True Life: I Did a Roth Conversion

I love Roth. That is Roth IRA’s.

You may have already figured it out due to the amount of posts I’ve written on the topic. If you didn’t know that or aren’t familiar with the concept of a Roth IRA, I suggest checking out one of the following posts I’ve already written on the topic:

• Traditional 401(k) vs. Roth 401(k)
• What is a Backdoor Roth Conversion?
• Should I Contribute to an IRA?
• What is a taxable account?
• The Best Christmas Gift

This year I decided to make a proactive Roth conversion. It’s important to note that this is different from a Backdoor Roth Conversion like I talked about in the post I reference above. A Roth Conversion is taking dollars from a current Traditional IRA (pre-tax) and moving them into a Roth IRA (after tax). The process of moving funds from a Traditional IRA to a Roth IRA is a taxable event and each dollar converted is recognized as taxable income for that tax year. Don’t get too hung up on the extra tax part because the reward is having those dollars in a Roth IRA that will grow tax free indefinitely.

So why did I decide to recognize additional income in 2020 and willingly pay more taxes?

Let me explain the best way I know how, with a little math!

The Math

I shared with you in a past post that early in my career I opened a contributory IRA and contributed a bit each year. I look back at that now and think of that as a financial misstep. Not saying it’s a bad thing to save into a traditional IRA, any type of savings is a positive, but knowing what I know now I would have instead increased my 401(k) contributions those years targeting my Roth 401(k) or saved into the Roth IRA. Oh well, live and learn.

Getting off track…

I have this contributory IRA that I’ve stopped adding to years ago when the contributions were no longer fully deductible (i.e. I made more than the annual income limit which in 2020 is $65,000 for a single individual or $104,000 for a married filing jointly couple). To keep the math simple, I’ll share that I have $14,000 sitting in my Traditional IRA. The Roth conversion is going to cost me roughly $3,360 in extra taxes this year as I will pay ordinary income tax on each dollar converted. That is a lot of money, but I promise there is a method to this madness.

Let’s say I keep the $14,000 invested in the pre-tax IRA environment. Over the next 30 years, assuming an investment return of 7%, that same $14,000 will grow to $106,571. In retirement I would eventually need to take distributions from the account to offset living expenses and pay ordinary income taxes on each dollar distributed. To make the point and math simple, if I were to withdrawal that entire amount in one year to cover retirement expenses, the taxes would equal $25,577 leaving me with only $80,994 of purchasing power after taxes.

In making a Roth Conversion, I am moving the $14,000 into a Roth IRA environment and letting those dollars grow tax-free! Over the same 30 years, assuming an investment return of 7% that same $14,000 will go to $106,571. Oh, and did I mention I never have to pay taxes on that again. By paying the $3,360 today I am saving myself (and future heirs) from having to pay income tax on $106,571 which would translate into $25,577 of taxes.

	Keep Traditional IRA	Make Roth Conversion
Taxes Paid Now	$0	$3,360
Future Value of $14,000	$106,571	$106,571
Taxes Paid @ Distribution	$25,577	$0
Purchasing Power	$80,994	$106,571

$3,360 of taxes today vs. $25,577 of taxes in the future?

Purchasing Power of $106,571 vs. $80,994 30 years from now?

Which scenario would you choose? In summary, short term pain, long term gain. 

Added Benefits

Another benefit of making this conversion is that I’ve now cleared the path to make future Backdoor Roth Contributions. With all my qualified retirement money in either my company 401(k) or Roth IRA, I can now move forward with making backdoor contributions in the years ahead. As a true financial nerd, this prospect makes me very excited, especially when I think of all the taxes I’ll be saving over the long-term.

Who wants to do another math problem with me?

In this exercise we will look at the benefits of saving an extra $6,000 in a Roth IRA vs. a regular taxable account. If I couldn’t contribute to a Roth IRA, a taxable account is where I would invest my $6,000. In the scenarios below, I am assuming growth over 30 years at a 7% rate of return.

	Taxable Account Contribution	Backdoor Roth Account Contribution
Annual Contribution	$6,000	$6,0000
Taxes Paid at Contribution	$0	$0*
Future Value of $6,000	$45,673	$45,673
Taxes Paid at Distribution	$9,521	$0
Purchasing Power**	$36,151	$45,673

Purchasing power of $36,151 vs. purchasing power of $45,673?

I’ll ask the question again, which would you choose?

This example just shows the power of making a Backdoor Roth contribution in one year. Imagine the power of contributing annually over the next 30 years! I’ll do the quick math for you, 30 years of Backdoor Roth contributions, assuming a growth of 7% per year, on top of the initial $14,000 conversion is $673,336! And that is straight purchasing power.

Do I need to go on?

Forward Looking

To summarize all of this, I made the decision to convert my entire Traditional IRA into a Roth IRA this year and am paying $3,360 in taxes. I’m doing this for two reasons:

1. The $14,000 I’m converting today could one day be worth over $100,000 tax-free.
2. Ability to make Backdoor Roth Contributions for the next 30 years + while working which could translate into over $600,000 tax-free.

I don’t know about you, but seeing these numbers gets me very excited about my financial future and the options I’ll have down the road. Another point I’ll add is that income taxes are close to historical lows which is even more incentive to convert dollars this year under the current tax rates. There is a strong chance that if rates do change in the years to come, they will only go up.

If this post has got you thinking you’d like to learn more about Roth IRAs or understand if converting your Traditional IRA into Roth makes sense within the context of your finances…don’t be a stranger! If you couldn’t tell, I love these discussions and looking at the math.