Is 2020 the Year for a Roth IRA Conversion?
The Coronavirus pandemic is a big fat pile of lemons that life threw at us. Who’s ready for some lemonade?
For all the negatives associated with COVID-19 and corresponding economic shutdowns, the positive is that for many investors there is no better time to take advantage of a Roth IRA conversion. A Roth conversion has the potential to pay big dividends when it comes to growing your tax-sheltered retirement nest egg.
Performing a conversion is a taxable event, however, so being opportunistic about timing is a key factor in pursuing such a strategy. Well, with our current economy a lot of folks will have lower than usual income this year, and that can be exactly the right opportunity to make a move.
This article is the first of a short series, where we will discuss what a Roth conversion is, as well as how to perform such conversions within an existing self-directed IRA or Solo 401(k) retirement plan.
What is a Roth Conversion?
In a conventional tax-deferred 401(k) or IRA retirement plan, you do not pay taxes on money you contribute to the plan. This allows you to put more savings into your plan on the front end. As you invest with your plan, gains are not taxed. This boosts your rate of return and allows you to compound that tax savings over time to exponentially grow your savings.
But, when you take distributions from your IRA or 401(k) in retirement, you are taxed at normal income rates on the amount withdrawn. You end up having more money, and ultimately paying more in taxes on that larger sum. It is still a really big win, but the Roth IRA can be even better.
In a Roth IRA, you pay taxes on the money as you contribute it into the plan. This reduces the amount you place into savings on the front end. However, all growth in value produced by investments over time and future distributions to you from the Roth IRA are tax free.
You pay taxes on the seed, but the full harvest is yours with no loss in value due to taxation.
A Roth conversion is the ability to move value from a currently tax-deferred retirement plan into a Roth IRA. The value converted is considered taxable income in the current tax year but is then switched over to Roth status. From that point forward, the gains in the account grow tax-free.
Evaluating the Payback
Determining whether a Roth conversion will create a positive outcome, meaning more spendable money to you in retirement, is a complex matter. We strongly recommend you discuss any conversion plan with your licensed tax counsel who is familiar with your full financial picture.
It is relatively easy to do a thumbnail sketch of the conversion and determine if there is a likely benefit before you schedule a call with your CPA. There are several calculators on the internet that can help you start your evaluation.
When you perform a conversion, you introduce two costs; the cost of the taxes paid on the conversion and the opportunity cost of future investment returns that cash could have produced.
Keep in mind, you need to have outside savings with which to pay the taxes. To tax a distribution and pay taxes on part of your 401(k) or IRA, to then use that to pay taxes on the converted amount will definitely be a losing proposition.
To effectively compare the non-conversion versus conversion approaches, you need to factor in the loss of cash basis at the starting point. You then need to look at potential investment returns over a period of time and see when the cost of the Roth conversion is recaptured. From that point forward, the Roth will pull ahead and produce more after-tax cash to you.
The following table illustrates the basic framework used to make the comparison.
Other factors will impact the results such as your current tax rate, any change in rate the conversion will create, the rate of return you can expect, and what your tax rate in retirement is likely to be.
Events such as a lower than normal income year or the availability of tax deductions such as a large amount of depreciation can reduce the up-front cost of making a conversion. This may allow you to make a conversion when you normally could not, or potentially convert a larger amount than might be otherwise possible.
Example 1 – Ross
Ross has done well in his career and has managed to accumulate $1,000,000 in tax deferred savings over the course of 25 years in the hotel business where is he a regional sales director serving multiple properties. He is now in his mid-50’s.
Due to the near complete shutdown of the hospitality industry, he was furloughed in March and expects his normal income of about $225,000 per year will be cut to more like $80,000 to $100,000 this year. That should push his tax bracket from 24% down to 12%. He can easily convert as much as $100,000 of his IRA to Roth status and have most of that fall within the 22% bracket. If he were to convert $200,000, that extra hundred thousand would mostly be taxed at 24%, and that may be more than he wants to bite off at the current time.
Ross has been investing in a private note fund that consistently produces about 11% annual returns.
The scenario Ross is going to evaluate is converting $100,000 to Roth status and seeing where he might stand after 15 years when he turns 70. Following are the results:
ItemNon-ConversionRoth ConversionTax Cost of Conversion$0$22,000Plan balance at age 70$478,459$478,459Plus income from savings invested outside of IRA$84,082$0Less lax on eventual distributions$105,261$0Spendable savings$457,459$478,459Difference+ $21,179 or 4.6%
Ross will add a bit more than $21K to his bottom line over a 15-year period. This is enough of a positive to be worth considering, but not exactly a game changer. If Ross were older and had less time for the Roth side of the ledger to pull ahead, this would be a non-starter. Likewise, with a lower rate of return, the differential in the two models might not be as significant.
Example 2 – Crystal
Crystal was just starting to hit her stride in her career in the finance department of a large restaurant chain. Coronavirus pretty much nixed that pathway for her. Fortunately, Crystal has already arranged a new position with similar potential at a regional grocery chain that is going strong even in this economy.
