Converting to a Roth IRA from a traditional IRA may result in an immediate tax liability but timing the conversion correctly can save on taxes in the long run. With the stock market’s instability and current income tax rates at a historical low, converting to a Roth IRA may be in your best interest, as long as you get the timing right.

Key Takeaways:

• Roth IRA contributions are taxed up front, as opposed to traditional retirement accounts, which are taxed when you take distributions at retirement
• Roth retirement accounts do not require you to pay tax on qualifying distributions
• Historically low tax rates are increasing the attractiveness of Roth IRAs for some taxpayers
• Proposed legislation suggests altering who is allowed to convert traditional IRAs to a Roth IRA

Traditional retirement accounts are funded with pre-tax dollars, reducing your tax liability at contribution. Distributions, or withdrawals from the account, are taxable.

Converting to a Roth IRA

In contrast, Roth retirement accounts are funded with post-tax dollars and you pay no tax upon distribution, as long as it’s a qualifying distribution as described by the IRS. At any time, you are allowed to convert your traditional IRA into a Roth via a Roth conversion, though you will need to pay required tax for the year of conversion. While there is an immediate tax liability upon converting, there are numerous reasons to consider a Roth conversion for 2022.

Current Income Tax Rates at Historic Lows

The Tax Cuts and Jobs Act of 2017 introduced historically low income tax rates, but the law is set to sunset on December 31, 2025. As a tax planning strategy, it may be wise to take a tax hit now while rates are low rather than waiting and possibly facing higher tax rates in the future.

Market is Low

Due to a number of factors, including rising interest rates, inflation and globally impactful events like the war in Ukraine, there’s been a painful drop of value in many retirement accounts lately. Paying tax now on the current and unfortunately lower account value can allow potentially more value to grow with a lower tax cost. As a bonus, that account will have tax-free withdrawals later.

Other Income Could Be Lower

Current economic conditions could also mean income is lower than usual due to inflation creating higher business expenses in addition to reduced market gains and potential net operating losses still carried over from the pandemic. Alternatively, someone who has recently retired may have a steep decline in income until retirement payouts begin. Converting to a Roth account in a lower income year can help keep the overall cost of conversion down.

Proposed Changes to Legislation 

Proposed legislation introduced in 2021 by House Democrats would prohibit Roth conversions for certain taxpayers. Single taxpayers who make at least $400,000 annually, or married taxpayers with annual income over $450,000, would be targeted by this proposed regulation. If enacted, the regulations wouldn’t take effect until 2032, giving wealthy taxpayers nearly a decade of runway to make the conversion if they are interested in doing so. Although this legislation has yet to be made into law, it could still influence some individuals to make the switch.

If a Roth conversion sounds tempting, but you’re reluctant to convert your entire account balance all at once, know that partial conversions are possible. Over several years, you can convert a small amount from your traditional IRA to your Roth account, paying off the tax liability in smaller doses rather than all at once.

Don’t know if a Roth IRA conversion is right for you? Every situation is different, which is why it’s so important to have a trusted Family Wealth and Estate Planning advisor by your side. Contact an Anders advisor below for assistance with year-end planning.