Can I Do a Roth Conversion in 2021? Everything You Need to Know

Yes, You Can Still Convert to a Roth IRA in 2021!

Looking to make the jump to a Roth IRA before the year ends? Good news – you absolutely can do a Roth conversion in 2021! With just a couple months left in the year understanding the rules benefits, and potential tax implications has never been more important.

I’ve helped dozens of clients navigate Roth conversions, and trust me it’s one of the smartest financial moves many people can make – if done correctly. Let’s dive into everything you need to know about Roth conversions in 2021.

What Exactly Is a Roth Conversion?

In simple terms, a Roth conversion allows you to transfer funds from a pretax retirement account (like a traditional IRA) into a Roth IRA. The big difference? You’ll pay taxes now, but get tax-free withdrawals later.

Here’s the basic concept:

• Traditional IRA: Contributions are often tax-deductible, but withdrawals in retirement are taxed as ordinary income
• Roth IRA: Contributions are made with after-tax dollars, but qualified withdrawals are completely tax-free

When you convert, you’re essentially changing the tax treatment of your retirement funds – paying taxes now for tax-free growth later

Three Ways to Convert to a Roth IRA in 2021

According to Investopedia, the IRS allows three different methods to convert your traditional IRA to a Roth IRA:

1. Rollover: Take a distribution from your traditional IRA via check and deposit it into your Roth IRA within 60 days
2. Trustee-to-trustee transfer: Direct the financial institution holding your traditional IRA to transfer money to your Roth account at another institution
3. Same-trustee transfer: Tell your current financial institution to transfer funds from your traditional IRA to a Roth account within the same institution

Most financial advisors recommend using either of the transfer methods rather than the rollover approach. Why? If you miss that 60-day window for rollover deposits, you could face regular income taxes PLUS a 10% penalty on the amount (unless you’re over 59½).

The Tax Implications of Converting in 2021

Here’s where things get real. When you convert to a Roth IRA, you gotta pay income tax on the converted amount in the year you make the conversion. This includes:

• Any tax-deductible contributions you originally made
• All the tax-deferred earnings that have built up over time

This converted money counts as ordinary income for 2021. Depending on how much you convert, it could potentially push you into a higher tax bracket!

For example, if you’re currently in the 22% tax bracket and convert $50,000 from your traditional IRA, you might pay $11,000 in additional federal taxes (plus any state taxes).

Is There a Limit on How Much I Can Convert in 2021?

Here’s some great news – unlike regular Roth IRA contributions that have income limits, there are NO LIMITS on how much you can convert from a traditional IRA to a Roth IRA in 2021, regardless of your income level.

That’s right! Even if your income is too high to contribute directly to a Roth IRA, you can still do a conversion. This strategy is sometimes called a “backdoor Roth IRA” and it’s completely legal in 2021.

However, just because you can convert your entire traditional IRA doesn’t mean you should. Converting a large amount at once could push you into a higher tax bracket, resulting in a bigger tax bill than necessary.

The Five-Year Rule: Something You MUST Know

Before you rush to convert, understand the “five-year rule” for Roth conversions.

When you convert funds to a Roth IRA, those converted funds must remain in your Roth IRA for at least five years. If you withdraw them earlier, you’ll get hit with a 10% early withdrawal penalty!

The five-year clock starts on January 1 of the year you make the conversion. So if you convert in December 2021, your five-year period actually started on January 1, 2021, meaning you could withdraw penalty-free after January 1, 2026.

And remember – this rule applies to EACH conversion you make. If you do one conversion in 2021 and another in 2022, the 2022 conversion must be held an additional year to avoid penalties.

Should You Convert to a Roth IRA in 2021?

This is the million-dollar question! Here are some situations where a 2021 Roth conversion might make sense:

Good reasons to convert in 2021:

• You expect to be in a higher tax bracket in retirement: If you think your tax rate will be higher when you retire, paying taxes now at a lower rate makes sense
• Your income is unusually low this year: If you had reduced income in 2021 (maybe due to COVID job changes), converting while in a lower tax bracket could save money
• You want to avoid RMDs: Unlike traditional IRAs, Roth IRAs don’t have required minimum distributions (RMDs) at age 73
• You want to leave tax-free money to heirs: Roth IRAs can be excellent wealth transfer vehicles
• Market values are down: If your IRA investments have temporarily dropped in value, converting now means paying tax on a lower amount

