BONUS BLOG: Roth Conversion Trick

A Roth IRA is a retirement account that allows you to contribute after tax money, grows tax-deferred, and at age 59 1/2, allows you to withdraw the money tax-free. (As long as the money has been in the Roth for at least 5 years.) The key here is that you have already paid taxes on your contributions so you won’t be taxed again on those. The earnings become tax-free as long as you wait until 59 ½ to withdraw them.

One important point to make for the purposes of retiring early is that you can withdraw your contributions back out of your Roth at any time. It doesn’t matter whether you are 40 or 55, you can take out your contributions at any time with no taxes or penalty.

So what is the Roth Conversion trick?

If you own a traditional IRA, you are probably aware that if you take withdrawals out of your IRA prior to 59 ½, then you’re going to pay federal and state taxes as well as a 10% IRS early withdrawal penalty. If you’re looking at retiring early, let’s say in 5 years from now or longer, doing a Roth conversion could possibly really benefit you.

A Roth Conversion is taking your traditional IRA and converting it into a Roth IRA. When you do this, you still have to pay federal and state tax on the move from traditional IRA to the Roth. However, you will avoid the 10% penalty. If you plan on doing a Roth conversion, it’s best to pay the taxes outside of your IRA, from your savings.

So you have converted your traditional IRA to your Roth IRA. Now what? Roth IRA’s have a five-year waiting period after the conversion in order for you to access your contributions. Once the five-year period is up, you now have access to your Roth Contributions (the amount you converted) tax-free. So instead of waiting until 59 ½ to access your funds, you now have access to your contributions and can leave the earnings in the account until you turn 59 ½.

Here is an example:

Jane is 41 years old and has a $150,000 traditional IRA. Jane plans on retiring early at age 47. Jane converts her traditional IRA into a new Roth IRA. She will have to pay approximately 30% in taxes or $45,000, due to the conversion. Jane was able to pay this from her savings. At 47 years old, Jane has waited beyond the five years for her Roth and she can now take out all of her contributions, $150,000, tax-free. Her account value grew to $201,000 over the 6 years she let it grow and she can now leave that balance in her Roth and access this once she turns 59 ½. The remaining balance will continue to grow and give her another pot of money to access at retirement age.

Doing a Roth conversion can be ideal for someone in the 30’s and 40’s. It can also make sense for someone in their early 50’s. Generally, the younger you are, the more benefit you will see from doing a conversion.