She will have lost 2 months of income for this year, which will drop her from about $80,000 to $68,000. Her husband’s job is stable and the drop in her income does not really change their tax bracket, which is 22%.
Crystal is 32 years old. As a result of the termination from her restaurant job, she has about $50,000 in her prior 401(k) she would like to convert to Roth status and use to make a down payment on a rental house for the IRA. The leveraged income she projects will likely produce about 10% annualized returns on rents, not including any potential appreciation of the property.
Crystal will certainly continue to add savings over time and broaden her investment portfolio, but for purposes of the comparison, she’ll just look at this $50,000 returning 10% until age 59 ½.
ItemNon-ConversionRoth ConversionTax Cost of Conversion$0$11,000Plan balance at age 60$721,050$721,050Plus income from savings invested outside of IRA$108,000$0Less lax on eventual distributions$158,631$0Spendable savings$670,419$721,050Difference+ $50,631 or 7.6%
Because Crystal is younger and her Roth IRA capital has a longer time to produce earnings, the benefit of conversion is more pronounced than was the case for Ross. This is true even though her rate of return is a touch lower.
In fact, if Crystal were to put the same 70-year-old end date on her scenario as Ross, the numbers get even more dramatic. Her $50,000 Roth IRA will grow to $1,870,217 and she will see about a $167,000 additional benefit from the Roth conversion!
Next Up
In our next article we’ll discuss several of the available pathways to achieve a Roth IRA conversion depending on your current plan format and investment holdings.
Disclosures
The information above is educational in nature, and is not intended to be, nor should it be construed as providing tax, legal, or investment advice. Please consult with your licensed tax professional to evaluate a taxable activity such as a Roth conversion.
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Quick answers to common questions
We’ll take you through a simple, step by step process designed to put your investment future into your own hands…immediately. Everything is handled on a turn-key basis. You take 100% control of your Retirement funds legally and without a taxable distribution.
YES! In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) making IRA, 401(k) and other retirement plans possible. Only two types of investments are excluded under ERISA and IRS Codes: Life Insurance Contracts and Collectibles (art, jewelry, etc.). Everything else is fair game. IRS CodeSec. 401 IRC 408(a) (3)
It’s actually pretty simple. Early on, regulators let the securities industry take the lead in educating the public about retirement accounts. Naturally, brokers and banks promoted stocks, bonds, and mutual funds—giving the impression that those were the only allowed investments. That was never true... and still isn’t. You can probably guess why they kept the rest under wraps.
It is possible to use funds from most types of retirement accounts:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Keogh
- 401(k)
- 403(b)
- Profit Sharing Plans
- Qualified Annuities
- Money Purchase Plans
- and many more.
It must be noted that most employer sponsored plans such as a 401(k) will not allow you to roll youraccount into a new Self-Directed IRA plan while you are still employed. However, some employers will allow you to roll a portion of your funds. The only way to be completely sure whether your funds are eligible for a rollover is by contacting your current 401(k) provider.
A Solo 401(k) requires a sponsoring employer in the format of an owner-only business. If you have a for-profit business activity – whether as your main income or as a side venture – and have no full-time employees other than potentially your spouse, your business may qualify. The business may be a sole-proprietorship, LLC, corporation or other entity type.
A self-directed retirement plan is a type of IRA or 401(k) that gives you greater control over how your retirement funds are invested. Unlike traditional accounts held at banks or brokerage firms that limit you to stocks, bonds, and mutual funds, self-directed plans allow you to invest in a wide range of alternative assets including real estate, private businesses, precious metals, cryptocurrency, and more.
These plans still follow the same IRS rules and maintain the same tax-deferred or tax-free benefits as conventional retirement accounts. The difference is simply in how and where you choose to invest.
No. Moving to a self-directed IRA or Solo 401(k) does not trigger any taxes, as long as your funds are eligible for rollover.
Self-directed retirement plans maintain the same tax-advantaged status as traditional plans offered by banks or brokerage firms. The key difference is flexibility—our plans are designed to give you greater control and allow for a wider range of alternative investments beyond stocks, bonds, and mutual funds.
A prohibited transaction is any action between your retirement plan and a disqualified person that violates IRS rules and can lead to serious tax consequences. Under IRS Code 4975(c)(1), prohibited transactions include:
- Selling or leasing property between your plan and a disqualified person Example: Your IRA cannot purchase a property you already own.
- Lending money or extending credit between the plan and a disqualified person Example: You cannot personally guarantee a loan your IRA uses to buy real estate.
- Providing goods or services between your plan and a disqualified person Example: You can’t use your personal furniture to furnish a rental property owned by your IRA.
- Using plan income or assets for the benefit of a disqualified person Example: Your IRA cannot buy a vacation home that you or your family use.
- Self-dealing by a fiduciary (using plan assets for their own benefit) Example: Your CPA shouldn't loan your IRA money if they’re advising the plan.
- Receiving personal benefit from a deal involving your IRA's assets Example: You can’t pay yourself from profits your IRA earns on a rental.
If a transaction doesn’t clearly fall within the allowed guidelines, the IRS or Department of Labor may review the situation to determine if it qualifies as a prohibited transaction.
