01/17/2025
Roth Conversions - Building Tax Free Wealth for Retirement
Roth IRAs and Roth 401ks are amazing vehicles for building financial resources into the future. Want distribution flexibility in retirement? Roth. Want to leave a completely income tax free gift to your heirs? Roth. In line to receive a pension during retirement and want to keep your taxes down? Roth. The benefits go on.
Roth accounts function as the mirror of traditional, pre-tax accounts...similar but reversed. With a traditional IRA or 401k, you receive an up front tax deduction, your earnings grow tax free, but when you withdraw the funds in retirement, both the contributions and earnings are taxed at your highest marginal rate.
Roths are the opposite. You do not receive an up front tax deduction, your earnings grow tax free, but when you distribute funds in retirement both the contributions and earnings are tax free. Amazing, right?
You might be thinking "Great! I choose whether to make a pre-tax traditional or post-tax Roth now, and then when I get to retirement, I pay taxes on the pre-tax IRA and don't pay anything on the Roth. Easy!"
But not so fast! You have another option available to you called a Roth Conversion that can turn massive amounts of pre-tax dollars into post-tax Roths.
Below we will explore two of the main types of Roth conversions: Roth IRA Conversions and 401k Intra-Plan Roth Conversions. Each have unique rules that govern them, but both can be powerful planning tools if used wisely.
Roth IRA Conversions
Roth IRAs have one main limiting factor to building significant wealth...they have income limits. In other words, if you make too much, you cannot contribute to a Roth in that year.
Enter Roth Conversions. As opposed to Roths, traditional IRAs do not have an income limit, meaning you can make a contribution to a traditional IRA regardless of how much you make.
What does this have to do with Roths? There is NO earnings limitation on a Roth Conversion...i.e. transferring funds from a traditional IRA to a Roth IRA. To be clear, you WILL pay taxes on the conversion amount (no penalties!), but ultimately, you end up in roughly the same place...you have added funds to a Roth IRA that will be tax free for the rest of your life, your spouse's life and even your heirs lives!
This strategy can be applied in a few different ways. First, you can make a traditional IRA contribution, and then decide at some future date to convert that contribution into Roth funds using a conversion. This is a way to slowly build your Roth savings over time.
Another option is to convert larger lump sums that have accumulated in your traditional IRA. You can do this at any time, but keep in mind that if you are working, the conversion amount will be taxed at your highest marginal income tax rate.
In my opinion, the best time for large Roth conversions is in "gap income years"...i.e. years where your income is low. This may happen if you take a sabbatical year, or if you retire early, before you receive either a pension or social security. The potential for "tax arbitrage" in these gap years is incredible...you can make Roth conversions using your 0%, 10%, 12% and perhaps even 22% or 24% brackets and convert hundreds of thousands of dollars into tax-free funds at relatively low costs.
401k Intra-Plan Roth Conversions
While slightly more obscure that Roth IRA conversions, 401k Intra-Plan Roth Conversions can be an even more powerful tool for building longterm Roth savings.
If you have a 401k, you are probably aware that there is a cap on how much you can contribute in a year...specifically $23,500 for 2025 if you are under age 50. Many plans allow you to make either pre-tax and/or Roth contributions up to that limit.
However, some plans now allow you to make AFTER-tax contributions beyond this $23,500 limit. To clarify, these contributions are NOT Roth contributions. In and of themselves, they offer no benefit other than tax-deferred growth, similar to a non-deductible IRA contribution.
But the story doesn't end there. In conjunction with the after-tax contributions, these same plans will offer you the ability to IMMEDIATELY convert those after-tax contributions into Roth funds, effectively circumventing the $23,500 limit on contributions.
To illustrate how powerful this can be, imagine you make $200,000 and your employer offers you a 5% match. A maximum Roth contribution would be $23,500, your employer would put in $10,000, but then you could effectively put in another $36,500 into Roth using an Intra-Plan Roth conversion (401ks have a maximum total contribution limit of $70,000). All told, you end up with $60,000 in Roth and $10,000 pre-tax. Do that for 10 years, add in some compounding and you have potentially over $1 million in tax-free retirement savings.
There are nuances to how roth conversions work, and as always, some tradeoffs. But with discipline and a sound strategy, you can build a tax-free nest egg that can support you and your family for well into the future. If you are interested in learning more about Roth conversions, or have other financial related questions, feel free to reach out to me via PM.
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