4 Unexpected Consequences of Roth Conversions and Backdoor Roth IRAs

Roth conversions and backdoor Roth IRAs are common planning tools, and often become a ‘hot topic’ during market downturns.

What Are Roth Conversions & Backdoor Roth IRAs

A Roth conversion is the transfer of retirement funds from a Traditional IRA or 401(k) into a Roth account. The money you convert is treated as ordinary income in the year you convert, and you must pay taxes on the full amount. Future withdrawals from the Roth account would then be tax-free. This is a strategy used by many to help manage future taxes during retirement.

Similarly, a backdoor Roth is an informal term used to describe a strategy used by high-income earners. Eligibility to make regular Roth contributions depends on your tax filing status and your modified adjusted growth income (MAGI). The amount you can contribute can be reduced or ‘phased out’ as your income approaches the upper limits of the phase out range. People whose income exceeds the phase-out range can contribute to a Traditional IRA and then use the Roth conversion process to transfer those funds to a Roth IRA.

While converting your IRA to a Roth IRA while the market is down may make sense for a lot of people, there are some unintended consequences you should be aware of before making any financial decisions.

Roth Conversions May Hike Medicare Premiums

Roth conversions can have an impact on your Medicare. Let’s say you are 65, and newly retired. You have $100,000 in a Traditional IRA that you convert to a Roth IRA. That $100,000 is added to your income the year you convert. Medicare Part B and Part D premiums are subject to IRMAA or Income-Related Monthly Adjustment Amounts. IRMAA is based on your MAGI from two years ago. So, an increase in income may not impact you this year, but two years from now it could mean a significant hike in your Medicare Premium. For 2022, IRMAA brackets can increase your Medicare Part B Premium up to an additional $408.20, and your Part D premium by as much as $77.90.

Impact to Capital Gains Tax Rate

When we talk about Roth conversions and taxes, the focus is often on the income tax amount you will have to pay on that conversion. But it can also impact your capital gains rate. Your capital gains tax rate is based on your taxable income. Adding in a large Roth conversion could bump you into the next capital gains tax bracket.

The Five-Year Rule

In a regular Roth IRA, there is a rule that states you must wait five years after your first contribution to withdraw your earnings tax-free. Any withdrawal prior to that could be subject to tax and penalties. Roth conversions is also subject to the five-year rule, with one important caveat. In the case of a Roth conversion, the five-year rule applies separately to each Roth conversion that you do. So, if you spread out your conversions over several years, each conversion will start its own five-year clock. This five-year rule applies to both pre-tax and after-tax funds in a traditional IRA, so if you are using the backdoor strategy every year, you need to be extra vigilant when making withdrawals from your converted Roth account.

The Pro Rata Rule

The pro rata rule kicks in if an investor has both pretax and after-tax money in their Traditional IRA. This is most common for high-earning investors who are looking to take advantage of the backdoor Roth. For example, if you have a $100,000 Traditional IRA, of which $20,000 or 20% is after-tax money. This means that 20% of any distribution from this account would be non-taxable.

If you convert $10,000 of that Traditional IRA to a Roth, many investors believe they are converting just the after-tax portion. In reality, the pro rata rule kicks in and a portion of the pre-tax funds move as well. So, in the case of our example, the $10,000 conversion consist of $2,000 after-tax money (20%) and $8,000 pre-tax money.

The Bottom Line

While a Roth conversion can be a great planning tool, it doesn’t make sense everyone. The best way to find out if a Roth conversion makes sense for you is to consult with the professionals. Talk with your tax preparer and work with a Financial Advisor to develop a Roth conversion plan.

If you need help, start your free financial plan today, or schedule a meeting with an advisor.

Important Information

Consult your tax professional about eligibility to Roth and Traditional IRA contributions. Contributions and earnings in a Roth IRA can be withdrawn without paying taxes and penalties if the account owner is at least 59 ½ and has held their Roth IRA for at least five years.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of the conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including the possible loss of principal. No strategy assures success or protects against loss.