Disqualified persons are individuals or entities that are prohibited from engaging in certain transactions with your IRA or 401(k). Doing so could trigger a prohibited transaction, which may result in taxes and penalties.
Here’s who is considered a disqualified person:
- You (the account holder)
- Your spouse
- Your parents, grandparents, and other ancestors
- Your children, grandchildren, and their spouses
- Any advisor or fiduciary to the plan
- Any business or entity owned 50% or more by you or another disqualified person, or where you have decision-making authority
These rules exist to prevent self-dealing and ensure your retirement plan remains in compliance with IRS regulations.
(Reference: IRC 4975)
Understanding and following these rules can be tricky, but it’s very doable. The best way to stay compliant is to work with professionals who specialize in self-directed retirement plans. They can help you navigate IRS guidelines and avoid prohibited transactions.
If an IRA holder is found to have engaged in a prohibited transaction with IRA funds, it will result in a distribution of the IRA. The taxes and penalties are severe and are applicable to all of the IRA’s assets on the first day of the year in which the prohibited transaction occurred.
Yes. While self-directed retirement plans allow for a wide range of investments, there are a few important restrictions.
You cannot invest in collectibles or life insurance contracts, and you must avoid prohibited transactions—activities that benefit you personally rather than the retirement plan. These include things like buying or selling property to yourself or family members, using plan assets for personal gain, or self-dealing in any way.
Violating these rules could cause your entire IRA to lose its tax-advantaged status. To protect your account, it’s essential to work with professionals who understand IRS regulations and can help you stay compliant.
This is a common misconception. In many cases, professionals may simply be unfamiliar with self-directed retirement plans, as they fall outside their usual scope of work. CPAs and tax preparers are trained to file taxes, not necessarily to advise on alternative retirement strategies. Financial advisors and brokers often work for firms that focus on traditional investments like stocks and mutual funds—and may not benefit from or support alternative options like real estate or private lending.
Self-directed retirement investing is legal under IRS rules—but like any specialized area, it requires working with professionals who understand how it works.
The IRS has rules in place to make sure your IRA is used only for the exclusive benefit of the retirement account—not for personal gain or to help family members. These rules can get complicated because there are many ways a conflict of interest can occur, even unintentionally.
For example, if your IRA buys a house and rents it to your mother, you might be reluctant to evict her if she stops paying rent. That emotional connection creates a conflict between what’s best for your IRA and your personal relationships, something the IRS aims to prevent.
These rules help ensure your retirement account stays compliant and protected. (See IRC 408)
Yes. Most tax-deferred retirement accounts—such as Traditional IRAs, old 401(k)s, 403(b)s, and TSPs—can be rolled over into a self-directed IRA or Solo 401(k), depending on your eligibility. Roth IRAs cannot be rolled into these accounts.
You can contribute directly from earned income, subject to annual IRS contribution limits. The method and amount depend on the type of plan you have (e.g., Solo 401(k) vs. IRA).
To take a distribution, you'll request funds through your custodian or plan administrator. Distributions may be taxable depending on your account type and age. Early withdrawals may be subject to penalties.
For 2025, the Solo 401(k) max contribution limit is $81,250 if age 60-63, $77,500 if age 50-59 or 69+, and $70,000 if under 50. Traditional and Roth IRAs have a limit of $7,000 ($8,000 if age 50+). Limits are subject to IRS adjustments.
Yes. IRA contributions are typically due by your personal tax filing deadline (e.g., April 15). Solo 401(k) contributions follow your business tax filing deadline, including extensions.
IRS reporting requirements vary depending on the type of self-directed retirement plan you have. Here’s a quick breakdown of what you need to know
Please note: Our team can help you understand what’s required for your specific account, but we don’t provide tax or legal advice. We always recommend working with a qualified tax professional to ensure full IRS compliance.
Self-Directed IRA (Traditional or Roth)
- Form 5498 – Filed by your custodian each year to report contributions, rollovers, and the fair market value (FMV) of your account.
- Form 1099-R – Issued if you take a distribution or move funds out of your IRA.
- Annual Valuation – You'll need to provide updated FMV for any alternative assets held in the account, such as real estate or private placements.
Solo 401(k)
- Form 5500-EZ – Required if your plan assets exceed $250,000 as of year-end. Must be filed annually by the plan participant.
- Form 1099-R – Required if you take a distribution or roll funds out of the plan.
- Contribution Tracking – Keep records of employee and employer contributions. These are not filed with the IRS but may be needed for tax reporting or audits.
SEP IRA
- Form 5498 – Filed by your custodian to report contributions and FMV.
- Form 1099-R – Filed by your custodian. Issued for any distributions.
- Employer Contributions – Must be reported on your business tax return (and on employee W-2s, if applicable).
Health Savings Account (HSA)
- Form 5498-SA – Filed by your HSA custodian to report contributions.
- Form 1099-SA – Filed by your HAS custodian. Issued for any distributions.
- Form 8889 – Must be included with your personal tax return to report contributions, distributions, and how funds were used.
