Roth IRA Conversions & Young Professionals: If & When You Should Do One

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  • Roth IRA Conversions & Young Professionals: If & When You Should Do One
Author: Joseph Reinke, CFA

I’m definitely excited to be writing this guide today.

I have over two decades of experience managing over $2.6 billion in assets and debts and am excited to shed light on one of the most powerful financial tools I’ve used to save a ton of money – the Roth Conversion. A Roth conversion is when you change your Traditional IRA, SEP, SIMPLE IRA, or 401(k) into a Roth IRA.

This strategy is typically discussed in regard to older individuals. However, it provides young professionals benefits as well. The two key benefits associated with a Roth IRA conversion are:

  1. For young professionals: Access to tax-free money without penalty prior to 59.5 years old
  2. Tax-free income during retirement.

However, the Roth conversion is not without complexities. In this guide, I discuss strategies, rules, and tax implications you need to be aware of before so you can take advantage of cool IRS tax loopholes. Stick with me as we navigate through the maze of this potentially advantageous financial maneuver.

7 Roth IRA Conversion Rules To Know

A Roth conversion involves transferring funds from a pre-tax retirement account into a Roth IRA. Here’s 7 rules we’ve identified as being the most important to the largest number of people.

  1. Eligibility: Good news. There are no income limits for converting funds to a Roth IRA. However, there could be significant tax implications which I discuss below.
  2. Tax Implications: Converted amounts are subject to income tax in the year of conversion. However, future withdrawals maybe tax free. This is where there is a massive tax loophole for young professionals which I detail further in the article.
  3. Conversion Methods: There are several ways to execute a Roth Conversion, including a rollover from a previous employer’s retirement account such as a 401k or 403b and converting a Traditional IRA.
  4. The 5-Year Rule: To withdraw converted funds without penalty, they must remain in the Roth IRA for at least five years. This rule applies to each conversion separately if you do a Roth conversion ladder.
  5. No Required Minimum Distributions (RMDs): Roth IRAs do not have RMDs during the account owner’s lifetime. Therefore, offering more flexibility in retirement planning.
  6. No Conversion Limits: There are no limits to the amount you can convert or the number of conversions that you can do. This is great because it means anyone can do it anytime it is beneficial.
  7. Roth Conversion Deadline: There are no official deadlines. However, if you want the conversion to count for a specific tax year you must complete it by the end of that calendar year.

The Process of Doing A Roth Conversion

Below is a step-by-step guide that we typically follow during the conversion process with FitBUX members.

Step 1: Assess Your Financial Situation

  • What’s Your Financial Outlook?: Consider your current tax bracket, expected future income, and retirement plans.
  • Understand the implications: Be aware that the converted amount will be added to your taxable income for the year.

Step 2: Can You Convert?

  • Identify the account: You can convert from Traditional IRAs, SEP IRAs, or SIMPLE IRAs (after two years of account opening) to a Roth IRA.
  • Employer retirement account: If you have a retirement account such as a 401k or 403b at a previous employer, you can convert that to a Roth IRA as well. Depending on the size of the account, you may want to roll it over first to a Traditional IRA then convert portions using a Roth conversion ladder.

Step 3: Open a Roth IRA (if you don’t already have one)

  • Select a provider: Choose a financial institution or brokerage to open a Roth IRA. I recommend using FitBUX to do this because we make it easy, wink wink 😉

Step 4: Decide How Much to Convert

  • Calculate the amount: Decide how much money you want to convert. You can convert the entire balance or a portion of it. Your FitBUX Coach can help you make these choices.
  • Consider tax implications: Remember that the converted amount will be taxed as ordinary income.

Step 5: Complete the Conversion

  • Fill out the paperwork: Complete any required forms provided by your IRA custodian to authorize the conversion.

Step 6: Pay the Tax Due

  • Understand the tax bill: The converted amount will be added to your taxable income for the year. If you do the conversion correctly and in certain situations, you may not owe any taxes! I provide a few examples of this below.
  • Set aside funds for taxes: It’s advisable to have funds set aside to pay the additional tax.

Step 7: Report the Conversion on Your Tax Return

  • File IRS Form 8606: This form is used to report the conversion to the IRS.
  • Include it with your tax return: Yes another form to submit but it will be worth it in the long run. Submit Form 8606 with your annual tax return for the year in which the conversion was made.

Step 8: Adhere to the 5-Year Rule

  • Understand the rule: Funds converted to a Roth IRA must remain in the account for at least five years to avoid penalties on withdrawals.

