Last week we talked about the three types of accounts we can use for our Long-Term Portfolio and I said it’s important to have balances in all three types.
The Already-Taxed or Roth account is the most difficult to contribute to so I want to talk this week about how we can get money into a Roth by making conversions.
What is a Conversion?
A conversion is where you take money that is already in a tax-deferred account and move it to a Roth account.
For example, let’s say you have $100,000 in a traditional IRA and that you originally took a tax deduction to fund the IRA. You can move that money to a Roth IRA today and at the end of the year, you will receive a 1099 for $100,000 of income. That means you will pay tax as if you received $100,000 of income, even though all you did was move money from one account to another.
The Benefit of Making Conversions
The reason you would do this, of course, is because you would never pay tax again on the original $100,000 or the earnings that money makes in future years. However, if you have after-tax money in ANY traditional IRA, then this won’t work as well as you’d like. It can get pretty complicated, so definitely talk to an advisor before doing this, but in short, don’t even consider doing a conversion if you have after-tax money in an IRA.
Some employers also allow you to overfund your 401k, putting in more than the deductible limit. You won’t get a tax deduction for these contributions and, if your employer allows, they can immediately convert that money into Roth within your 401k. There’s no tax owed because you are putting in after-tax money, to begin with, and immediately converting it to Roth.
Why You Should Have a Plan in Place Before Converting
Check with your employer regarding the options available, but remember, you’ll not have access to this money until retirement so be sure you have a solid plan in place to meet your expenses up to that point.
Performing conversions on an annual basis is a great way to balance out your exposure to the three tax structures of accounts. Also, if you are attempting to even out your taxable income across years, doing Roth conversions regularly can get you there.