overlooked steps that could get you on the IRS’s bad side. There are a few approved ways you can do the conversion, including:
-Indirect rollover: You take the distribution out of a traditional IRA account and move it to a Roth IRA within 60 days
-Direct rollover: You notify the financial institution that has your traditional IRA that you want to transfer the funds to a Roth IRA at a different financial institution.
-Same trustee transfer: You set up your traditional IRA and Roth IRA at the same financial institution, and ask the trustee to transfer the amount you want to your Roth.
If you’re hesitant about converting to a Roth IRA, you can also work with a financial advisor or CPA to make sure the transaction is processed correctly.
Just make sure you’re certain you want to convert to a Roth before you move ahead. Part of the Tax Cuts and Jobs Act back from December 2017 stipulated that Roth conversions could no longer be undone.
About Your Richest Life
At Your Richest Life, Katie Brewer, CFP®, believes everyone should have access to financial resources and coaching. For more information on the services offered, contact Katie today.