For some investors, getting a Roth IRA moving from the start may not be a possibility. Internal Revenue Service (IRS) standards place income caps on Roth IRA investments since they allow investors to collect money post-retirement without having to pay tax on that money.
Instead, there are opportunities to invest in 401(k)s and traditional IRAs. But there’s a catch: where the Roth IRA allows you to withdraw money that has earned interest without paying taxes once you retire, the traditional IRA doesn’t require you to pay taxes while you’re investing – it requires that you pay them when you withdraw.
That means that, if you convert from a traditional IRA to a Roth IRA, there is a gap in tax payment that needs to be mended for the IRS to benefit.
You Must Pay Taxes on the Conversion
The process is sometimes called creating a “backdoor” Roth IRA. Since you’ll be transferring a predetermined amount of money into a new account, and that money hasn’t been taxed (assuming it was part of a traditional IRA), then you’ll have to pay tax on the money being transferred.
The IRS counts this money being transferred as “income” and will tax it the same way they tax your annual income. Beware: your contributions up to this point may cause you to fall into a higher tax bracket for the year.
Another thing to keep in mind: most contributions to a traditional IRA are made pre-tax, but if you contribute post-tax money (for example, money that you earned on your paycheck that was already taxed through income tax), then you may not have to pay any new taxes on the conversion.
You Can Optimize Your Tax Liability with Smart Conversion
Use the tax advantages of IRA conversion to optimize the amount you pay in taxes on your investments. In certain career fields, significant income drops on an annual basis are sometimes predictable. In these cases, you can convert your IRA to a Roth for the year that you’ll be making less money. Doing so will help place you in a lower tax bracket and, consequently, lower your tax liability on your investment.
If you expect to earn your greatest amounts of money (and thus make you greatest contributions to your post-retirement investments) toward the beginning of your career, you can also plan to convert once you make a major career shift and expect income to lower permanently. Back-loading your investment plan allows you to make a conversion to a Roth IRA at a time when your income will be lower, which reduces your tax liability and allows you to collect on your investment post-retirement without paying any additional tax.