[My April column in Physician's Money Digest is on a strategy that isn't particularly new, but if you haven't heard of it, then it is new to you. I frequently am asked to write something about Roth conversions, and this article gave me a chance to cover them in general, but also the multiple Roth/recharacterization strategy used by more and more people every year.]
Many investors are aware of the benefits of a Roth conversion. Essentially, any time an investor owns a tax-deferred account, the government gives him the right to change it at any time to a tax-free Roth IRA. The only price to pay is the taxes due on that money. Thus, for most investors, there are times in life when it is more advantageous to do a Roth IRA conversion than others. Before examining those times, and discussing a less well-known strategy for doing these, let’s consider the benefits of a Roth IRA conversion.
4 Benefits of a Roth IRA Conversion
The main benefit of a Roth conversion is that the investor’s tax-free to tax-deferred ratio increases. This allows for lower future tax bills. This is especially advantageous when the taxes can be paid at a lower rate now than they can in the future. That higher future tax rate may occur due to either personal financial issues, or dramatic changes in the tax code. If nothing else, more tax-free money provides valuable flexibility and tax diversification in retirement.
A second benefit is an advantage that Roth IRAs (but not Roth 401(k)s) have over traditional IRAs—there are no Required Minimum Distributions (RMDs) on Roth IRAs. Thus, a Roth conversion allows you to leave your money in a tax-protected account for a longer period of time, and thus have more to spend or pass on to heirs.
A third advantage of a Roth IRA conversion is that it allows you to essentially move money from a taxable account accessible to your creditors to a tax-protected account not available to your creditors (in most states.) For example, instead of $30,000 in a traditional IRA and $10,000 in a taxable account, after the conversion you may have $30,000 in the Roth IRA.
Finally, a Roth IRA conversion reduces the size of your estate and may keep your estate size under the federal, or more likely, a lower state estate tax exemption limit.
The Seasons of Your Life and Roth Conversions
The idea behind a Roth conversion is that you want to do them when your taxable income is relatively low compared to your peak earnings years. Residency and especially the year you leave residency are relatively attractive times. If you cut back to part-time for any reason, or go on a sabbatical, that is also a good year for a Roth conversion. Perhaps the most popular time for Roth IRA conversions is after retirement but prior to receiving Social Security benefits.
Multiple Roth IRA Conversions
A little-known technique for doing Roth conversions involves taking advantage of the government’s offer to re-characterize your Roth IRA conversions. If you decide that a conversion was a mistake, you can reverse it until October 15th of the following year. That allows you a period of 9-21 months to change your mind. The IRS does not, however, require you to have a good reason. You can do it for whatever reason you like, including if it is financially advantageous to do so. This is the essence of the multiple IRA conversions strategy.
If your goal were to do a $20,000 Roth conversion, but you wanted to make sure it was as financially advantageous as possible, you may wish to split your IRA into multiple $20,000 IRAs. Perhaps 2, 3, 4, or even more. Convert ALL of them to a Roth IRA and invest each IRA into a different asset class. Perhaps one into US Stocks, one into international stocks, one into bonds, and one into real estate. The asset class that performs the best is left as the “true” Roth conversion, while you re-characterize the rest. For example, if your marginal tax rate is 25% and the US stock market did poorly and dropped 40% while bonds went up 10%, converting the “bond IRA” instead of the “stock IRA” means you get $22,000 in the Roth IRA for your $5,000 in taxes instead of $12,000 for that same $5,000 tax bill.
This strategy obviously involves significant hassle, and may not be worth the time and effort for smaller conversions, but the larger the conversion, the more benefit to the strategy. There are 2 more re-characterization rules to be aware of. If you later decide to reconvert an IRA you re-characterized, you must wait 30 days, or until the first of the year after the conversion, whichever is longer. Also, if you do your re-characterization after filing your taxes, you must file an amended tax return. These rules are important to be aware of, but relatively easy to work around. For example, if you wait until October of the following year to re-characterize, you only have to wait 30 days to initiate a new conversion. You can even delay filing your taxes until October by filing for an extension.
