High-earners, like most doctors, surgeons, and physicians, face an interesting conundrum when saving for retirement. They need to save more than most to maintain their lifestyle, but they can’t directly access certain savings accounts, like Roth IRAs.
Roth IRAs are especially useful for young physicians earning less now than they likely will in the coming decades. But if you’re making more than $144,000 filing single ($214,000 if married, filing jointly) in 2022, you can’t directly contribute.
There is, however, another way into these advantageous accounts: Roth conversions.
What is a Roth conversion, and why should it be an ongoing part of your financial strategy?
What’s a Roth Conversion?
A Roth conversion is a strategy to “convert” funds from a traditional IRA into a Roth IRA.
Doing so is helpful for several reasons.
First, there is no income cap for contributing to traditional IRAs, which means no cap on creating a Roth conversion, either.
Second, there is no limit to the number or size of the conversion. By comparison, eligible participants can directly contribute up to $6,000 (or $7,000 if you’re 50 and older) to a Roth IRA in 2022.
But you can convert as much as you want and as often as you like—as long as you can cover the tax bill (more on this below).
A Little About Roth IRAs
To better understand a Roth conversion, you need a full grasp of what a Roth IRA is first.
A Roth IRA is a tax-advantaged retirement account. You fund it with after-tax dollars, making it different from a traditional IRA, 401(k), or 403(b). You fund those accounts using pre-tax dollars, meaning they lower your taxable income for the year you make the contributions.
Conversely, contributions to a Roth IRA do not lower your taxable income. So if you don’t receive a tax break up front, what’s the benefit of these accounts?
The funds within the account grow tax-free, and qualified distributions in retirement remain tax-free. Additionally, putting your retirement savings into a Roth IRA may be useful in avoiding means testings for government programs like Medicare.
What Are Qualified Distributions?
Remember, qualified distributions from a Roth IRA are tax-free. But what counts as a “qualified” distribution?
You must meet two conditions. Your account must be open for at least five years, and you need to be 59 ½ or older to take a qualified distribution.
However, there are a few exceptions to the rules. If you’ve had the account for over five years, you may take qualified distributions on the amount you contributed to the account, but not the growth. So, if you’ve contributed $5,000 but the account is now worth $7,000, you may take a qualified distribution up to the original $5,000.
As long as you’ve had the account for at least five years, here are some other examples of qualified distributions:
- You’re permanently disabled.
- Your beneficiary withdraws from the inherited account after your death
- You’re buying your first home ($10,000-lifetime maximum)
- You have a baby or adopt a child
- You pay for qualifying education costs (while you’ll avoid the penalty, you’ll have to pay income tax on the distribution).
A distribution is non-qualified if it does not meet the above criteria. In that case, the withdrawal may be subject to ordinary income tax and a 10% tax penalty.
Roth IRA Income Limits
The IRS established income phase-out ranges for high-earning individuals and couples. If your MAGI falls within the phase-out range, you can still contribute a reduced amount to a Roth IRA account. If your MAGI lies above the ceiling cap, you can’t contribute at all.
Here are the Roth IRA income limits for 2022:
- Single or head of household: $129,000 to $144,000
- Married, filing jointly: $204,000 to $214,000
- Married, filing separately: $0 to $10,000
If you earn too much to contribute to a Roth IRA directly, it might be time to consider a Roth conversion.
The Rules of a Roth Conversion
There are three ways to make a Roth conversion happen: a rollover, trustee-to-trustee transfer, or same-trustee transfer.
No matter which way you slice it, remember this: you should prepare yourself to pay taxes on the conversion during the upcoming tax season. If you’re converting the pre-tax dollars from a traditional IRA, you are responsible for paying taxes on that income. This means that the more you convert, the greater your tax obligation may be.
Taxes on Roth conversions can be complex, depending on how many IRAs you have, the specific type, and whether you funded them with pre-tax dollars, after-tax dollars, or a mix. Given the complicated nature of this strategy, you may find it beneficial to consult your financial advisor and tax professional to determine if a Roth conversion is a viable option. Your financial team can also help you understand how to convert your accounts and assist in the transition.
When Does a Roth Conversion Make Sense?
A Roth conversion can be a beneficial move if you’re in a lower tax bracket than usual or earning less than what you anticipate making in the future.
In addition, a conversion works best for those who don’t need to access the money for at least five years. As we mentioned, withdrawals made less than five years after you established the account may be subject to additional tax and penalties.
For some, the ideal time to do a Roth conversion falls after you’ve finished working and before you start receiving Social Security benefits or taking your RMDs. Why? Because this is the time when your taxable income will likely be at its lowest.
Is There a Time When a Roth Conversion May Not Be Best?
The biggest drawback of a Roth conversion is the nearly immediate tax bill. If you don’t have the cash flow to cover the bill this year, it may not be worth trying to sell or use other assets to pay for. This is especially true if you anticipate being in a lower tax bracket during retirement.
If you’re a highly compensated physician in your peak earning years, now may not be the time to take on the additional tax burden.
Here’s Why Roth IRAs are So Special
Why go through all the hassle of a Roth conversion? What makes this account so unique?
The primary benefit of a Roth IRA is the tax-free withdrawals in retirement. Tax-free retirement money is such a tremendous perk, especially for those who expect to be in a high tax bracket later in life.
You pay taxes on the money now, so you don’t have to pay them later. Adding this kind of tax diversity to your portfolio helps manage your tax situation in retirement. Ultimately, tax-free withdrawals give you more flexibility and control over your money when you need it most.
Unlike traditional IRAs or 401(k)s, the IRS doesn’t mandate required minimum distributions for Roth IRAs. You have the freedom to take distributions on your time without following a schedule the government determines.
Roth IRAs also make excellent estate planning vehicles, and one reason is that The SECURE Act eliminated the “stretch” provision for most non-spouse beneficiaries of IRAs. When the rule was in effect, an heir could stretch the distributions out over their lifetime, but now many have to remove all the funds within 10 years.
For traditional accounts, this could scream tax trouble since most beneficiaries would be in their prime earning years when receiving the IRA. But if they inherit a Roth IRA, the distributions would be tax-free under the current law.
If you wanted, you could leave all the money in your Roth IRA for your beneficiaries after you pass away. The funds can grow tax-free for decades, and any distributions your heirs make will be tax-free (at least under current tax law), making Roth IRAs an ideal and efficient estate planning tool and a retirement savings powerhouse.
Helping High-Earners Save For Retirement, Smarter
Because there is no limit, use Roth conversions throughout your lifetime to build up a bucket of tax-free retirement income. Of course, you should consider this in conjunction with your greater financial goals and tax planning strategies.
Is a Roth conversion the right move for you this year? The Partners in Financial Planning team can help review your financial standings and decide.
Reach out anytime to talk retirement planning, Roth conversions, and anything else on your mind.
Partners in Financial Planning provides tax-focused, comprehensive, fee-only financial planning and investment management services. With locations in Salem, Virginia and Charleston, South Carolina, our team is well-equipped to serve clients both locally and nationally with over 100 years of combined experience and knowledge in financial services.
To learn more, visit https://partnersinfinancialplanning.com