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Tax Free Income In Retirement Using a Back Door Roth IRA Conversion

It is year end, and many people are looking at tax strategies to reduce their taxable income in this and the coming years.  For people approaching retirement, it sometimes makes sense to do a back door Roth conversion.  If you have a tax deferred account, such as a 401K or an IRA, you can convert it to a Roth IRA so that your income in retirement will not be taxable.  This can make sense if you think that your tax rate will be higher in retirement and have some room available in your tax bracket so that additional income from the Roth conversion will not push you into the next higher tax bracket. 

How does this work, and why would someone want to do this?  First of all, by converting a traditional IRA to a Roth IRA, withdrawals will not be taxable in the future as long as you have established the account for at least five years, and have attained the age of 59 1/2.  Tax rates in 2018 are lower than they have been for many years, so it makes sense for some people to do a Roth Conversion this year.  You have to pay taxes on the amount converted to a Roth IRA, but all future earnings and rollover contribution would not be taxed upon withdrawal.  Also, in times of a market downturn, if the account is worth less temporarily due to a decline in the market, you would pay tax on the value of the amount converted, so it sometimes makes sense to do the conversion at the lower market value.

Advantages of converting from a traditional IRA to a Roth IRA include the following:

  1. All future withdrawals from your Roth IRA are tax free
  2. Investment growth in your Roth IRA is tax free
  3. Roth IRA's are exempt from RMD's (required minimum distributions)  This provides more control of when you choose to receive your money in retirement. Tax and penalty-free withdrawals can be made once you have attained the age of 59 1/2 and have had at least one Roth IRA open for at least 5 years

There are important tax considerations when making the decision to convert to a Roth IRA.

  1. When you do a Roth conversion, you owe taxes on the amount of the conversion.  You can convert a portion of it each year to strategically fill up your taxable income bracket so that you are only converting enough so that your tax bracket does not increase. This can be done in the pre-retirement years if you think that your tax rate will be higher in retirement, or a portion can be done strategically converted in each year of retirement while your tax rates are lower until you fill up your taxable income bracket so you can minimize the taxes paid on the conversion. 
  2. You usually cannot convert the amount in your traditional 401K if you are still working,  You can convert your traditional IRA's, but you usually have to wait until you have terminated your employment to convert the 401K amount to a traditional IRA, and then roll it into a Roth IRA.
  3. If you are paying for college, this additional income could affect financial aid packages
  4. If you are 65 or older, the more taxable income you have could cause you to pay more for medicare.
  5. You can do a Roth conversion up until December 31, 2018. 

It is important to consult a Certified Financial Planner to see if this strategy makes sense for you. Please contact me if you would like to schedule a Financial Strategy Session to see if this is a viable option for you.