Step 9: Monitor and Manage Your Roth IRA

  • Review your investment choices: Decide how you want to invest the funds in your Roth IRA.
  • Plan for future contributions: Consider making regular contributions to your Roth IRA, subject to IRS limits.

Tax Implications Of A Roth Conversion

Roth conversions come with promising long-term benefits but also have immediate tax implications. The amount converted is treated as income for that tax year, and you will be obligated to pay ordinary income taxes on it.

The rate at which these Roth Conversion taxes apply depends on your income bracket for that particular year.

Performing a Roth Conversion during years of lower income can result in significant tax savings.

Furthermore, it’s essential to note that while the initial conversion has tax implications, the withdrawals made from a Roth IRA during retirement are tax-free. This makes Roth IRAs an attractive retirement savings option, providing tax-free income in your post-work years.

Key Points:

  • A Roth Conversion is treated as income for the tax year it’s performed, bringing immediate tax implications.
  • The rate for Roth Conversion taxes depends on your income bracket for that year.
  • Executing a Roth Conversion during lower income years can lead to significant tax savings.
  • While the initial conversion is taxed, withdrawals from a Roth IRA during retirement are tax-free.

Examples For Taking Advantage Of Roth Conversions

High income earners can take advantage of Roth Conversions but it requires strategic financial planning to determine who its right for and when to do it.

In this guide I’d like to keep it simple and focus on young professionals.

Below are situations that we’ve encountered at FitBUX.

Students That Have Pre-Tax Retirement Accounts

Consider the case of Mariah, a diligent worker who decided to return to school for a graduate degree. Before making this transition, she had accumulated $40k in her 401k from her previous employer.

She was not working during school. Therefore, she made a strategic decision to roll over her entire 401k into a traditional IRA. Once the rollover was complete, she converted $20k during her first year of school and the other $20k during the second year.

This careful planning meant that she didn’t have to pay any income taxes on the conversion. In addition, within 5 to 6 years after her graduation, Mariah could withdraw the entire $40k without incurring taxes or penalties. If she didn’t do the conversion and tried to access the funds prior to 59.5 years old, she’d have to pay approximately $10,000 in taxes and penalties.

Mariah could also keep saving the money for retirement. She was 30 years old at this time. Therefore, the funds would be worth about $230,000 in 30 years. Had she not converted the funds, she would have had to pay approximately $46,000 in taxes during her retirement. Instead she converted the funds to a Roth IRA and can access the full $230,000 in retirement without paying taxes!

Married & Using An Income-Driven Repayment Plan For Student Loans

Let’s now consider the case of Michelle, who is married with $220K in student loan debt. She has decided to use the new SAVE repayment plan, keeping her monthly payments minimal by filing taxes separately from her spouse. Recently, she became a full-time mom. Her existing 401K from her previous job was worth $100K and she rolled over into a Traditional IRA.

Each year, Michelle strategically converts $13K from her IRA to a Roth IRA which means she pays $0 in income tax on the conversion. This smart move will allow her to access the full $100K prior to 59.5 years old.

If she continues this pattern through her retirement, she can save approximately $115K in taxes that would otherwise be due in retirement.

This strategy enables Michelle to have greater flexibility with her retirement savings and offers a tax-efficient way to access her funds. By using her low-income years for these conversions, Michelle is setting herself up for a financially secure future. Most importantly, the funds in her Roth IRA will grow tax-free, providing a tax-free income stream during her retirement years.

The Travel Health Care Worker

Let’s take a look at the case of Kyle, who transitioned from a full-time physical therapist role to a travel PT.

Initially, he was earning a taxable income of $78,000 per year. However, upon transitioning to a travel PT, his taxable income significantly dropped to $40,000 per year.

He had $25,000 in his previous employer’s 401k. He planned to return to full-time physical therapy after three years of travel work which would inevitably elevate his taxable income.

Recognizing his current low tax bracket, he astutely decided to convert $10,000 from his 401k each year. This strategic move is projected to save Kyle $10,000s in taxes over time.

The Roth Conversion Five Year Rule Explained

The Roth Conversion Five Year Rule is an indispensable piece of knowledge for those considering a Roth IRA. Essentially, this rule stipulates that once you convert funds to a Roth IRA, a five-year waiting period commences before you can withdraw the converted amount tax-free and free of penalties. This means that you won’t have to wait till the retirement age of 59.5 to capitalize your funds.

