Roth Conversion 101

Introduction

☁️ Imagine retiring with a substantial nest egg that you can tap into without paying a single dollar in taxes.

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☁️ This may be possible through a strategic Roth conversion, especially during low-income years.

Introduction

☁️ Imagine retiring with a substantial nest egg that you can tap into without paying a single dollar in taxes.

​ 

☁️ This may be possible through a strategic Roth conversion, especially during low-income years.

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Subscribe to The Dream Bigger – Physician Edition Newsetter

A weekly newsletter designed for early-career physicians and anyone looking to enhance their financial well-being.

Discover helpful tips, strategies, and insights to dream bigger and take control of your financial future. 🥼

Get student loan updates, money-saving tips, and financial strategies – all delivered to your inbox.

Understanding Roth IRA and Traditional IRA

☁️ Roth IRA: Contributions are made with after-tax dollars. Your investments grow tax-free, and qualified withdrawals in retirement are tax-free.

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☁️ Traditional IRA: Contributions may be tax-deductible (lower your taxable income), but withdrawals in retirement are taxed as ordinary income.

What is a Roth Conversion?

☁️ A Roth conversion involves transferring funds from a Traditional IRA to a Roth IRA.

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☁️ You will pay taxes on the amount converted in the year of the conversion, but future growth and withdrawals from the Roth IRA will be tax-free.

Why Consider a Roth Conversion?

☁️ A Roth conversion can be particularly advantageous during years when your income is lower than usual. This could happen for various reasons, such as:

• Starting a New Job: If you transition from a residency to an attending physician role, your income might be lower for part of the year.

• Changing Jobs: A gap between jobs can result in a lower annual income.

• Losing a Job: Unemployment can significantly reduce your income for the year.

• Taking a Sabbatical: Time off for personal reasons or further education can lower your taxable income.

Example Scenario

☁️ Let’s look at a simplified tax situation during the transition from training to attending:

• Residency Salary (half-year): $40,000

• Attending Salary (half-year): $100,000

• Total Income: $140,000

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☁️ For simplicity, assume the following tax brackets:

• 12% for income up to $40,000

• 22% for income from $40,001 to $85,000

• 24% for income from $85,001 to $160,000

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☁️ In this scenario, your total income of $140,000 places you in the 24% tax bracket.

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☁️ If you expect to consistently earn $200,000 or more in the future, your future conversions or withdrawals from a Traditional IRA would likely be taxed at a higher rate (24% or more).

Strategy for Roth Conversion

☁️ Step 1: Roll Over Old Employer’s 401(k)/403(b)

Transfer your old employer-sponsored retirement account into a personal IRA. This is the first step towards being able to convert those funds.

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☁️ Step 2: Execute the Roth Conversion

Convert a portion or all of the IRA to a Roth IRA during a low-income year. You’ll pay taxes on the converted amount at your current tax rate.

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Note: You will likely want to convert all the funds in a low-income year so it doesn’t impact your ability to perform a Backdoor Roth IRA in future years.

Considerations

☁️ Size of the Old Employer’s 401(k)/403(b): The amount you convert from your old employer’s retirement account to a Roth IRA will be added to your taxable income for the year. If your old 401(k) or 403(b) balance is large, this could significantly increase your taxable income and result in a substantial tax bill.

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☁️ Earnings Timing: If you start your attending role closer to July and your attending income is higher, consider rolling your old retirement account into your new employer’s plan instead. You likely will not benefit as much from this strategy. This will allow you to perform a Backdoor Roth IRA in the future.

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☁️ Marital Status and Tax Filing: If you are married or file separately due to student loans, your strategy might differ. Always consider your specific circumstances and consult a financial or tax professional.

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☁️ Student Loans: If you have student loans and are on an Income Driven Repayment plan, this strategy will increase your Adjusted Gross Income (AGI) which will result in higher student loan payments, and as a result, may not be the best time to take advantage of this strategy.

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☁️ Tax Penalties: If you do this strategy before age 59.5 and withhold taxes to pay the tax on the conversion, the withheld taxes are subject to a 10% penalty. You likely only want to complete this strategy if you have liquid cash/funds outside of the IRA to pay the tax. You do not want to withhold taxes when completing this strategy.

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☁️ Timing of Conversions:

• Market Conditions: Converting during a market downturn can be advantageous because the value of your investments is lower, resulting in a lower tax bill on the conversion. When the market recovers, the growth in the Roth IRA will be tax-free.

• Year-End Planning: Consider doing conversions towards the end of the year when you have a clearer picture of your total income and tax situation.

Additional Benefits of Roth Conversions

☁️ Avoiding Required Minimum Distributions (RMDs):

Traditional IRAs require you to start taking RMDs, which are taxed as ordinary income. Roth IRAs do not have RMDs, allowing your investments to grow tax-free for as long as you live.

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☁️ Estate Planning:

Roth IRAs can be an effective tool for estate planning. Beneficiaries can inherit and withdraw from Roth IRAs tax-free, making it an ideal way to transfer wealth.

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☁️ Impact on Social Security and Medicare:

Well-planned Roth conversions can minimize the impact on Social Security taxes and Medicare premiums. Large RMDs from Traditional IRAs can increase your taxable income, potentially affecting these benefits.

Common Mistakes to Avoid

☁️ Not Considering the Tax Impact:

Converting too much at once can push you into a higher tax bracket. A systematic approach, converting smaller amounts over several years, can help manage the tax impact.

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☁️ Ignoring State Taxes:

Some states tax Roth conversions, while others do not. Be sure to understand your state’s tax laws.

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☁️ Alternative Minimum Tax (AMT):

The AMT is a parallel tax system designed to ensure that high-income individuals pay a minimum amount of tax. It disallows many deductions and exemptions allowed under the regular tax system. If your income is high enough, you may be subject to the AMT, which could negate some of the benefits of a Roth conversion.

Conclusion

☁️ A Roth conversion can be a powerful tool, especially in years where your income is lower than it will be in the future.

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☁️ This strategy allows you to take advantage of your current lower tax bracket, setting yourself up for tax-free growth and withdrawals in retirement.

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☁️ This is a high-level overview and not personalized advice. Consult with a financial or tax professional to tailor strategies to your unique situation.