When to do a Roth Conversion – Advice from a Tax Attorney

One of the most popular questions that I receive from clients is whether they should elect to convert their pretax IRA or 401(k) to Roth.  This article will explain what a Roth IRA is and details the advantages and disadvantages of electing to do a Roth conversion.

Roth IRA & Roth 401(k) Advantages

Roth IRA

A Roth IRA is an after-tax account that offers tax-free income and gains if you are over the age of 59 1/2 and any Roth has been opened at least five years.  The maximum Roth IRA contribution is $6,000 for 2022, plus an additional “catch-up” contribution of $1,000 if you are at least age 50.

Unlike a pretax, or traditional IRA, a Roth IRA does not have a required minimum distribution (RMD) at age 72. This gives Roth owners a distinct advantage as they don’t have to draw down the account if they don’t need to. Instead, they can pass it on to their beneficiaries in whole.

Though, there are income limitations on who can make Roth IRA contributions.  For example, if one is single and earns more than $144,000 or married/files jointly and earns more than $214,000, he or she cannot establish a Roth IRA.  However, since 2010, there is no longer any income limitations on Roth conversions.

Enter the “Backdoor Roth IRA” conversion strategy.  Now, one who earns more than the Roth IRA income limitations, can make an after-tax IRA contribution to a traditional plan, and then immediately convert to Roth.  There would be no tax on the conversion from after-tax to Roth, although, if the individual had other pretax IRA funds at the time of the conversion, the amount converted to Roth could be limited based on the pro-rata conversion requirement.

Roth 401(k)

Like a Roth IRA, a Roth 401(k) account is an after-tax account where the income generated by the Roth grows tax-free. Distributions can be taken tax-free so long as the Roth 401(k) participant is over the age of 59 1/2 and any Roth has been opened at least five years.

Unlike a Roth IRA, there are no income limitations for making Roth 401(k) contributions. Further, a Roth 401(k) does have RMD requirements at age 72. However, they can be circumvented by having the funds rolled into a Roth IRA prior to December 31, leaving the balance of the Roth 401(k) at zero.

Roth Conversion Advantages

The major advantage of electing to make a Roth conversion is the ability to receive tax-free wealth at retirement. So long as the requirements mentioned earlier are in place, you don’t pay single cent in taxes on the funds or assets withdrawn. Have cash in the account? Withdraw it tax free. Own an investment home with your Roth, distribute it from the plan and gain the ability to utilize it – all tax free.

As we mentioned, beginning in 2010, the modified Adjusted Gross Income (“AGI”) and filing status requirements for converting a traditional IRA to a Roth IRA were eliminated.  Prior to 2010, any taxpayer with earned income above $100,000 was not permitted to do a Roth conversion. However, the IRS was in need of funding, so the restriction was eliminated to collect taxes.

Savings from a traditional IRA or an employer-sponsored plan, including 401(k)s, 403(b)s and 457(b)s, can be converted to the Roth.

Currently, in 2022, anyone with a pretax IRA or 401(k) can do a Roth conversion.  Income tax, and not capital gains, would be due on the amount of cash and/or the fair market value of the asset converted. The tax rate is based on all net income reported on your IRS Form 1040.

For example, if one purchased Bitcoin for $60,000 in 2021 and on the date of the Roth conversion, the Bitcoin was worth $22,000, the tax due on the conversion would be on the fair market value at the date of the conversion ($22,000) and not what the asset was purchased for.

Should I do a Roth Conversion?

There is generally no wrong or right answer as to whether one should do a Roth conversion.  Every individual is different. Below are a few key points to keep in mind before deciding to perform a conversion:

• Age The younger you are, the more tax-free deferral opportunities you will have.
• Can you afford to pay the tax?  If you cannot afford to pay the tax on the conversion with personal funds and have to use some of the converted funds to pay the tax, then doing the Roth loses some of its appeal.
• Type of investments to be made Does the investment have upside?  How risky is it?  Will there be cash flow?  In most cases, taxpayers who believe their investment will lead to a major gain would be more inclined to engage in a Roth conversion in order to lock in the tax-free gains.  The downside to this strategy is that if the investment falters, then you have just paid tax at an inflated price and are left with an asset at a lower value.  Not an optimal situation to be in.
• Future income tax rate expectation What do you expect your income level to be at when you reach age 72?  If you expect to be in a high-income tax bracket, then doing a Roth conversion may make more sense than if you will be in a lower tax bracket. The higher your income, the more taxes you pay!

In sum, the key is to consider the liability of paying tax up-front on potential gains vs. the benefit of having tax-free income at a later time. The major Roth conversions risks are:

• Memories of Enron, Lehman, Bitcoin, etc. Convert at a high value and now asset is worth less.
• Roth IRA rules change As the Build Back Better bill showed, politicians aren’t afraid to go after retirement plans, which could diminish the power of the Roth.
• Premature Roth IRA distributions If you think you’ll need access to those funds prior to them being “qualified,” you’ll face taxes, penalties, and the tax-free growth of the account.

Roth IRA Conversion Strategies

Here are three popular Roth conversion strategies you may be able to take advantage of.

Depressed Asset Value

Every dark cloud has a silver lining. When the value of the assets you hold in a pretax retirement decline, the silver lining is that it makes a Roth IRA conversion more attractive.  In times of financial uncertainty, such as our current economic condition, gaining the ability to convert temporarily devalued assets to Roth has a major tax advantage.

Of course, the risk is that the asset will not increase in value after the conversion date (remember Enron, Lehman, Bear Stearns, etc.) Nevertheless, if you believe in the future growth potential of the asset that has experienced a decrease in value, a conversion could prove to be a very savvy tax decision.

Discounted Valuation

The amount of taxable income on a Roth conversion is based on the fair market value of the IRA asset(s) subject to the conversion. Therefore, the lower the fair market value of the IRA asset, the less taxes that will be due on the conversion.

Fair market value is an objective test using hypothetical buyers and sellers. Depending on the asset being converted, receiving a discounted valuation for the asset from 20%-50% could be possible.  For example, common discounted valuations used by appraisals would be for a lack of control or marketability of the asset, such as raw land or minority interests in privately-held entities.

Net Operating Losses

Since Roth conversions trigger ordinary income tax, having net operating losses (NOL) that can be used to offset ordinary income on a taxpayer’s individual income tax return (Form 1040) could prove highly valuable.

The NOLs could reduce, or potentially even eliminate, the tax owed on the Roth conversion depending on the amount of NOLs available.  They generally come from active pass-through business losses or other deductions.

Conclusion

The Roth conversion option can prove to be a highly valuable tax and estate planning strategy.  There is no guarantee that your Roth conversion will prove successful.  However, gaining the ability to lock in tax-free growth on a growth asset or income-producing asset can be potentially very tax rewarding.

By Adam Bergman, Esq.

About the Author

Adam Bergman is the Founder of IRA Financial Group & IRA Financial Trust. Prior to starting IRA Financial, Mr. Bergman worked as a tax and ERISA attorney at some of the largest law firms in the world, including White & Case LLP. Adam has written 8 books on self-directed retirement plans and is a frequent contributor to Forbes.com.