Should You Do a Roth IRA Conversion?

Let's start at the beginning:

🏦 What even is a Roth IRA Conversion?

The process of rolling over money from a Traditional IRA to a Roth IRA. There is no limit on the rollover amount and no income restrictions on who can complete the conversion, but the funds are TAXED at the time of the conversion. The contributions can be withdrawn penalty-free after 5 years.

🤔 Who should consider it?

• High-income earners who cannot typically contribute to a Roth IRA

• Someone in an abnormally low tax bracket (due to job loss, sabbatical, business losses, etc.)

• Someone looking to retire early who will need access to their retirement funds earlier than the typical retirement age.

👉 What is the process?

1. (Optional) Roll over an old 401k account to a Traditional IRA

2. Open a Roth IRA account

3. Roll some amount of money from a Traditional IRA account to the Roth IRA account

4. Invest the Roth IRA money into funds/stocks/bonds of your choosing

5. (If needed) Make an estimated tax payment before the end of the year to cover the conversion

💰 What are the benefits?

• Can potentially pay a lower tax rate on retirement savings

• The Roth IRA now grows tax-free forever

• Earlier access to retirement contributions

• No Required Minimum Distributions (RMDs) in retirement

  
  

Example:

Ella leaves her current job and takes a year-long sabbatical to travel and work on some side projects. Her income during this year is unusually low compared to her usual tax bracket.

Because Ella has left her job, she rolls her previous 401k into a Traditional IRA. This is all pre-tax money, so she has never paid any taxes on the contributions or the growth. Ella’s income is normally too high to contribute directly to a Roth IRA.

Since she has no income this year, Ella decides to complete a Backdoor Roth IRA Conversion – she opens a Roth IRA and rolls $24,850 from her Traditional IRA into this Roth IRA. Income taxes are now due on the $24,850, but since that is the only income Ella has this year, after the standard deduction of $13,850, Ella only owes 10% tax on the remaining $11,000, for a tax bill of $1100, and a total net tax rate of 4.4% on that $24,850.

🎉 Ella was able to deposit that money in her 401k tax free, move it to a Roth IRA at only a 4.4% tax rate, and now it will continue to grow forever tax free. She can also withdraw that $24,850 contribution in 5 years without penalty! 🎉

What is a Backdoor Roth IRA Conversion?

Another popular type of Roth Conversion is the "Backdoor" Roth IRA Conversion. High-income earners often don't qualify to contribute directly to a Roth IRA and they often have to contribute after-tax (rather than pre-tax) dollars to a traditional IRA (due to having a workplace 401k and a high income). The Backdoor Roth IRA Conversion gives them a path to land those after-tax dollars in a Roth IRA anyway.

👉 How it works:

1) Deposit after-tax dollars in your Traditional IRA

• Try not to mix pre-tax and post-tax dollars in your IRA, as this move can get messy and trigger more taxes because of the IRS “pro-rata rule”.

2) Wait at least 30 days, and roll those funds into a Roth IRA within the same calendar year

That money now grows tax-free, and you’ve just snuck into the Roth club through the backdoor!

The big difference between the two types of conversions is that a regular Roth Conversion typically involves pre-tax money (either rolled from a 401k or already in a Traditional IRA), while a Backdoor Roth Conversion typically involves after-tax dollars.

Whether you’re using the backdoor or doing a regular Roth conversion, the goal’s the same - more money growing tax-free for the long haul. It’s all about playing smart with your tax strategy now so 'future-you' has way more freedom later.

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