Retirement accounts are a great way to save money. They are also a powerful vehicle to grow your earnings tax deferred. However, any time you make a withdrawal or distribution from a traditional retirement account, you’ll owe taxes. Converting traditional retirement funds to Roth is a powerful strategy some investors use to grow their wealth not only tax-deferred, but tax free.
When to Consider Roth Funds
The most powerful benefit of Roth funds in a retirement account is that qualified distributions can be tax-free. This means that any qualified distributions can be made without paying any taxes on withdrawing funds. A distribution is qualified once the account has met the following two requirements:
- Funds have been in Roth plan five years or longer
- Accountholder is age 59.5 or older
Roth funds are particularly advantageous when you want to have the opportunity to withdraw tax-free growth on future investment returns. This makes Roth funds a particularly good fit if you anticipate an investment will yield a high return.
For example, if you are able to put $50,000 into an investment that can grow to $500,000 – using Roth funds might be a good strategy to consider. If you completed that investment with traditional funds, while you’d get a tax deduction on the $50,000 going in to your retirement plan, you’ll have to pay taxes on the $500,000 as it comes out. Chances are the tax deduction up front on the traditional funds might not be large enough to offset the taxes you’d pay on your withdrawal.
Alternatively, let’s imagine you completed that same investment with Roth funds. Your $50,000 initial investment would be non-deductible. That is, you’d have to pay ordinary income taxes on that $50,000. However, assuming your later $500,000 growth and profit is qualified, you could take that $500k out of your retirement account completely tax free.
Crypto and Roth Investing
Many investors consider using Roth funds for crypto and Bitcoin investing. That’s largely because the volatility in the crypto market has been upward moving volatility. Put plainly, even though the crypto and bitcoin prices bounce around a lot, the prices move up over the long term. This makes crypto and Bitcoin particularly attractive for Roth funds. As shown in the example above, $50k put into crypto that grows to $500k would mean you can withdraw the $500k profit tax free.
How to Convert Traditional Funds to Roth
- Decide conversion amount
- Calculate your income taxes
- File appropriate forms
- Pay taxes on converted funds
- Transfer fund into Roth account
Deadlines and Paperwork
Roth conversions must be completed by the end of each calendar year. Therefore, your Roth conversion must be complete with funds transferred by December 31st of each year in order for the conversion to “count” for that tax year. There is no minimum or maximum amount determined by the IRS for a Roth conversion. Choose the amount that’s right for your investing strategy.
You may convert funds to Roth even if you make too much money to qualify for a Roth IRA. In fact, some investors will setup an fund a traditional IRA and then convert those funds to Roth to end up with a Roth IRA for investing.
You will owe income taxes on the amount of funds you are converting. Work with your CPA to accurately calculate the taxes owed. Converted funds are added to your taxable income and taxed as ordinary income. For an IRA conversion, your CPA will need to complete IRS form 8606. Your IRA custodian may file form 5498 to document the distribution from the traditional portion of your IRA. For both an IRA and 401k conversion, form 1099-R will be required as well.
On IRS form 1040, you’ll report an IRA Roth conversion on line 15. Enter the total amount on line 15a and the taxable portion on line 15b. For a 401k Roth conversion, input the total conversion amount on line 16a and the taxable portion on line 16b. Always check with your CPA to ensure your forms are filed correctly, taxes paid, and conversion documented properly on your tax return.
Why to Consider a Roth Conversion Now
The 2017 Tax Cuts And Jobs Act created a special bubble of time over the next 7 years before taxes will undoubtedly go up. Of course, the government could repeal or change the law, but for now we should tax advantage of the tax cuts where we can. What this means for many investors is that Roth conversions are essentially “on sale.” It can be good to consider a Roth conversion now with lower tax rates over the next seven years and subsequent tax increases we can assuredly expect in 2026.
While seven years seems like a long time, some investors choose to complete Roth conversions bit by bit over several years, instead of converting a large lump sum and taking a bit tax hit in one particular year. With that in mind, spreading the conversion out over a few years makes sense and with historically low tax rates, the time to start performing the conversions is sooner, rather than later.