What You Need to Know About IRA Conversions in 2022

In 2022, we mark the 25th anniversary of the Roth IRA amid a surge in its popularity. The Roth IRA was created in the Taxpayer Relief Act of 1997, and the first Roth IRAs were opened in 1998.

The IRA is named after its sponsor, Sen. William Roth, of Delaware. Sen. Roth also co-sponsored the Kemp- Roth tax cuts that became the centerpiece of the Economic Recovery Tax Act of 1981.

Initially, Roth IRAs were favored primarily by upper-income taxpayers who had sophisticated tax advisors. Advisors to other taxpayers often asked, “Why pay taxes before you have to?” But Roths increased in popularity over the years as their benefits became clear.

Roth IRAs were perhaps the topic most asked about by my readers in 2021, especially in the teleforums we conduct several times each year. Most readers know that Roth IRAs don’t provide up-front tax advantag- es. You don’t receive a deduction or exclusion for money contributed to a Roth IRA. or its counterpart the Roth 401(k). But the investment returns of a Roth IRA compound free of taxes, and distributions from the account (after a five-year waiting period) are tax free.

In addition, the original owner of a Roth IRA doesn’t have to take required minimum distributions (RMDs) during his or her lifetime. Beneficiaries who inherit a Roth IRA have to fully distribute the IRA within 10 years, but the distributions are tax free. Annual contributions to a Roth IRA aren’t the strategy that attracts taxpayers.

Taxpayers are more interested in the ability to convert large traditional IRAs and 401(k)s to Roth IRAs. You can convert an entire IRA or any lesser amount you want. There’s no limit to the number of conversions you can do in year or a lifetime, and conversions currently aren’t limited by your income or the value of the IRA. You pay a tax to convert a traditional IRA to a Roth IRA. The amount you convert is included in gross income as though it had been distributed to you.

IRA conversions are increasing in popularity, partly because many people believe it’s likely they’ll face higher income tax rates in the future than they do now. It is no secret that Congress is taking aim at the trillions of dollars accumulated in traditional IRAs and 401(k)s.

It is considering ways to accelerate and increase taxes on those balances. I dis- cussed these proposals through 2021 in Retirement Watch and my weekly Bob’s Journal posted on the website and sent via email to subscribers.

None of the proposals were enacted in 2021 because of disagreements on other issues. But they have bipartisan support and are back on the agenda for 2022. In addition, many in Congress want to increase income tax rates, even if that means only letting the 2017 tax cuts expire as scheduled after 2025. The clearest case for converting some or all of a traditional IRA to a Roth IRA is when you anticipate facing higher income taxes in the future than today.

Indeed, it appears that some in Congress want to make traditional IRAs less attractive in the future, so more people will convert to Roth IRAs now, generating more tax revenue in the next few years instead of having it spread over a decade or longer.

But it’s important to consider more than stated income tax rates. Many retirees bear a heavy burden from Stealth Taxes. The prime Stealth Taxes are the tax on Social Security benefits and the Medicare premium surtax, also known as IRMAA. There’s also the additional 3.8% tax on net investment income for higher-income taxpayers.

Other tax breaks are phased out when income is above a certain level. RMDs from traditional IRAs often trigger or increase the Stealth Taxes. This is especially likely when the IRA owner is in their late 70s or older, because the percentage of the IRA that must be distributed increases each year.

Many people with substantial traditional IRAs find they are forced to take distributions that exceed their spending needs, and that triggers higher income taxes and Stealth Taxes. You have to consider the potential future Stealth Taxes when deciding whether it makes sense to convert a traditional IRA today.

While the difference between current and future income taxes often is the most important factor in deciding whether a conversion makes sense, it’s not the only factor. In the research I’ve done over the years, I’ve found it can make sense to convert all or part of a traditional IRA even when there’s no change anticipated in income tax rates.

Keep in mind that all distributions from a traditional IRA are taxed as ordinary income, even if they are long- term capital gains, preferred dividends or other tax-favored investments.

Because of that, it can be profitable to take money out of a traditional IRA early, pay taxes at today’s rates and invest the after-tax amount in the most tax-wise ways, keeping taxes on the investment returns low. Another important factor is the rate of return earned on the investments.