Roth IRA conversions are likely to make sense for you at some point in your life. This multiple IRA conversion strategy can help you to eke out even more benefit from doing them.
Sitting here today, this seems like it’s on the wrong side of the hassle/reward factor. Maybe that will change when retired and I’m actually doing the conversions. Something to keep in mind.
It also comes down to the size of the conversion. Not much bang for the buck for a $5K conversion, but for a $100K conversion? Maybe different story.
Adding to the complexity is the need to transfer previous traditional IRA money into and out of 401k status, if one were also interested in backdoor roth, unless the career sequence is a more traditional roth ira (residency), traditional 401k with concurrent backdoor roth ira (attending), transfer to trad IRA then conversion to (multiple) roth (Early-ish retirement).
How would the Roth conversion work for SEP-IRA?
You transfer the money from a SEP-IRA to a Roth IRA, paying taxes on the income in the year of conversion.
I really like that you are getting into these esoteric topics related to maximizing all of the advantages in the tax code if retirement accounts. Many times these saving are seen as being more significant for the lower income early retiree but the scale on which high-saving, high-income can employ these strategies can literally save hundreds of thousands of dollars in taxes, generally worth your time!
Interesting ideas. Like many things I learned here, can’t use it right now, but when I do retire and have some more time to try it all out, I’ll have to come back an review this.
I wonder how many financial advisors would help you through this? I may be a skeptic, but I doubt many would bring up these strategies on their own.
Avg income: $550k/yr, independent contractor
I have been doing full SEP and back door Roth conversions for about 3 years now. I have had some advisors say the opportunity costs of the money I’m currently paying in taxes to convert outweigh the future benefit of tax free withdrawl. This is the crux. If things go well and I have millions in my retirement accounts, I will theoretically still be at the highest tax bracket; therefore withdrawing tax free at the time seems very appealing. If Washington has taken an about face by that time (who here thinks this is likely?) I may lose a little on the math.
By converting your entire SEP, you’re also betting you’ll never have the chance to do the conversion at a lower rate- sabbatical, early retirement etc.
Part of me is worried they will take the conversion away especially as more and more people catch on to it.
Why, they still get their tax money with these conversions.
The whims of Congress can be pretty interesting sometimes.
our ret plans are in partnership with the govt as there is 24 trillion in these accts and the govt will get their fair share with conversions and distributions
OBAMA WANTS RMDS for roths as well as limits on your ret accounts-will never pass and Gov Christie wants no SS benefits if you earn over 200k
Why not be even more ambitious? Do 1000 conversions, each invested in a different emerging markets nanocap value stock.
Sounds like an idea for an ambitious Robo advisor service with a spare computer engineer.
Keep in mind, however, you are only recharacterizing the conversion not reversing the whole trade. Doesn’t make sense to incorporate assets that you wouldn’t be investing in the tax deferred or taxable account, anyways.
-Dr. JB
When reading about Roth conversions, I get confused about the maximum limit you can convert. For example, let’s say I hypothetically contribute $10,000 into a SEP-IRA when I’m 30 years old; I then decide to convert that into a Roth when I’m 35 years old. In this scenario, let’s assume I continued to contribute $10,000 per year, bringing the total to $60,000. Since the maximum Roth contribution is $5,500 per year, does that mean I could only convert $5,500 x 6? Or could I convert the whole $60,000?
No limit on IRA conversions, only IRA contributions. So you could do the whole $60K, $600K, or $6M if you like.
Wow, that is great. Thanks for your response.
I am a dentist finishing residency, and I will be an employee for the next two years with no retirement plan offered through the company I will be working for. I expect my income to be much less than it will be five years from now (when I am a partner), so I am planning on mostly contributing to my Roth over these next two years. If I want to contribute more than the maximum $5,500 per year to my Roth, should I also start a SEP IRA? That way my limit would be much higher, and I could convert even more into the Roth. Is there a better option for this? How else would you recommend maximizing my retirement savings while I am an employee?
