In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses Roth conversions, and the idea that the government can change the rules at any time, as seen in the original tax proposal. Are Roths worth the risk of a bait and switch?
One thing the latest legislation back and forth has shown us is nothing is ever written in stone. There have been a number of provisions in the bill (some have been taken out) that may change how we save for retirement. Because of this, many might think the Roth conversion is dead. Is that true, or is the Roth still the best plan to save for retirement.
A Little History
Prior to 1981, social security benefits were not taxable. But, the government decided to change the rules, and tax social security. In the latest tax proposal, as part of the larger infrastructure bill, there are a number of provisions that could change the rules again. Specifically, a cap on retirement savings, and the elimination of backdoor Roths and conversions.
The worry is that if you have a Roth IRA, you won’t reap the tax benefits of the plan. As one IRA Financial client put it, he would rather receive the upfront tax breaks of a traditional plan, since they can’t take that away. Are you taking chances that you won’t see a tax break on your Roth distributions? Maybe.
What is a Roth Conversion?
Unlike a traditional or pretax IRA, you do not receive a tax break upfront. The benefit comes on the back-end, when you withdraw from the account. Assuming a Roth has been open for at least five years and you are at least age 59 1/2, all distributions from the plan are tax free.
A conversion is when you move funds from a pretax plan to a Roth. For example, you have $50,000 in your 401(k) from an old job. You decide you want those funds in a Roth. You can convert it and pay tax on the amount converted. In fact, you can convert a little each year as to not have a large tax bill at once. Once converted, your money can grow tax-free inside the Roth.
What is Changing?
As Adam states in the podcast, this episode was recorded between tax proposals. When recorded, all retirement-related provisions were removed from the bill. However, since then, some have made it back in. Here’s a quick primer:
- The cap is back – if you have more than $10 million across your retirement plans and earn $400,000 annually ($450,000 if married filing jointly), you will be forced to withdraw funds, especially if you have a Roth.
- No more “back door” – You can no longer convert after-tax funds to a Roth if you are above the above income limits.
- No more conversions – Again, if you are above these limits, you will no longer be able to convert pretax funds to a Roth.
- No more contributions – You will not be allowed to contribute to a retirement plan if you are over the $10 million limit and the annual income limits.
Is the Roth Conversion Dead?
It’s probably not dead, or even on life support. However, you need to consider the “governmental risk.” There’s always risk when it comes to finances. You can convert an asset now, but earnings disappear in the future – think Enron. Now, if you do exceed that $10 million cap, you will have to take a distribution. Some of which will certainly be taxable.
Roth conversions can still make sense, but need to now incorporate risk of law change which was not really an issue a few months ago. We still believe in the power of the Roth. But, now more than ever, it’s important to make sure a conversion is in your best interest.
Stay tuned, as this Build Back Better bill is a fluid situation until it gets passed. Of course, even though some provisions are out of the bill, they’re sure to be revisited in the future. This is especially true when the Democrats control the government.
Thanks for listening, and be sure to visit our SoundCloud page to keep informed of any changes in the tax bill.