What Is a Roth Conversion?
A Roth conversion transfers funds from a traditional (pre-tax) retirement account to a Roth IRA under IRC Section 408A(d)(3). The converted amount is included in the taxpayer's ordinary income for the year of conversion.
All future growth and qualified withdrawals from the Roth IRA are tax-free under current law, provided the account has been open for at least five years and the owner is age 59-1/2 or older. The Roth conversion is the primary vehicle in the "Pay Now, None Later" component of the DEAPR framework.
As discussed in "Billionaire Wealth Strategies" (Jim Dew, 2024), Chapter 9, the Roth conversion represents a deliberate trade of a known current tax cost for the elimination of an unknown future tax liability.
How Does a Roth Conversion Work?
Traditional IRAs and employer-sponsored plans like 401(k)s defer taxes until withdrawal. Contributions reduce taxable income in the contribution year, but every dollar withdrawn in retirement is taxed as ordinary income at rates up to 37% (2025) under IRC Section 1.
Roth IRAs reverse the sequence under IRC Section 408A: contributions are made with after-tax dollars, but growth and qualified withdrawals are entirely tax-free. Direct Roth IRA contributions are limited to $7,000 per year (2025) under IRC Section 408A(c)(2) and are subject to Modified Adjusted Gross Income (MAGI) phase-outs ($150,000 to $165,000 for single filers; $236,000 to $246,000 for married filing jointly in 2025).
A Roth conversion bridges the two systems by moving pre-tax funds into the Roth environment. Under IRC Section 408A(c)(3), Roth conversions have no income limits and no dollar cap. Any taxpayer can convert any amount in any year, regardless of income level.
The key variables in the conversion decision are the current marginal tax rate, the expected future tax rate at withdrawal, the time horizon for tax-free compounding, and whether the taxpayer has non-retirement funds available to pay the conversion tax. Paying the conversion tax from the converted amount itself reduces the Roth balance and diminishes the long-term benefit.
The five-year rule under IRC Section 408A(d)(2)(B) applies separately to each conversion. Converted amounts withdrawn within five years are subject to a 10% early withdrawal penalty under IRC Section 72(t) if the taxpayer is under age 59-1/2. Earnings withdrawn before satisfying both the five-year period and the age requirement are taxable and penalized.
When Do Entrepreneurs Use Roth Conversions?
During transition years, career changes, sabbaticals, or business downturns create an unusually low tax bracket. Converting during a year when income falls in the 12% or 22% bracket rather than the 37% bracket produces a permanent rate arbitrage on every dollar converted. The federal income tax brackets are set under IRC Section 1 and adjusted annually for inflation by the IRS.
Before anticipated rate increases, the current top federal rate of 37% is scheduled to revert to 39.6% after 2025 under the Tax Cuts and Jobs Act (TCJA) sunset provisions. Converting at 37% before a potential rate increase locks in the lower rate permanently. However, Congress may extend, modify, or allow the current rates to expire, creating planning uncertainty.
In early business years, entrepreneurs in the startup phase may have lower income before the business reaches profitability. Converting during these lower-income years captures the rate differential before peak earning years begin.
Post-exit planning uses the earnout period following a business sale, when annual income may be lower than during active ownership, as a conversion window. Spreading conversions across multiple low-income years avoids pushing the entire converted amount into the highest bracket in a single year.
Estate planning leverages the fact that Roth IRAs have no Required Minimum Distributions (RMDs) during the owner's lifetime under IRC Section 408A(c)(5). The SECURE 2.0 Act (2022) eliminated RMDs for Roth 401(k) balances starting in 2024, aligning employer Roth accounts with Roth IRA rules. Roth IRAs can grow tax-free for the owner's entire lifetime and then pass to beneficiaries under the 10-year distribution rule established by the SECURE Act of 2019.
How Does Dew Wealth Approach Roth Conversions?
Bryce Keffeler executed a personal Roth conversion when he transitioned from a six-figure corporate finance role at a Fortune 50 company to wealth management, earning less than a teacher's salary. That artificially low tax bracket created the ideal conversion window, as described in "Billionaire Wealth Strategies" (Chapter 9). The taxes paid at that low rate unlocked decades of tax-free compounding.
The Roth conversion is a tax arbitrage tool that rewards strategic timing. The Fractional Family Office monitors each client's annual tax situation to identify optimal conversion windows that standard tax preparation may not flag. The Linchpin Partner coordinates between the CPA, investment advisor, and estate planner to model the long-term impact of each conversion decision.
Roth conversions carry costs and risks that must be weighed against the benefits. The conversion tax must be paid from non-retirement funds; using the converted amount to pay the tax reduces the Roth balance and undermines the compounding advantage. If tax rates decrease rather than increase, the conversion may produce a net loss compared to keeping funds in the traditional account.
The decision is permanent. Since 2018, Section 13611 of the Tax Cuts and Jobs Act eliminated the ability to recharacterize (undo) Roth conversions. Once the conversion is executed and reported on IRS Form 8606, the tax obligation is irreversible. The 3.8% Net Investment Income Tax (NIIT) under IRC Section 1411 may also apply to the conversion amount if it pushes the taxpayer's MAGI above $200,000 (single) or $250,000 (married filing jointly) in 2025.