What is a Roth conversion?
A Roth conversion is the conversion of the tax type from Traditional to Roth. Funds and/or assets transfer from a Traditional account to a Roth account. Because the person who has a Traditional IRA or 401(k) likely took an income tax deduction when they contributed to their retirement account, the IRS never collected income tax on that contribution.
Tax structure of a Traditional IRA or 401(k):
Contributions to a Traditional IRA and 401(k) are eligible for a tax deduction. Plus, the earnings on that money can compound inside the account without paying income tax. The withdrawal (distribution) of funds or an asset from a Traditional IRA or 401(k) triggers a taxable event. The distribution value determines the tax rate.
Tax structure of a Roth IRA or 401(k):
Contributions to a Roth IRA are not tax-deductible. However, the growth and the distributions from a Roth account are not taxed. So if you think your investments will grow in value, a Roth IRA could save you from paying an enormous tax bill at the time you take your distributions.
If a conversion from Traditional to Roth is a taxable event, why would a person want to convert?
- Let’s say you have $75,000 in your Traditional account.
- So far, you have paid zero taxes.
- You are about to make or have recently made an investment that you think will be successful.
- Let’s say you believe it will grow to $250,000.
What might you do?
- Contact IRA Club and instruct us to convert your Traditional account at its current value ($75,000) to a Roth IRA.
- Results: You have a taxable event based on the current value ($75,000). Ouch.
- However, when the asset grows to $250,000 and you take a qualifying distribution, you pay zero taxes. Because the distribution is now coming from a Roth IRA account, not a Traditional IRA, the $250,000 comes to you, income tax-free.
What is a Backdoor Roth conversion?
- Alice Smith owns a successful small business (she has no employees). To help her reduce future income taxes, she wants to put as much as possible into a Roth IRA.
- She currently has a Solo 401(k). A Solo 401(k) allows a contribution based on a percentage of her business profits.
- Alice’s business is profitable, and Alice is over 50. Her maximum 2022 contribution to her Solo 401(k) would be $67,500.
- But wait a minute, all this money is going into her self-employed 401(k), but she wants it to go into a Roth IRA to save taxes in the future.
- Unfortunately, Alice earns too much to make a Roth contribution, plus, a Roth IRA can’t accept that much money as a contribution.
Remember, Alice wanted her money in a Roth IRA (to reduce future income taxes.) However, she used a Solo 401(k) to get the most into the account.
How does the money go from the Solo 401(k) into a Roth IRA?
- Because there are no limits on Roth conversions, we could tell Alice to do a Roth conversion of the $67,500 from the Solo 401(k) to a Roth IRA.
- We would hold the $67,500 in her Solo 401(k) account overnight.
- The next day convert the money from the Solo 401(k) to a Roth IRA. Where Alice wants the funds to be.
- Now Alice can invest the Roth funds to get INCOME TAX-FREE RETURNS FOR LIFE. Sure, Alice has a taxable event based on the $67,500 conversion; however, that money can now grow, and all its earnings will never be taxed again.
However, what happens if the Building Back a Better America Act eliminates the Backdoor Roth conversion?
Don’t worry. IRA Club members will have a handy workaround. The proposed Act suggests eliminating the Backdoor Roth conversion, but it does not eliminate Roth conversions.
A Backdoor Roth conversion is a conversion that is complete before the end of the current tax year.
Let’s go back to Alice. Assume she made her 2022 Solo 401(k) $67,500 contribution on December 15, 2022. As the taxable year ends on December 31, 2022, Alice can complete her Roth conversion on the first business day following January 1, 2023. Sure, the conversion will not be completed the next day, and yes, Alice will need to wait a few weeks. However, she will get what she wants. A big pile of money in a Roth IRA.
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