TAXES | IRA Roth Conversion Strategies
Updated: Jul 4, 2019
A ROTH IRA is an individual retirement account that allows after-tax contributions to grow and be distributed after age 59½ are tax-free. To be clear, distributions from a ROTH IRA are not taxed. So, money contributed to a ROTH IRA could grow exponentially, and that growth would never be taxed.
If you have earned income and a modified adjusted gross income of less than $137,000 and $203,000 for single and married taxpayers respectively, you can contribute directly to a ROTH IRA. If you do not meet those requirements, the only way to contribute to a ROTH IRA is with a ROTH IRA conversion.
When assets in a qualified retirement account are converted to a ROTH IRA, the converted value is reported as income for the tax year in which the conversion occurred. This means the converted amount is taxed at the taxpayer’s highest marginal tax rate. ROTH conversions are an important tool for tax management—especially during post-retirement years when there is still room in some of the lower tax brackets. However, ROTH conversion mistakes can be very costly, so they should be done as part of a comprehensive tax management strategy.
Here are several conversion strategies:
Backdoor ROTH IRA
Taxpayers who do not qualify for to contribute directly to a ROTH IRA can use a two-step, backdoor ROTH IRA contribution. The first step is to make a non-deductible IRA contribution. The second step is to convert the desired amount to a ROTH IRA. An amount equal to the after-tax, non-deductible IRA contribution can be converted to a ROTH without incurring tax. Prudent advisors encourage tax payers to wait a period of time between the two steps to avoid violating the IRS’ step transaction doctrine.
Mega Backdoor ROTH
Taxpayers who participate in 401(k) plans that allow for both after-tax 401(k) contributions and in-plan ROTH 401(k) conversions, can convert more money than would otherwise be available. For participants in plans that qualify, the process is relatively straightforward.
Similar to dollar-cost averaging for investors who spread their purchases out over multiple periods to mitigate timing risk, conversion-cost averaging involves converting equal amounts of a period of time to avoid timing risk. For example, a taxpayer who wanted to convert $120,000 in one calendar year could either convert the entire amount in January or convert smaller equal amounts over the course of the year. This approach reduces the taxpayers risk of being taxed on assets converted at market highs.
Working together investment and tax advisors can use ROTH IRA conversions to leverage lower tax brackets. One approach is to run year-end tax projections, and then determine the optimal ROTH conversion for that year based on the projected taxable income for the year. However, waiting until the end of the year can not only increase timing risk but it also requires everyone involved to remember to run the calculations. Another solution is to prepare projections in the first quarter and convert 80% of the projected amount with the intent to execute a second conversion later in the year to maximize tax bracket management.
Converting distressed assets where recovery is expected leverages ROTH Conversions’ long-term tax benefits. ROTH Conversions completed after either steep market contractions or security-specific events can be extremely valuable because tax is calculated on the distressed value and the recovery is tax free.
ROTH Conversions can be executed with either cash or specific securities. Because securities in an IRA can be sold without tax implications, in most cases, it is easiest to sell a position, convert cash to the ROTH IRA, and then purchase the original security. Some securities, however, are not liquid, and therefore the specific security must be converted to the ROTH IRA.
As always, please consult with your tax advisor to determine how tax rules affect your personal circumstances.