Can’t have a SEP-IRA as an employee. You need self employment income. Pay off your loans, save up a down payment, boost your emergency fund, convert any old tax-deferred accounts you may have, backdoor Roths for you and a spouse, your spouse’s retirement plans, taxable account etc.
Thank you!
Are there any retirement accounts that can’t be converted into a ROTH IRA? I currently hold a SIMPLE IRA, a 401k, a ROTH 401k, as well as a TIRA. If I wanted to reduce my potential RMDs as much as possible down the road (15 years away), could I convert all of these into my ROTH IRA?
To add to this question, can I convert my HSA into a RIRA via TIRA after age 65?
You can do conversions at any age. You can do Roth IRA contributions at any age. You cannot do traditional IRA contributions after age 70 1/2.
http://www.irs.gov/taxtopics/tc451.html
However, you can never convert an HSA to anything else. It acts just like a traditional IRA after age 65, but only until your death. It can’t be stretched.
The Roth 401(k) to Roth IRA wouldn’t be a conversion, just a transfer/rollover. But the others are all convertible.
Hi, looking for a little advice on a big Roth conversion. I am in my mid 30s, and just left a job to start a new business in January 2015. I have about $200k in my previous employer’s traditional 401(k), as well as some miscellaneous traditional IRA accounts adding up to about $30k. Even though I am now self-employed in a new business, we’ll still be in at least the 33% tax bracket for 2015 between my spouse’s and my income. I plan to transfer my old 401(k) to an IRA soon, and I’d love to convert all my traditional IRAs (including the 401(k), once transferred) to Roth IRAs through the backdoor, but obviously that will cause a big tax bill, and it seems like the timing/order of operations could be important. Any thoughts on the best approach here? I asked my CPA, and it did not seem to be an issue he understood very well. Thanks!
That’s not the “backdoor” that’s just a standard Roth conversion. Backdoor Roth conversions have no tax cost. They’re like doing a direct contribution to a Roth IRA.
A $230K Roth conversion is going to cost you a heck of a lot of taxes. At what rate do you plan to convert it all? If you did all that in one year, a good chunk of it would likely be converted at 33%, 35%, 39.6% etc, not including state taxes. Do you really expect your effective withdrawal tax rate to be that high? I can see where if you’re in the 25% bracket or something this year where you might want to do a smaller conversion, but I have a hard time imagining a scenario where doing a $230K conversion in a single year is a good idea for the vast majority of doctors.
Thanks, WCI! I guess I don’t know what our effective withdrawal rate will be–that’s a good point, of course. I was more focused on the idea of wanting that tax free growth over the next 30+ years, and thinking that once I roll my old 401(k) into an IRA, the pro rata rule on the backdoor Roth will mean most of my conversions will be taxable. I didn’t know if it made sense to try to convert as much of my existing traditional IRAs and the 401(k) as I could to Roth in big chunks over several years, or what. Another alternative, of course, would be to leave my 401(k) with my old employer where it is–their investment options are not exactly what I would choose, but there are some ok choices available, and I wanted to have access to that money without going through them forever–but maybe it’s not the worst option after all.
Get some 1099 income, open an individual 401(k), and do your rollovers into that.
I was thinking about this more. Right now, I am operating as a solo practitioner, but will be incorporating as a PC with a partner in the next month or so. I wonder if I should open a solo 401(k) now, roll my old employer 401(k) into that, and then not have to worry about ever rolling that old 401(k) money into any kind of IRA, AND avoid paying pro rata taxes on all my backdoor Roth conversions going forward, AND maintain more personal control over that 401(k) money. I’m not clear on whether I could continue to contribute to the solo 401(k) after we incorporate (since we will both be shareholders, rather than partners in the legal sense), or after we take on an employee or two, which we’ll likely do in the coming year. But for now, anyway, the solo 401(k) might be the way to go.
You don’t have to close it just because you can’t contribute to it any more.
