Roth or Traditional: Strategies for Converting Your Traditional Self-Directed IRA into a Roth Account

Estimated reading time: 3 minutes(Last Updated On: October 31, 2018)

Regardless of whether you currently have a Roth or traditional self-directed IRA, you’re benefitting from one of the most valuable retirement savings tools. The combination of long term growth that’s free from yearly taxation, the potential for tax deductible contributions to the account, and the investment freedom that a self-directed IRA custodian such as Quest Trust Company can provide you.

But for many individuals debating Roth or Traditional, the Roth self-directed IRA is a preferable structure. Arguably the only advantage that a Traditional IRA has over a Roth IRA is that contributions to the traditional IRA can sometimes be deductible in the year they’re made. In contrast, with a Roth IRA your investment earnings will grow on a tax free basis (rather than a tax deferred basis as with a traditional IRA), you won’t be subject to the rules on required minimum distributions, and you’ll have greater options for using your account to achieve your estate planning goals.

Fortunately, it’s not necessary for all of the funds in your Roth self-directed IRA to come from direct contributions. The IRS permits you to convert any funds you have in a traditional IRA account to a Roth IRA, provided that you pay taxes on the fair market value of the traditional IRAs being converted.

Roth or Traditional: Timing Your Conversion. The biggest downside of an IRA conversion is the current year tax bill that you’ll be faced with. If possible, you’ll want to time your conversion so that your tax burden is as light as possible. For example, if your adjusted gross income varies significantly from year to year (as is the case with sales professionals), then you could benefit from timing your conversions so that they occur during years when your tax rate is comparatively low. However, you must also consider that the longer you wait to make the conversion, the larger the balance in your Traditional IRA can grow – and thus the bigger tax bill you’ll face.

Roth or Traditional: Paying Your Tax Bill. Because a conversion will cause you to owe additional taxes on the amount of the conversion, you’ll need to have a source of funds to pay that bill. Avoid taking an early withdrawal of money from your account in order to pay the tax bill, as this amount will incur a 10% penalty and taxes on that amount itself, as well as reduce the amount in your account. The best strategy is to plan ahead for the tax bill and to save money to cover the additional financial obligation.

Roth or Traditional: Selective Conversion. One of the potential downsides in converting a self-directed IRA to a Roth IRA is the possibility of paying taxes on the fair market value of your account assets at the time of conversion, but having them decline in value. Recharacterization (basically returning your Roth account back to a traditional IRA) can solve this, but the recharacterization can only be done with respect to what you converted in the first place, so if you convert your entire account then you’d need to recharacterize the entire account to undo the conversion. A better strategy may be to convert different asset classes or type from your Traditional IRA to separate Roth IRAs, so that you can selectively recharacterize your conversions later if you need to.

Even though the conversion process is relatively straightforward, it’s important not to inadvertently make the process more expensive for yourself than it needs to be.

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