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Roth IRA

Q&A: When it comes to Roth IRAs, 59½ and 5 are the magic numbers

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Dear Liz: You recently answered a question about Roth conversions, saying that each conversion triggered its own five-year holding period. It was my understanding that after age 59½, the five-year rule doesn’t apply and earnings aren’t taxed.

Answer: The rules for Roth IRAs can be complicated, and they’re different for accounts that you fund directly versus those that are funded through conversions.

If you contribute directly to a Roth, you can withdraw your contributions any time without tax or penalty. You can withdraw earnings tax free if you’re 59½ or older and the account has been open for at least five years.

But as mentioned in the previous column, the five-year holding period applies to each conversion you make from another retirement account into a Roth. What goes away after age 59½ is the 10% penalty for early withdrawal, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Earnings withdrawn before five years can be taxed as income. However, it’s assumed that any withdrawals are principal first, so you’d have to withdraw the entire conversion amount before earnings would be taxed.

Luscombe notes that some people set up separate accounts for each conversion to make tracking the five-year periods easier. That could be especially helpful if they plan to make substantial withdrawals that could include earnings before the last conversion amount hits its five-year mark. Once all the five-year periods have expired, the accounts can be combined into one.

Q&A: Roth conversions and holding periods

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Dear Liz: Eight years ago I converted a number of stocks from an IRA to a Roth IRA and paid the taxes. Now I am in a position to convert the last shares but want to do it incrementally over the next four years. Does each conversion then require its own five-year waiting period or will anything in the existing Roth now qualify to be withdrawn at any time?

Answer: The IRS requires five-year holding periods before earnings can be withdrawn tax-free from Roth accounts. The five-year rule applies separately to each Roth conversion, so the partial conversions you’re contemplating will each have their own five-year holding period, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

That’s different from regular Roth accounts, where the five-year rule starts the year the account was first opened and isn’t triggered again by subsequent contributions, Luscombe says.

This week’s money news

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This week’s top story: Smart Money podcast on the price of parenthood. In other news: 4 tips on avoiding financial regrets in retirement, opening a Roth IRA with a summer job, and Supreme Court strikes down student debt cancellation.

Smart Money Podcast: The Price of Parenthood: In Vitro Fertilization and the Future of Parenthood
This week’s episode continues our Nerdy Deep Dive into the price of parenthood.

Experts Offer 4 Tips on Avoiding Financial Regrets in Retirement
Even if you’re already retired, you can take action to improve your retirement finances.

Got a Summer Job? Consider Opening a Roth IRA
You don’t have to wait until your first full-time job out of college to start saving for retirement.

Supreme Court Strikes Down Student Debt Cancellation. Now What?
Get in touch with your servicer and prepare for payments to resume in October.

Q&A: Here’s a retirement tax trick: the mega backdoor Roth IRA

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Dear Liz: I am a 32-year-old married father of two. My income is high enough to contribute to my kids’ 529 and custodial brokerage accounts. I’ve been able to max out my 401(k), health savings account and backdoor Roths for my spouse and myself. Next, I’m debating between starting a life insurance retirement plan (LIRP) or making after-tax 401(k) contributions because my plan allows mega backdoor Roth conversions. What are your thoughts on LIRP versus mega backdoor Roth?

Answer: Mega backdoor Roths are such a sweet deal for higher-income workers that you probably should take advantage if you want to put aside more tax-advantaged money for retirement.

For those who are unfamiliar: Roth IRAs allow tax-free withdrawals in retirement, but only people with incomes under certain limits can contribute directly to a Roth. The ability to contribute phases out for married couples filing jointly with modified adjusted gross incomes of $204,000 to $214,000.

There’s no income limit on conversions, however, so people with higher incomes can contribute to a traditional IRA and then convert the contribution to a Roth IRA in what’s known as a backdoor Roth. Conversions typically trigger income taxes on any pretax contributions or earnings, so this tactic works best if the person doesn’t have a large existing IRA.

The mega backdoor Roth takes this strategy to a new level.

Some employer 401(k) plans allow participants to make after-tax contributions that can then be converted to a Roth. The amounts that can be contributed and converted are substantial. Although the pretax limit for contributions is $20,500 for workers under 50 in 2022, the total amount that can be contributed by employees and employers to a 401(k) is $61,000.

The amount you can put in after tax would be reduced by any company match you get. Assuming there’s no match, you could contribute $20,500 to the pretax plan and an additional $40,500 to the after-tax plan this year.

A mega backdoor Roth would allow you to build up a substantial fund of tax-free retirement money without the costs and other potential disadvantages of a LIRP, which requires you to buy a permanent life insurance policy. With a LIRP, you would use the cash value of the policy to hold investments that you could access tax free through withdrawals or loans.

LIRPs can make sense if you otherwise need permanent life insurance, but many people need only term insurance, which is much less expensive.

If you’re still interested in a LIRP, consult with a fee-only, fiduciary financial advisor first to ensure you understand how these work and determine if they’re a good solution for you.

Q&A: How your health insurance costs could rise because of a Roth IRA conversion

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Dear Liz: With the recent stock market correction, I am considering doing a Roth conversion on an existing IRA now that it is worth less. I can handle the accompanying income tax hit. But while I see plenty of ink spilled on how a Roth conversion can increase Medicare premiums, what about Affordable Care Act costs? Is it the same story there: Will a one-time income spike this year due to Roth conversion impact what I pay all next year for ACA health insurance?

Answer: Potentially, yes. Roth conversions count as income for Affordable Care Act subsidies, so a large enough transaction could increase the premiums you pay.

A conversion allows you to transfer money from a regular IRA or 401(k), which would be taxable in retirement, to a Roth IRA, which would be tax free. If you expect to be in a higher tax bracket in retirement, conversions can make sense — you’re paying income taxes at the lower rate now, rather than the higher rate later. But obviously higher health insurance premiums would offset some of that benefit.

A tax pro can help you model conversions of different sizes to see the effects on all your finances, not just your tax bill. It’s possible that a partial conversion could help you take advantage of the current downturn without dramatically increasing your health insurance costs.

Q&A: Consider taxes before retirement

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Dear Liz: I began converting two 401(k)s from previous employers to Roth IRAs. To lessen the huge tax hit, I decided to do the conversions over the course of seven years. Even with that, the tax hit is higher than I realized and too painful. Now that partial conversions have begun annually, am I required to complete the total conversion to 100%? Or can I stop midway and leave the remainder in the original accounts? Also, is there an age limit before which Roth conversions must be completed?

Answer: You don’t have to continue making conversions. (Before 2018, you could have even reversed conversions you already made, but that’s no longer possible.) There’s also no age limit for conversions, but the older you get, the less likely conversions are to make financial sense.

Conversions are a good bet if you expect to be in the same or a higher tax bracket in retirement. If you’re young and in a low tax bracket now, you can reasonably expect that to be the case.

As you approach retirement, though, the opposite may be true. Many people find their tax bracket drops once they retire. Why pay a big tax bill now if you can access the money at a lower tax rate later?

Then again, if you’re a good saver, you may discover you’ve accumulated so much that your tax bill will soar once you’re required to start taking minimum distributions at age 72. If that’s the case, then converting some of your retirement money might save you on taxes overall.

But you’ll want to discuss this with a tax pro or financial planner who can model how the conversions are likely to affect your overall finances, including any Medicare premiums, since those can increase with income.