Just to clarify a point you made about the HSA acting like a TIRA after age 65: I was under the impression that HSA accounts are not included when determining RMDs, but TIRAs are once you hit 70 1/2.
That’s true. No RMDs with HSAs. Another difference from an IRA.
No RMD’s, but you don’t want to die with an HSA balance, or at least you don’t want to die with a non-spouse as the beneficiary.
I plan to spend down my HSA in early retirement and/or the early years of my retirement and preserve my Roth balances.
A good summary of the issue is this:
“When the beneficiary is not your spouse, the HSA ends on the date of your death. Your heir receives a distribution and the fair-market value becomes taxable income to the beneficiary—though the taxable amount can be reduced by any qualified medical expenses incurred by the decreased that are then paid by the beneficiary within a year of the death.
Failure to name a beneficiary at all means the assets in your account will be distributed to your estate and included on your final income tax return.”
http://time.com/money/3503270/what-happens-to-hsa-when-you-die/
Hi WCI,
Thanks so much for your post on the backdoor Roth IRA conversion. After reading all of these posts, I’ve decided to take the plunge, but definitely had a few more questions regarding the conversion. My situation is pretty simple:
*contributed to T-IRA for the last several years
*NEVER took a tax deduction,
*completed form 8606 every year to let the IRS know all contributions are after-tax payments
At present, I have not made any contribution to 2015 because I had wanted to do more research on the issue.
My questions are as follows:
1) Do you still have to complete the form 8606 on a yearly basis for the T-IRA, even if you contribute after-tax money to a traditional IRA, and then immediately convert it to a Roth IRA?
2) If I convert my entire T-IRA to a Roth IRA, is it better to add my contribution (for 2015) into my traditional IRA before or after I convert the T-IRA to the Roth-IRA?
—I’m asking this because I have not made a 2015 contribution yet, and wanted to convert my T-IRA to a Roth-IRA first, then contribute to the T-IRA again with the 2015 max, and convert immediately into the Roth-IRA (to diminish the amount of gains that could come about with the 2015 contribution).
Any help would be appreciated. Thanks!
1) yes
2) Before (then you only have to do one transaction to convert, instead of two)
My husband and I have each contributed to a nondeductible Traditional IRA since 2006 for a total contribution of $49,500 each. Both accounts are worth approximately $54,500 each. In doing a backdoor Roth conversion would it make more sense to convert all at once and pay the taxes, or convert some now and wait to see if the market drops the value of our account before converting the rest?
Convert it all ASAP. You’ll then have a $110K in Roth assets for the mere price of something like $3K. Quite a deal that.
Your alternative is using your crystal ball to see if the market is going to go down soon. If your crystal ball says yes, then convert at the market bottom. But historically, the market goes up most of the time, so I’d convert ASAP because my crystal ball is so cloudy.
Thanks, appreciate the reply! BTW, your site is awesome, your advice spot on. I have recommended your site to all my partners (ED peeps)!
My wife and I are new to the physician investing world and plan to start doing annual Roth conversions this year. We plan on doing this through Vanguard. I am trying to figure out tax rules. I see that we can make an IRA contribution until April 18,2016 for the 2015 tax year, but everything I have found says that the Roth conversion deadline for the 2015 tax year was December 31,2015. If we do our Roth conversions before April 18, are these the only conversions we can do for the 2016 tax year or is there someway to do 2 $5500 contributions for each of us this year. Just to complicate things we already filed taxes for the year through turbo tax so I’m wondering if we can make this work for the 2015 tax year, if im going to have to deal with doing a taxes addendum. Thank you as well for all your information in the book and this site … I am in the process of getting out of a whole life plan, firing an insurance(financial) advisor, and putting our own financial plan into work.
Yes, you can do both 2015 and 2016 contributions and conversions this year. And yes, you’re going to have to do a 1040X if you want to go back and make IRA contributions for 2015. You’ll soon become an expert on form 8606!
Thanks! I had thought the limit for yearly contributions also applied to conversions. Lesson learned!