Converting Tax-Deferred Retirement Money into a Roth IRA

The following is a tip for anyone with assets in a tax-deferred retirement plan or traditional IRA and will be reporting little or no taxable income in a given year, for example because of  fieldwork.

Please bear in mind that this is general information and should not be construed as specific advice.  Please consult your tax advisor and/or me if you have questions specific to your circumstances.

Background

For traditional, deductible IRAs and company retirement plans, contributions are typically deducted from one's income in the year of the contribution.  When the money is ultimately withdrawn for retirement, it must be reported as taxable income.  Roth IRAs, on the other hand, are funded with post-tax money.  They are not deductible in the year of the contribution, but when withdrawn in retirement, the money is not taxed as income. 

Traditional IRAs and retirement plan assets can be converted into Roth IRAs, as long as certain conditions are met (such as being under an income threshold).   When they are converted, the assets are declared as income in that year.

The Strategy

If you have deductible retirement plan assets and will have little or no income in a given tax year, consider converting tax-deferred retirement money into a Roth IRA.  (Please consult your tax adviser first.) 

Fictitious Case Study: How Mary Gave Herself $26,418

Mary (age 25) worked for a few years before graduate school, during which time she contributed to a 401(k).   She saved $5,000 of her own money, and the company match added an additional $2,500, for a total of $7,500 in her 401(k) plan.

Because she is going to the field, Mary will earn no income this year.  Instead of leaving her money in a 401(k),  she chooses to roll it into a Roth IRA.

She must now declare $7,500 as taxable income on her income taxes.  But taking the standard deduction and exemption means that she is left with no taxable income, and no tax liability.  She places the money in a brokerage account and invests it.  It compounds at 9% a year (net).

Forty years later, Mary's initial investment has grown to $235,570, as it would have had she left it in the company 401(k).  She wants to withdraw all of the money in this account (to which she has added nothing) over a ten year period. Her combined federal and state tax bracket is 30%.   Assuming the money continues to grow at 9%, she will be able to withdraw $33,675 per year for ten years.  If her tax bracket remains the same, she will avoid about $10,103 in taxes per year that she would have paid were she withdrawing the same gross amount from a 401(k) or traditional IRA.  Over a ten year period, Mary will save about $101,000 in taxes.

How much would that be worth in today's dollars?  Assuming a 3% rate of inflation, her future tax savings would be equivalent to about $26,418 today.

Conclusion

Returns can never be guaranteed, and small changes in the assumptions can lead to big changes when carried out over 40 years.  The point is, Mary converted money that was going to be taxed in the future into money that would not be taxed in the future, thereby avoiding those future taxes.  She converted in a year when she had no taxable income, and thus was able to make the conversion without paying any taxes on the money. 

By the way, of the $5,000 that Mary originally put in her 401(k), $1,500 would have gone to taxes anyway, so that original contribution really only cost her $3,500.   Making the conversion allowed her to keep that $1,500, so even if she had no company match and her Roth IRA grew only at the same rate as inflation, her move would have saved her $1,500.

Calculator

Click on the button below to calculate the potential benefits to you of this strategy. 

Roth IRA Transfer