Diversifying Your Retirement Plan Assets with Roth Conversions

A Roth Conversion provides a way to shift the tax treatment of retirement funds from being taxable to tax free upon distribution. That may sound too good to be true, but there is a cost associated with doing the conversion because the IRS does not offer anyone a “free lunch”. When you execute a Roth Conversion, you take money that had been previously untaxed, either partially or fully, and move it into an account that can be withdrawn from and not subject to income tax, assuming you have met two conditions: you are age 59-1/2 or older and you have held the account for at least 5 years. In order to make that money movement, however, you must count the amount that you moved as income in the year you executed the conversion. That recognition of income is what allows the tax treatment to be changed because you in essence have turned what had been a tax deferred investment into one where the income tax on the deposit has been paid. As a result of that, there are no taxes due on any growth that the investment gains in subsequent years. Let’s illustrate how this would work through an example.

You are 60 years old and contributed over the years $15,000 to your Traditional IRA account on a pre-tax basis, and the value of the investment has grown to $25,000. If you wanted to withdraw those funds in full, the entire $25,000 would be subject to income tax, which would be $6,250, assuming a combined 25% tax rate. On the other hand, if you decided to convert the $25,000 to a Roth IRA instead, you would need to count the $25,000 as income for that year, paying the tax on the conversion when you filed your tax return, the same $6,250 you would have owed if you took the full distribution in cash. Let’s say that you didn’t need to withdraw those funds anytime soon, and in the next 10 years, the Roth IRA had grown to $50,000 in value. If you decided to withdraw the funds in the account at that point, you would have the full $50,000 at your disposal with no additional taxes due because you paid the “toll” at the time of conversion, meaning you would have received more than double the amount of proceeds than had you left the money as a Traditional IRA.

When executing a Roth Conversion, it is always preferred that you plan on paying the tax due from funds outside of the investment. If you don’t make that provision and instead withhold the tax at the time of conversion, you will be starting your Roth account with a smaller amount, and will have to overcome that reduction before you start truly benefiting from the tax-free gains. Perhaps the easiest way to cover the tax on the conversion is by adjusting withholding from your existing income to account for the additional tax liability. In doing so, you will have less take home income throughout the year, but you allow all of your invested funds to remain at work and growing for you. If the amount of tax you will owe on the conversion of your pre-tax investment is too daunting, another route you can take is to perform a series of smaller conversions rather than trying to convert a much larger amount. For example, if you had $100,000 in pre-tax retirement plan assets, at a 25% tax rate, you would be looking at an additional $25,000 in taxes due from the conversion. If you instead decided to convert $10,000 per year over 10 years, you would still be converting $100,000, but you would only be increasing your taxes due by $2,500 annually, which is a more manageable figure to handle year-by-year.

Since you must pay the tax on the amount of assets you convert, it benefits you to execute a Roth Conversion on a smaller amount of assets, with the expectation that the value will grow in the coming years. If you hold a tax deferred investment, it is to your advantage to execute a conversion when the value is at a lower point. Of course, we never want to see the value of our investment drop, but a drop in the value of a tax deferred investment presents an opportune time to execute a Roth Conversion. As an example, let’s say you hold a tax deferred investment that grew to $50,000 in value, but due to market movement had declined to $40,000 in value temporarily. You can turn the proverbial lemons of the $10,000 drop in value into lemonade by converting while the value is at the $40,000 point, essentially saving yourself $2,500 in taxes, assuming the 25% combined tax rate we’ve been using. From that point forward, any growth, even getting back to the $50,000 valuation you had before, would come with no additional taxes due. A variation on this same strategy is utilizing investments that are structured such that they are expected to reassess the value to a lower amount temporarily. A good example of this is oil and gas exploration because those investments by their nature deplete the resource they are investing in during the early stages, which allows them to “write down” the value of the investment. If you can convert the asset during the period of time when the value has been written down, you can see more tax-free gain if the value goes back up again. A strategy that can be employed by higher earners is known as the “Back Door Roth”, which can be done in one of two ways, in an IRA or an employer plan. The reason it is known in this lingo is that it is a way for people whose income exceeds income limits for Roth contributions to get money into a Roth indirectly. For the IRA version of this, you would make a contribution to a Traditional IRA but not take the tax deduction, making it a Non-Deductible Traditional IRA and then convert the assets to a Roth IRA. Note that this approach has limited utility if you already own a Traditional IRA. The other option is performing a similar approach within an employer plan. As we said earlier, it is more common for employees to contribute pre-tax to their work retirement plan, but executing this Back Door Roth in an employer plan may be another option to consider. Similar to a Roth contribution, After-Tax contributions to an employer plan do not lower your current income taxes, but they are not subject to the employer plan contribution limits. The downside is that they also do not provide the tax-free distributions that you get with the Roth assets in the plan. If your employer plan allows it, a way to close that loop is to do an In-Plan Conversion, making the After-Tax contributions and subsequently converting those assets to Roth assets. If you can do either of these strategies before there is a gain in the value of the assets, you can do that conversion without increasing your tax liability.