The higher the expected investment return, the more benefit to be gained from converting the distributions from ordinary income to tax-free income. A very conservative investor, on the other hand, is less likely to benefit from a conversion absent an increase in income tax rates. The length of time the money will compound in the Roth IRA also should be considered.

The longer the gains compound tax free in the Roth IRA, the greater the benefit can be from paying taxes early. But that doesn’t mean a person automatically is too old to convert an IRA, especially if the primary goal is to have the IRA inherited by younger family members.

When a beneficiary inherits a traditional IRA or 401(k), he or she pays taxes on the distributions just as the original owner would have. It’s only the after-tax value of the IRA that’s inherited. Plus, the distributions might push the beneficiary into a higher tax bracket. But when the owner converts a traditional IRA to a Roth IRA, he or she is making a gift to the beneficiaries by paying the income taxes.

This isn’t considered a gift under the tax code because the owner really is paying his or her own taxes. The money used to pay the taxes also is out of the owner’s estate, making it less likely the estate will be subject to estate taxes.

These are good reasons an older person might want to convert a traditional IRA to a Roth IRA. Another conversion consideration is the source of the money to pay the in- come taxes. You can take money from the traditional IRA to pay the taxes on the conversion.

But that money will be included in gross income with the converted amount. Essentially, you’ll be paying income taxes on the income taxes. A conversion is more likely to pay off when money outside the IRA is used to pay the taxes.

You don’t have to convert an entire IRA. You can convert as much or as little of the IRA as you want. One popular strategy is to convert just enough of the traditional IRA to keep from pushing you into the next higher tax bracket.

Doing this over several years is known as serial conversions. Some already subject to RMDs must take the year’s RMD before converting any of the traditional IRA. You can convert only money that’s left in the IRA after the year’s RMD. When determining the cost of the conversion, remember that the Medi- care premium surtax is determined using adjusted gross income from two years earlier. The surtax for 2024 will be determined using 2022 adjusted gross income.

That doesn’t matter if you won’t be 65 or older in 2024. But if you’ll be a Medicare beneficiary in 2024, any amount you convert in 2022 will help determine the amount of your Medicare surtax in 2024. That doesn’t mean you shouldn’t convert all or part of a traditional IRA in 2022 if you’ll be a Medicare beneficiary in 2024.

It does mean that you must estimate how a conversion in 2022 will affect the premium surtax in 2024. Be sure to realize that’s part of the cost of doing the conversion, though you won’t be paying the Medicare premium surtax until 2024.

You can see there are multiple factors to consider before deciding to convert all or part of a traditional IRA to a Roth IRA. To make the decision easier, I developed my IRA Conversion Calculator. The calculator is a spreadsheet that lets you change the different variables so you can see the effects of conversions under different scenarios.

My calculator lets you change all the variables I could think of, more variables than can be changed in the free and low-cost calculators available on the internet. Plus, you download my calculator to your computer and keep the data private. You can save multiple scenarios and compare them. More details about the calculator are at www.RetirementWatch.com. It regularly costs $39.95, but it’s free to those who sign up for our Lifetime Retirement Protection Plan.

Keep in mind that Roth IRA distributions are not tax free in all states. Check your state’s tax law before deciding to do a conversion. Also, remember that a conversion no longer can be reversed. Congress repealed the ability to reverse a conversion in the 2017 tax law. Unlike IRA contributions, a conversion must be done by Dec. 31 to be effective for the year.

There’s no grace period that lets you do a conversion in early 2022, for example, and have it effective for tax year 2021. Don’t wait until the end of the year to consider converting a traditional IRA to a Roth IRA. Carefully analyze the factors and determine whether a conversion, and how much of a conversion, could be profitable for you.

Then, monitor retirement account values during the year. Some taxpayers find it advantageous to convert an IRA after a market decline. They convert the assets to a Roth IRA at a lower tax cost, and the ensuing recovery in asset values then is tax free.

Another reason to convert is to have tax diversification. It’s risky to have too much of your retirement nest egg in tax-deferred accounts, such as traditional IRAs and 401(k)s, because Congress has shown it wants to impose additional taxes and restrictions on them.