If the Build Back Better bill, passed by the House in November and currently before the Senate, becomes law, it could limit the options for high-income savers to convert their savings to Roth IRAs and Roth 401 (k) s, that offer tax-free withdrawals in retirement.
The most immediate restriction, unless lawmakers change the date, would start in 2022, when you would no longer be allowed to convert after-tax contributions – say from a non-deductible IRA – to a Roth.
Converting to Roth would not only allow your money to grow tax-free, but also allow you to make tax-free withdrawals. Having this option makes sense if you expect to be in a higher tax bracket in retirement or want more flexibility in deciding when to use different pots of money for different purposes in retirement or at any other time. .
Since the law has not yet changed, high income savers can still take steps to maximize their Roth 2021 options.
You can contribute up to $ 6,000 (or $ 7,000 if you are at least 50 years old) into a Traditional or Roth IRA. But if your modified adjusted gross income is $ 140,000 or more ($ 208,000 if you are married and filing jointly), you cannot contribute directly to a Roth in 2021. And if you’re covered by a workplace pension plan and your income is $ 76,000 or more ($ 125,000 if you’re married), you’re also not allowed to make deductible contributions to a traditional IRA.
Either way, however, you can make after-tax contributions to a traditional IRA. And you can then immediately convert those contributions into a Roth IRA.
While technically you can make your 2021 contributions until April 15, 2022, conversions must be completed – or at least be in progress – by December 31 in order to count for that year, before any potential restrictions take effect, California said. Mary Kay Foss, Certified Public Accountant based.
But usually a conversion can be done in a day or two. “It’s very fast,” Foss said.
The tax bite
The immediate problem, however, is that you will likely owe tax on at least some of the money you convert, even if you only convert your after-tax contributions.
To determine how much tax you will have to pay on your after-tax contributions, the IRS uses a pro-rata rule, which calculates what you convert as a percentage of all your IRA balances.
Here’s how it works: Say you’re 51 and earn $ 7,000 after tax contribution this year to a non-deductible IRA, but you also have a traditional pre-tax IRA savings of $ 63,000. Under the pro rata rule, the after tax portion ($ 7,000) represents 10% of your total IRA savings ($ 70,000). So when you convert this year’s contribution to Roth, only $ 700 will convert tax free; you will have to pay tax on the remaining $ 6,300. And you will have to pay this tax by April 15, 2022.
While this sounds like double taxation, technically it won’t be because the remaining portion of your after-tax contributions will eventually reduce the taxes you pay when you make taxable withdrawals in retirement. “The remaining base of your non-deductible IRA contribution is taken into account when you make subsequent IRA withdrawals. It is not lost forever,” Foss said.
And of course, if you convert your pre-tax IRA savings to Roth as well, you’ll have to pay taxes on those savings as well.
There is a way to avoid the pro rata rule. If your employer allows you to transfer your IRA savings into your 401 (k), and you can do so before December 31, you will effectively have no other IRA savings other than the after-tax contribution of $ 7,000 for 2021 to convert. So, in this case, 100% of your conversion to Roth IRA that year will be tax exempt.
Get good advice before you act
The specifics of your situation maybe more complex as the examples above. And the IRS rules governing the different types of IRAs – especially Roths – are very complex, and never more so than when you transfer money from one to the other.
This is also the case if you are considering converting your after-tax savings. in your pension plan qualified to work in a Roth 401 (k), if your employer offers the option of making voluntary after-tax contributions. The advantage of Roth 401 (ks) over Roth IRAs is that there are no income eligibility rules and you can contribute much larger amounts each year. As with the Roth IRA, the restrictions for Roth 401 (k) would go into effect as early as next year under the Build Back Better bill passed by the House, if it becomes law.
So before you do anything, consult with a knowledgeable tax and retirement advisor who can guide you through your options and help you think through the tax consequences now and in retirement.