Are you thinking about converting your Traditional IRA or 401(k) to a Roth IRA or wondering if a Roth conversion is right for you? It’s important to understand what a Roth conversion is, how it works, the rules associated with it and the possible tax implications before you decide.
What is a Roth Conversion?
A Roth conversion is a potential strategy to maximize tax-free retirement savings by moving money to a Roth IRA, even if you earn too much and don’t qualify for Roth contributions. This is often referred to as a “Backdoor Roth IRA.”
Essentially, it is a process of converting cash and/or assets from a Traditional IRA, SEP IRA, 401(k) or other tax-deferred retirement plan to the tax-free environment of a Roth IRA. The deadline to complete a Roth conversion is December 31 of each tax year.
There are generally three ways to convert funds
from a Traditional IRA to a Roth IRA. According to the IRS
, you can complete a rollover, transfer trustee to trustee or execute a same trustee transfer.
Should you consider a Roth conversion?
Since Roth IRAs
weren’t available until 1998, a Roth conversion is a strategy many individuals use to transition their existing tax-deferred retirement savings to tax-free savings in a Roth.
It’s also used by individuals who want to take advantage of the potential benefits of a Roth IRA but earn too much income to qualify for contributions.
According to Forbes
, “If you believe that income tax rates will increase in the future – as many finance and tax experts do – then you will agree that the Roth IRA is often a better choice than the traditional IRA, if the objective is to choose the one that results in the lower income tax.”
It’s important to note that a Roth conversion is a taxable event and will impact your taxable income, so be sure to consult and plan with a financial professional. Just as Roth contributions are not tax-deductible, any funds converted from a Traditional IRA to a Roth IRA are also included in your ordinary income and taxed as such.
How Does a Roth Conversion Work?
Hypothetical Example 1:
Your income exceeds the modified adjusted gross income (MAGI) limits to be eligible to contribute to a Roth IRA. You could potentially contribute to a Traditional IRA and then convert the funds to a Roth IRA (sometimes known as the Backdoor Roth IRA).
For this example, let’s say you contribute $6,000 to a Traditional IRA for the year. But, instead of leaving it in the Traditional IRA and receiving a potential tax deduction, you instead convert the $6,000 contribution to a Roth IRA in the same tax year.
The net effect of the backdoor Roth contribution is that the Roth conversion eliminates any potential tax deductions from the Traditional IRA contribution and the $6,000 remains in your taxable income for the year. Except now, it’s in your Roth IRA to grow tax-free.
Hypothetical Example 2
: You have $100,000 in a tax-deferred 401(k) from a previous employer. You want to fund a Roth IRA with a conversion of $50,000 and have a 20% effective tax rate. How would this potentially work?
First, you would establish a Traditional IRA with a custodian such as Equity Trust Company. Once the Traditional IRA is established, you are able to roll over $50,000 from your 401(k) to the Traditional IRA.
Then, you would establish a Roth IRA as the destination for the converted funds and would facilitate the conversion from the Traditional IRA your Roth IRA. You then could close the Traditional IRA if you wish.
As you can see in this example, you aren’t required to convert the entire account and have the option to choose a partial Roth conversion in an amount that makes sense for you. You may also conduct multiple partial Roth conversions throughout a given tax year or over a series of many years. Please consult with a tax or financial professional to discuss your options.
Roth Conversion Rules: Taxes Involved with a Backdoor Roth IRA
In the second hypothetical example, the $50,000 you are converting from the Traditional IRA to your Roth IRA would be added to your ordinary income in the year of the conversion and taxed at your ordinary income tax rate.
Because of this, it’s important to consult and plan with a tax professional because a Roth conversion will increase your taxable income for the year, potentially resulting in a higher tax bracket.
With a 20% effective tax rate, you would owe $10,000 in taxes on the converted funds for this Roth conversion example.
It’s possible to pay the tax from the converted funds, thus reducing the amount moving to your Roth to $40,000 for the above example. However, some investors decide to convert the full amount and pay the tax out-of-pocket to maximize the amount of tax-free Roth IRA dollars available to invest and compound tax-free.
Continuing this example, if you chose to pay the tax out-of-pocket, you would have $50,000 in your newly established Roth IRA, after the conversion, available to invest.
It may be difficult to weigh the present cost of a Roth conversion and accept the tax hit today without any concept of the potential benefits in the future. One helpful way to conceptualize a decision 10, 20 or even 40 years down the road is to utilize a Roth IRA Conversion Calculator
, which we used in our video breakdown of a Roth conversion example:
Watch: Roth IRA Conversion Calculation
Roth IRA Investing Options
With a self-directed Roth IRA at Equity Trust, you have the freedom to invest your Roth IRA in real estate, notes, private equity, precious metals, cryptocurrency and a wide variety of alternative assets, in addition to stocks, bonds and mutual funds in your tax-free account.
Understanding how a conversion works is the first step to considering the option of a Backdoor Roth IRA. Evaluating a Roth conversion means assessing where you are today compared to where you may be in the future.
Remember, since it is a taxable event, it’s important to consult with your financial advisor or a tax professional before deciding to do a Roth conversion.
Case Study: Roth Conversion
In 2010, two Equity Trust clients rolled over their 401(k)s to Traditional IRAs at Equity Trust. The couple were both real estate investors and were confident they could achieve a solid return in their IRAs through real estate investing.
They decided to each do a Roth conversion
and started with approximately $100,000 between both Roth IRAs.
Fast forward to today, less than ten years later, and they’ve grown their Roth IRAs to over $1,000,000 and have 13 rental properties between both accounts.
Their rental properties are generating nearly $110,000 in tax-free cash flow each year.
Since they are both over the age of 59½, they’re able to take tax-free distributions from the cash flow in their accounts. They can also continue holding the properties and investing without worrying about Required Minimum Distributions (RMDs).
Today, that tax-free cash flow can be traced back to their decisions in 2010 to execute Roth conversions.
They now have the ability to fund their retirement years with their tax-free investment income, can cash out tax-free by selling the properties or have the option to leave a portfolio of tax-free, cash-flowing properties to their children, grandchildren or whoever is the beneficiary of their accounts.
Ready to Get Started?
If you’re interested in learning more or have questions, schedule a consultation today
. To get a better understanding of the Roth IRA specifically, download our free guide.
Examples and case studies are provided for illustrative purposes only. Past performance is not indicative of future results. Investing involves risk, including possible loss of principal. Information included in the above case study was provided by the investor and included with permission. Equity Trust Company does not independently verify all information provided by third parties.
Equity Trust Company is a directed custodian and does not provide tax, legal or investment advice. Any information communicated by Equity Trust Company is for educational purposes only, and should not be construed as tax, legal or investment advice. Whenever making an investment decision, please consult with your tax attorney or financial professional.