Essential Tax tips for IRAs
Roth IRAs have two big tax advantages
The two most-important Roth IRA tax advantages are:
Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free too. What is a qualified withdrawal? It’s one that is taken after you, as the Roth account owner, have met both of the following requirements:
1. You’ve had at least one Roth IRA open for over five years.
2. You’ve reached age 59½ or become disabled or dead.
For purposes of meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which you make your initial contribution to your first Roth account. That initial contribution can be a regular annual contribution, or it can be a conversion contribution. For example, say your initial Roth pay-in was an annual contribution made on 4/1/18 for your 2017 tax year. The five-year clock started ticking on 1/1/17 (the beginning of the tax year for which the contribution was made), and you met the five-year requirement on 1/1/22.
Exempt from required minimum distribution rules
Unlike with a traditional IRA, you don’t have to start taking annual required minimum distributions (RMDs) from Roth accounts after reaching age 72. Instead, you can leave your Roth account(s) untouched for as long as you live if you wish. This important privilege makes your Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth money to help finance your own retirement).
Making annual Roth IRA contributions
Annual Roth contributions make the most sense for those who believe they will pay the same or higher tax rates during retirement. Higher future taxes can be avoided on Roth account earnings, because qualified Roth withdrawals are federal-income-tax-free (and usually state-income-tax-free too).
The downside is you get no deductions for making Roth contributions.
So if you expect to pay lower tax rates during retirement (good luck with that), you might be better off making deductible traditional IRA contributions (assuming your income permits), because the current deductions may be worth more to you than tax-free withdrawals later on.
The other best-case scenario for annual Roth contributions is when you have maxed out on deductible retirement plan contributions. For example, you’ve contributed the maximum possible amount to your 401(k) plan at work. In that case, making Roth contributions is basically a no-brainer.
Annual contributions are limited and earned income is required
The absolute maximum amount you can contribute to a Roth account for any tax year is the lesser of: (1) your earned income for the year or (2) the annual contribution limit for the year. Basically, earned income means wage and salary income (including bonuses), self-employment income, and alimony received that is included in your gross income (believe it or not). If you are married, you can add your spouse’s earned income to the total.
For 2021, the annual Roth contribution limit is $6,000 or $7,000 if you will be age 50 or older as of year-end.
Annual contribution privilege is phased out at higher incomes
For 2021, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $125,000 and $139,999 for unmarried individuals.
For married joint filers, the 2021 phase-out range is between MAGI of $198,000 and $207,999.
Annual contribution deadline
The deadline for making annual Roth contributions is the same as the deadline for annual traditional IRA contributions, i.e., the original due date of your return. For example, the contribution deadline for the 2021 tax year is 4/15/22. However, you can make a 2021 contribution anytime between now and then. The sooner you contribute, the sooner you can start earning tax-free income.
Well-seasoned individuals can still make annual Roth contributions
After reaching age 72, you can still make annual Roth IRA contributions — assuming there are no problems with the earned income limitation or the income-based phase-out rule. In contrast, you cannot make any more contributions to traditional IRAs after you reach age 72.
The quickest way to get a significant sum into a Roth IRA is by converting a traditional IRA to Roth status. The conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a payout from the traditional account with the money then going into the new Roth account. So doing a conversion before year-end will trigger a bigger federal income tax bill for this year (and maybe a bigger state income tax bill too).
However, today’s federal income tax rates might be the lowest you’ll see for the rest of your life. Thanks to the TCJA, the rates shown below apply for 2021. These brackets will be adjusted for inflation for 2019-2025. In 2026, the pre-TCJA rates and brackets are scheduled to come back into force.
Single Joint HOH*
10% tax bracket $ 0-9,875 0-19,750 0-14,200
Beginning of 12% bracket 9,876 19,751 14,201
Beginning of 22 bracket 40,126 80,251 54,201
Beginning of 24% bracket 85,526 171,051 86,351
Beginning of 32% bracket 163,303 326,601 164,901
Beginning of 35% bracket 207,351 414,701 209,401
Beginning of 37% bracket 518,401 622,051 523,601
* Head of household
So if you convert in 2021, you’ll pay today’s low tax rates on the extra income triggered by the conversion and completely avoid the potential for higher future rates on all the post-conversion income that will be earned in your Roth account. That’s because Roth withdrawals taken after age 59½ are totally federal-income-tax-free, as long as you’ve had at least one Roth account open for over five years.
To be clear, the best candidates for the Roth conversion strategy are people who believe that their tax rates during retirement will be the same or higher than their current tax rates. If you fit into that category, please keep reading.
Consider multi-year conversion strategy
Converting a traditional IRA with a relatively big balance could push you into a higher tax bracket. For example, if you’re single and expect your 2021 taxable income to be about $110,000, your marginal federal income tax rate is 24%. Converting a $100,000 traditional IRA into a Roth account in 2021 would cause about half of the extra income from the conversion to be taxed at 32%. But if you spread the $100,000 conversion 50/50 over 2021 and 2022 (which you are allowed to do), almost all of the extra income from converting would be taxed at 24%.
Ill-advised conversions in 2021 and beyond cannot be reversed
For 2021 and beyond, you cannot reverse the conversion of a traditional IRA into a Roth account. Under prior law, you had until October 15 of the year after an ill-advised conversion to reverse it and thereby avoid the conversion tax hit.
2021 conversions can still be reversed as late as Oct. 15, 2022
The IRS has clarified that if you converted a traditional IRA into a Roth account in 2021, you can reverse the conversion as long as you get it done by 10/15/22. That 10/15/22 deadline applies whether or not you extend your 2021 Form 1040.
You accomplish a Roth conversion reversal by “recharacterizing” (weird word chosen by the IRS) the Roth account back to traditional IRA status. That is done by turning in the proper form to your Roth IRA trustee or custodian.
Read: This is your last chance ever to reverse a Roth IRA conversion
Conclusion on conversions
Low current tax cost for converting + avoidance of possibly higher tax rates in future years on income that will accumulate in your Roth account = continuing perfect storm for the Roth conversion strategy. However, talk to your tax adviser before pulling the trigger on a conversion — just to make sure you’ve considered all the relevant factors.
The Bottom Line
Even with the new law’s disallowance of the Roth conversion reversal privilege, Roth IRAs are still a tax-smart retirement savings alternative for many folks. Maybe now more than ever.