Though waiting may seem tedious, this period is vital to the process. It empowers the money to grow tax-free during this tenure, which can lead to a substantial increase in the value of your investment. Furthermore, once this waiting period is over, there are no restrictions on how you can use these funds – you’re free to use them for whatever you wish. This flexibility, combined with the potential for significant financial growth, makes understanding and utilizing the Roth Conversion Five Year Rule an excellent strategy for young professionals navigating their financial futures.

Key Points:

  • The Roth Conversion Five Year Rule is a vital concept for those considering a Roth IRA investment.
  • This rule mandates a five-year waiting period post conversion before the funds can be withdrawn tax-free and penalty-free.
  • Post the waiting period, there are no restrictions on the use of these funds, providing flexibility in financial planning.

The Roth Conversion Five Year Rule in Action: Mariah’s Success Story

Consider the example of Mariah, who astutely leveraged the Roth Conversion Five Year Rule during her time at school. She converted $40,000 into a Roth IRA

Committed to financial wellness, Mariah chose FitBUX’s financial planning method of focusing on one short-term financial goal at a time.

Upon graduation, her primary objective was to pay off her student loans within five years. Achieving her goal slightly ahead of schedule, she managed to pay off her loans in 58 months, just under the five-year target.

As the waiting period concluded, Mariah was then able to liquidate $40,000 from her Roth IRA, entirely free of tax and penalty. This amount served as a substantial down payment on her new house.

Mariah’s story serves as an inspiring illustration of the Roth Conversion Five Year Rule’s potential when used strategically. It underscores the rule’s flexibility and its capacity to help attain significant life goals, whether it’s paying off debts or making that crucial first step onto the property ladder.

Roth Conversions In Different Market Conditions

There’s a common notion that a Roth conversion should be executed when the market dips. However, this isn’t a blanket strategy that suits everyone’s financial situation. While it may seem logical to convert when your retirement account’s value is lower to pay less in taxes, the benefits might not be as substantial as anticipated for many individuals.

For instance, when the stock market drops, so does the value of your IRA. If you convert during this time, you’ll pay taxes on a smaller amount. However, keep in mind that if the market rebounds after you convert, you will miss out on the tax-free growth that could have occurred within the IRA. Therefore, timing your conversion based on market conditions can be risky and quite speculative.

A more personalized, and often more beneficial, approach is to base your Roth conversions on your income. If you’ve experienced a drop in income, for example, you may have moved down to a lower tax bracket. In this situation, a Roth conversion could be advantageous as you would pay a lower tax rate on the converted amount.

Remember, the central goal here is to pay as little tax as feasible during conversion. It’s not about predicting market swings, but about understanding your unique financial situation and planning accordingly.

The Backdoor Roth IRA

The Backdoor Roth IRA strategy is often used by high-income earners or couples who are filing their taxes separately.

This approach involves the use of a Roth conversion, which is not the same as a Backdoor Roth IRA, but is an essential step in the process.

The Backdoor Roth IRA strategy allows individuals who might otherwise be ineligible due to their income level, to avail the benefits of a Roth IRA account. For a comprehensive understanding of this strategy, refer to the linked article on the Backdoor Roth IRA.

Wrapping Up The Power of Roth Conversions

Roth conversions present a powerful tool in financial planning. They offer tax efficiency and flexibility in achieving your financial goals.

From Mariah’s success story to Kyle’s strategic moves, we see the potential of using a Roth Conversion.

While market conditions may impact your decision, remember, the primary goal is to pay the least amount of tax during the conversion process. Understanding your unique financial situation and planning your conversions based on your income, rather than market swings, generally yields more beneficial results.

Financial planning is a journey tailored to individual circumstances, and Roth Conversions are a significant tool to use. If you’re considering a Roth conversion, we recommend consulting with professionals to ensure the most beneficial outcome. FitBUX has successfully guided numerous individuals like Mariah and Kyle on their financial path. Let us help you navigate your financial future. Visit our website to get started.

For in-depth details about Roth IRAs and Roth conversions consult the Internal Revenue Service. The IRS provides comprehensive guidelines on these topics, helping you make informed decisions. Here’s the IRS webpage dedicated to Roth IRAs and the one on Roth conversions. Please consult these resources to fully understand the tax implications and other relevant details.

Joseph Reinke, CFA

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About the Author

Joseph Reinke is a Chartered Financial Analyst (CFA) Charter Holder and founder of FitBUX which has helped over 14,000 young professionals on their journey to financial freedom. Joseph has been personally investing since he was 12 years old.

In addition, he has experience in student loans, mortgages, wealth management, investment banking, valuation, stock trading, and option trading. He has been on 100s of podcast and has been invited to 100s of universities to discuss financial planning with their soon to be graduates.

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