Reasons to maybe wait:

• You’re close to retirement: If you’re retiring soon, you might be better off paying taxes gradually through traditional IRA withdrawals
• You don’t have cash to pay the tax bill: Using money from the IRA itself to pay conversion taxes significantly reduces the benefit
• You’re in your peak earning years: If your income will drop in retirement, waiting might mean converting at a lower tax rate

The Mega Backdoor Roth – A Special Opportunity for 2021

If you have after-tax (non-Roth) contributions in a qualified employer plan like a 401(k), 2021 presents a special opportunity. You may be able to convert those after-tax contributions to a Roth IRA through what’s informally called a “mega backdoor Roth.”

This strategy works if your employer plan:

1. Allows after-tax contributions (beyond regular pre-tax or Roth contributions)
2. Permits in-service distributions for non-hardship reasons

According to a Plan Sponsor Council of America Survey, about 20.9% of plans allowed after-tax contributions and 56.3% permitted in-service distributions in 2019.

But be aware – proposed legislation in Congress might eliminate this strategy after December 31, 2021! So if you’re considering this approach, 2021 could be your last chance.

Act NOW: Proposed Changes Could Limit Future Conversions

Here’s something SUPER important to know! Congress has been considering changes to Roth conversion rules as part of budget reconciliation legislation.

According to a Congressional Research Service report from November 5, 2021, Section 138311 of H.R. 5376 would:

1. Prohibit ALL taxpayers from converting after-tax (non-Roth) savings in qualified plans and nondeductible IRA contributions to Roth IRAs after December 31, 2021
2. Prohibit high-income taxpayers (income over $400,000 for single filers or $450,000 for married filing jointly) from converting pre-tax retirement savings to Roth IRAs after December 31, 2031

While these changes aren’t final yet, they underscore why 2021 might be a particularly good time to consider a Roth conversion, especially if you use the “backdoor” or “mega backdoor” strategies.

Steps to Complete Your 2021 Roth Conversion

If you’ve decided a Roth conversion makes sense for you in 2021, here’s how to make it happen before the December 31 deadline:

1. Contact your financial institution: Call or visit the company that holds your traditional IRA
2. Request the conversion paperwork: Each institution has its own forms and procedures
3. Choose your conversion method: Decide whether you’ll do a trustee-to-trustee transfer (usually simplest) or another method
4. Determine conversion amount: Decide how much to convert based on your tax situation
5. Complete and submit paperwork: Allow enough processing time before year-end
6. Set aside money for taxes: Remember you’ll owe taxes on the converted amount when you file your 2021 return
7. Report the conversion on Form 8606: You’ll need to report the conversion when you file your taxes

Don’t Forget the Tax Reporting Requirements

When you convert to a Roth IRA in 2021, you’ll need to report it on Form 8606 (Nondeductible IRAs) when you file your 2021 tax return. This is mandatory!

Many people forget this step, which can cause headaches with the IRS later. I always tell my clients to make sure their tax preparer knows about any Roth conversions they’ve done during the year.

Final Thoughts: Is a 2021 Roth Conversion Right for You?

Converting to a Roth IRA can be an excellent financial move, but it’s not right for everyone. The end of 2021 is approaching fast, so if you’re considering a conversion, now’s the time to talk with a financial advisor or tax professional about your specific situation.

Remember these key points:

• Yes, you CAN do a Roth conversion in 2021
• There are no income limits on who can convert
• You will owe taxes on the converted amount
• The five-year rule applies to withdrawals of converted funds
• Proposed legislation might limit certain conversion strategies after 2021

For many people, 2021 represents a unique opportunity to take advantage of Roth conversion strategies that might not be available in future years. Don’t miss your chance!

Have you done a Roth conversion before? Are you considering one for 2021? I’d love to hear your thoughts in the comments below!

You can do a Roth conversion at any time during the year, but to have the conversion count for the current tax year, you must complete it by December 31 of that year.

Yes, there is a separate 5-year waiting period for each Roth conversion, beginning on January 1 of the year the conversion was made, to avoid a 10% early withdrawal penalty on that converted amount. You can make multiple Roth conversions over several years, creating a “Roth conversion ladder” where each conversion has its own independent 5-year clock.

There is no age limit for doing a Roth conversion. You can convert money from a traditional IRA to a Roth IRA at any age, provided you meet the income and compensation requirements to have a Roth IRA in the first place.