Traditional, tax-deferred retirement accounts, like 401(k)s and traditional IRAs, give you a nice tax break up front, but then you have to pay taxes on your withdrawals in retirement. Fortunately, if you don't want to deal with that, you can move your savings to a Roth account later on.
These accounts give you tax-free withdrawals in retirement, which can be a huge relief to seniors living on a fixed income. But it's important to understand how a Roth IRA conversion will affect your finances both now and in retirement before you go through with it. Here are four key things to remember.
1. It's permanent
Once you convert your tax-deferred retirement savings to Roth retirement savings, there's no turning back. It's impossible to switch from Roth to tax-deferred savings, so it's not a decision to make lightly. If you don't think it's a good fit for you or you're on the fence, don't do a Roth IRA conversion this year.
2. It'll raise your tax bill this year
In order to convert tax-deferred savings to Roth savings, you must pay taxes on the converted amount. So for example, if you earned $50,000 from your job this year and you convert $5,000 from a traditional IRA to a Roth IRA, you'd have $55,000 in taxable income for 2022. For some, this might just mean a smaller tax refund, but for others, it could mean a tax bill due in April.
That's why a lot of people who want to convert large sums tend to do so over several years. This way, they can control how much their taxable income increases each time. That's also why so many people wait until the end of the year to do Roth IRA conversions. By then, they have a pretty good idea of where they'll fall in their tax bracket.
If you convert just enough to take you to the top of your tax bracket, you won't have to pay a larger percentage of your income to the government. But you still need to understand how this will affect your tax liability for the year. If you have any questions about this, reach out to a tax professional.
3. It has to be done by Dec. 31 to count for 2022
It's possible to make IRA contributions for 2022 up until the tax filing deadline: April 18, 2023. But you must complete Roth IRA conversions by Dec. 31, 2022, if you want them to count for this year.
If you miss this deadline, you can do your conversion in 2023 instead. But as discussed, you may prefer to wait until the end of the year when you know where you'll fall in your tax bracket.
4. The government could still tax your earnings if you withdraw your funds too soon
The whole idea behind a Roth IRA conversion is to ensure tax-free withdrawals in retirement, but there's something called the five-year rule that could throw a wrench in that. There are actually a few five-year rules associated with Roth IRAs. The best-known one says you must have your Roth IRA for at least five years before you can withdraw any earnings tax-free.
But there's a separate rule for Roth IRA conversions: You must leave your converted funds in the Roth IRA for five years before you withdraw them, or else the government could tax them. But the five-year countdown doesn't start on the day you do the conversion -- it actually begins on Jan. 1 of the year you did the conversion in. So for example, if you do a Roth IRA conversion on Dec. 1, 2022, the countdown actually begins on Jan. 1, 2022, so you'd be able to make tax-free withdrawals beginning on Jan. 1, 2027.
That said, you could still face penalties if you withdraw Roth IRA earnings if you're younger than 59 1/2, even if it's been more than five years since you did your conversion. Once you're clear of the five-year rule, though, you can withdraw your contributions tax-free at any age.
If any of this information is news to you, you may want to rethink your decision to do a Roth IRA conversion right now. You might decide to go ahead with it, but by reviewing the implications it will have for your current and future finances, you could avoid some unpleasant surprises at tax time.