Unlocking the Power of Roth Conversions for Long-Term Wealth Growth

As wealth managers, we often help clients navigate strategies to maximize their retirement savings and tax advantages. One powerful tool in the arsenal is the Roth conversion, including the “Mega Backdoor Roth.” But what are Roth conversions, and how can they help you achieve your financial goals?

What is a Roth Conversion?

A Roth conversion involves transferring existing funds from a pre-tax retirement account—like a traditional IRA or 401(k)—into a Roth IRA or Roth 401(k). Once the funds are in a Roth account, they grow tax-free and qualified withdrawals in retirement are also tax-free.

A Roth conversion is different from making contributing to a Roth IRA within the annual IRS limits. Only individuals with income below a certain threshold can take advantage of funding these accounts directly, so access is often limited for those with high earnings. (See this article on Backdoor Roth IRA contributions to see if you may be eligible to fund Roth IRAs indirectly.)

For many, this leaves pre-tax accounts as the only retirement option to fund, and conversions as the only way to add balances into a Roth account for tax-free growth over time.

The Mega Backdoor Roth: Supercharging Your Savings

The Mega Backdoor Roth is a specific strategy that allows high earners to contribute additional after-tax dollars to their pre-tax 401(k) plans and then convert those contributions into a Roth account. This approach is particularly beneficial because it enables you to exceed the standard annual contribution limits for tax-advantaged accounts.

For example, in 2025, the total contribution limit for a 401(k) is $70,000 (or $77,500 for those over 50). This total includes:

• Employee contributions (up to $23,500 or $31,000 for those over 50 – either pre-tax or Roth)
• Employer matching contributions
• After-tax contributions (if allowed by your employer’s plan)

Not all employer-sponsored 401(k) plans offer the Mega Backdoor Roth option. Check with your plan administrator to see if this strategy is available to you.

Benefits of Roth Conversions and the Mega Backdoor Roth

• Tax-Free Growth: Once funds are in a Roth account, any earnings grow tax-free, making it a powerful tool for long-term wealth building.
• Tax-Free Withdrawals: Qualified distributions from Roth accounts are entirely tax-free, which can significantly reduce your tax burden in retirement.
• No RMDs: Unlike traditional (pre-tax) accounts, Roth IRAs do not require minimum distributions during your lifetime, offering flexibility in how you use your funds.
• Estate Planning Advantages: Roth accounts can be a tax-efficient way to pass wealth to heirs.

Who are Roth Conversions Best For?

Roth conversions are a great strategy for those who:

• Have high pre-tax account balances
• Have a break in employment or a lower income year
• Are retired, especially before Required Minimum Distribution (RMD) age or Social Security income has begun
• Want to take advantage of a down market by opportunistically converting shares at lower prices to their Roth for future recovery
• Want to set up their estate’s beneficiaries to pay less taxes
• Are aiming to lower their future RMDs or smooth taxes paid over time

Understanding the Taxation of Roth Conversions

When converting funds to a Roth account, it’s essential to understand the tax implications of the conversion:

• Roth Conversions are Taxable Events: When you convert funds from a traditional IRA or 401(k) to a Roth account, the amount is taxed at ordinary income rates that are pre-tax status.
• Prorating for IRAs: In traditional IRAs, the IRS requires that Roth conversions include both after-tax and pre-tax funds on a prorated basis. You cannot selectively convert only the after-tax contributions. For example:
  • If your IRA has $100,000, consisting of $80,000 in pre-tax funds and $20,000 in after-tax contributions, and you convert $50,000, the IRS will prorate the conversion:
    • 80% ($40,000) will be taxable at ordinary income rates as pre-tax contributions and earnings
    • 20% ($10,000) will not be taxable, representing after-tax contributions
• Conversions of After-Tax Contributions are Not Taxable: When you convert after-tax dollars in a 401(k), those contributions themselves are not taxed again because taxes were already paid at the time of contribution. However, any earnings and growth on those after-tax contributions are taxable as ordinary income when converted.
• Timing: Convert after-tax funds to a Roth account as soon as possible to minimize tax liability on earnings.

The distinction between 401(k) plans and IRAs is significant for planning your conversion strategy. Careful planning is needed with your advisor and accountant to determine what amounts to convert at each tax bracket.

Avoiding Proration by Isolating After-Tax Contributions

One effective way to avoid the prorating rule in an IRA is to roll the pre-tax contributions and earnings from the IRA into a 401(k) plan that accepts rollovers. By doing this, you can isolate the after-tax contributions in the IRA, allowing you to convert them to a Roth IRA without triggering taxes on pre-tax amounts. This strategy is particularly useful for individuals aiming to maximize the tax efficiency of their Roth conversions or to start backdoor Roth IRA contributions in the future.

Roth Conversion Example

A retired, age 66 single individual has an IRA with a $1 million balance. They have not filed for Social Security income, have not reached RMD age, and are in the 12% tax bracket currently. Their CPA estimates that at their RMD age (73), they will be in the 24% tax bracket, as this income plus Social Security benefits will be taxable to them then.

They complete a Roth conversion of $100,000 now (age 66) and the full amount is taxable to them at ordinary income rates this year. They will pay taxes at the 12% rate now on the Roth conversion.

At their RMD age, they now have:

• Less of a pre-tax account balance, so their RMD will be a smaller amount to distribute at the now higher tax rates (24%)
• Locked in paying lower tax rates (12%) when they completed the original Roth conversion
• They will have multiple years of tax-free growth in the Roth IRA, which will never be subject to RMDs

Let Us Help You Maximize Your Benefits

Navigating Roth conversions and the Mega Backdoor Roth strategy can be complex, but the benefits are well worth the effort. Your Coldstream wealth management team specializes in helping clients optimize retirement savings and tax strategies. If you’re ready to explore how these tools can support your financial goals, we’re here to guide you every step of the way.

*Certified Financial Planner Board of Standards Inc. owns the certification marks CFP^®. CERTIFIED FINANCIAL PLANNER™ and CFP^® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.