Roth Conversions: A Fabulous Way to Build Wealth, Part 1/2

OCTOBER 05, 2016
Johanna Fox Turner, CPA, CFP

Imagine having a stash of hundreds of thousands of tax-free dollars awaiting your retirement.  No rules about what you can use the money for, and no limits - at any time you choose, you can take out all, a little, or none. And because you aren't required to take onerous RMDs (Required Minimum Distributions), you can leave a bundle of tax-free income to your heirs and they'll never pay a dime of taxes, either.

I'm describing a Roth IRA, a valuable financial planning tool and a potent estate planning device. You can contribute up to $5,500 to a Roth each year or $18k into a Roth 401k ($6,500/$24k if age 50+) but it’s unlikely you’ll get to 6- or 7-figure accounts that way. You also need to make periodic Roth IRA conversions.

A Roth IRA conversion is a way of moving money into a Roth IRA without making a direct contribution to a Roth IRA. You are "converting" the character of your savings from a traditional retirement account to savings that will forever grow tax free. While you have until April 15 to contribute to an IRA, conversions are always made on a calendar year basis.

There are several ways to convert retirement funds into a Roth IRA:
  • By converting a pre-tax TIRA (Traditional IRA) to a Roth After training, it is doubtful you will qualify to contribute to a pre-tax TIRA, but you probably have an IRA from low-earning years. You can move (convert) all or part of it to a Roth IRA each year. The best time is when your AGI is unusually low, such as your last year of training with only a partial year of attending salary. You’ll pay taxes on the amount you convert, so run the numbers to make sure you can afford to do so.
  • By converting a nondeductible TIRA to a Roth If your AGI is above certain limits, your TIRA contributions will be nondeductible. Any growth in a nondeductible TIRA will be taxed at your highest marginal tax bracket when you withdraw the money. To avoid this, you should convert this balance to a Roth as soon as possible. This is called a "backdoor” Roth conversion. (NOTE: you will owe taxes on part of your backdoor conversion if you have other pre-tax IRA accounts that you have not yet converted. I do not recommend a backdoor conversion if you will owe taxes.)
  • By converting employee rollovers to a Roth When you change jobs, you can roll the balance in your 401k or 403b out to an IRA. You can also roll this money directly into a Roth IRA or gradually convert to a Roth over a period of years.
  • By making an “in-service” rollover Many retirement plans allow for after tax contributions to your account. For example, if you have already filled out your $18k ($24k if age 50+), you can contribute another $35k ($41k if age 50+) in after tax contributions. Beginning in 2015, the IRS allows you to convert these funds to a Roth IRA, allowing for a supersized Roth contribution, as I wrote about recently.
And here’s one of the best incentives to convert to a Roth: The IRS lets you “recharacterize” your conversion if you change your mind later. I call it a Roth conversion mulligan. You have until October 15 of the year following the year you converted to recharacterize, or “undo”, the transaction, if the stock market drops or you can’t pay the tax bill. One nifty trick is to convert sectors of the market into several Roth IRA accounts (Large caps, International, and REITs, for example). You would recharacterize only those sectors that are down, leaving the sectors that have gained alone. If you convert on January 2, you have 21.5 months to decide what and how much to recharacterize!

But how are Roth IRAs a "fabulous way to build wealth", as my title claims? In the next article, I'll refute the conventional wisdom that you should wait until retirement to convert. Roth conversions, carried out strategically, should be made early to begin the wealth accumulation process. In my next article, I’ll explain why and how you should convert sooner rather than later.

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