Focusing on Roth Conversions and Contributions Prior to sunsetting Tax Cuts and Jobs Act

Strategies, for Long Term Tax Savings through Roth IRA Contributions and Conversions

With the Tax Cuts and Jobs Act (TCJA) set to expire in 2026 it's important to consider ways to maximize your tax benefits before any potential changes take effect. Once the Act expires tax brackets are expected to revert to their TCJA levels resulting in an increase of around 2 3% per bracket and potentially higher taxes for many individuals unless there are adjustments made by Congress.One popular approach gaining traction is the utilization of Roth IRA contributions and conversions as a measure. This article delves into the advantages of implementing Roth contributions and conversions.

Exploring Roth IRA Contributions

Investments, into a Roth retirement account (IRA) come with a tax advantage since they are funded using tax earnings. This implies that withdrawals from a Roth IRA can be taken tax free in retirement along with providing advantages under specific circumstances. Unlike retirement accounts Roth IRAs do not offer a tax deduction for contributions. However, the chance for tax accumulation and withdrawals during retirement makes them an attractive choice, for saving over the long-term.

Key Benefits of the Roth IRA 

Tax free withdrawals: Withdrawals from a Roth IRA are typically exempt from taxes provided that specific criteria met such as the account being open for at least five years and the individual being, over 59½ years old.

No Mandatory Required Minimum Distributions (RMDs); Unlike IRAs Roth IRAs do not require withdrawals during the account owner's lifetime granting more flexibility in deciding when and how distributions are taken. Roth contributions offer flexibility allowing for penalty withdrawals at any time to handle financial needs or emergencies.

When it comes to Roth IRA conversions you can move funds from an IRA or employer sponsored retirement plan, like a 401(k) into a Roth IRA. While the converted amount is taxed in the conversion year it can bring long term tax advantages.

Benefits of Roth conversions include tax diversification, where having both traditional and Roth accounts lets you strategically choose which one to withdraw from based on your tax situation. Additionally, Roth IRAs can serve as an estate planning tool by providing tax distributions to beneficiaries for potential tax-free growth over their lifetimes.

Considering the tax landscape and the potential for increasing rates after 2026 due, to the TCJA changes expiring, contributing directly to, or converting to a Roth IRA now could lock in taxes and allow for tax free growth as rates rise.

Things to be Aware of--

Income restrictions: A key advantage of Roth IRAs is that contributions are made using after-tax income ensuring tax-free withdrawals in retirement. Nonetheless there are income limits determining who can contribute to a Roth IRA. Single filers with a modified adjusted income (MAGI) in 2024 exceeding $146,000 – $161,000 and married couples filing jointly with a MAGI above $230,000 – $240,000 are ineligible for direct Roth IRA contributions (Phaseout in-between) but could consider the back-door Roth IRA contribution if the right circumstances exist.  

Contribution limits: In 2024 the maximum yearly contribution to a Roth IRA stands at $7000 for individuals under 50 years old and $8000 for those aged 50 and above. It's crucial to be mindful of these limits and avoid surpassing the amounts to prevent facing a 6% penalty due to excess contributions.

Conversion taxes: If you possess an IRA or an employer sponsored retirement plan you might contemplate converting it into a Roth IRA. This process will require you to pay the taxes on the conversion amount at your current tax rate.

While it might seem like an easy decision, in these situations it's important to understand the tax consequences involved. When you change a retirement account to a Roth IRA you'll be required to pay taxes on the amount. This could lead to a tax bill so it's crucial to take into account your tax bracket and how the conversion will affect your financial situation.

The 5-year rule is another factor when dealing with Roth IRAs. To withdraw earnings from a Roth IRA without incurring taxes you must have held the account for 5 years and be at least 59 1/2 years old. If you withdraw funds before meeting these criteria you may face taxes and penalties.

Backdoor Roth IRA contributions

Many people may not know about a retirement savings tactic called the backdoor Roth IRA contribution. This approach allows individuals, with incomes, who surpass the income restrictions for Roth IRA contributions to still benefit from a Roth IRA.

The process of making a backdoor Roth IRA contribution involves adding deductible funds to a traditional IRA and then transferring those funds to a Roth IRA. This enables individuals to experience tax growth on their investments and tax-free withdrawals during retirement of their income.

Here's a general overview of how this process unfolds-

1. Establish an IRA; If you don't already have one, you'll need to set up an IRA with your chosen financial institution.

2. Make deductible contributions; Given that individuals with higher incomes might not qualify for direct Roth IRA contributions they can instead contribute nondeductible amounts, to their traditional IRAs. It's crucial to adhere to the IRSs contribution limits.

3. Convert to a Roth IRA; Following the deductible contribution you can proceed with converting the funds into a Roth IRA. This conversion is usually facilitated through your institutions portal or by contacting their customer support team.

4. File Form 8606.

To correctly inform the IRS about the deductible donations and subsequent conversion you must submit Form 8606 along, with your tax filing. This form helps in calculating the portion of the conversion and ensures that you are not taxed twice on your contributions.

When completing Form 8606 it is important to disclose the amounts of your deductible contributions and conversions. Failing to report these transactions correctly could lead to penalties or owing taxes to the IRS.

Overall utilizing the backdoor Roth IRA contribution method can be beneficial for individuals with incomes who aim to maximize their retirement savings. By following the steps mentioned above and properly filling out Form 8606 people can leverage the advantages of a Roth IRA and experience tax growth on their investments, in the future. It is important to discuss this strategy with a tax professional prior to implementation as there can be some unintended consequences. 

In summary

Utilizing Roth contributions and conversions prior, to the expiration of the Tax Cuts and Jobs Act, in 2026 could lead to tax advantages and increased financial flexibility. By grasping the advantages detailed in this blog post and utilizing tax diversification effectively you can fine tune your retirement savings approach. Seek guidance from a financial planner to evaluate your individual circumstances and maximize the potential of these tactics.

About the author:

Paul Carriere, CFP® provides fee-only financial planning and investment management services in Colorado Springs, Co. Carriere Financial Planning serves clients as a fiduciary and never earns a commission of any kind. Paul has over 10 years of experience as a financial advisor in Colorado Springs. 

* This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities.