Roth conversions are a way boost your tax free money within retirement accounts. This is when you have money in a Traditional 401(k) or IRA and you convert some or all of the balance to a Roth 401(k) or Roth IRA. In this way, you are converting tax deferred money to Roth, and paying taxes on it after the conversion.
Example
I ran into a situation in December, where I was going to end up with an unexpectedly high tax refund. I used the excellent TaxCaster in December to get an idea of my potential refund, which was higher than I wanted it to be. December is too late to make changes to the W-4. It wasn’t too late, however, to make some Roth conversions inside my Traditional 401(k).
I converted a portion of my Traditional 401(k) balance to the Roth 401(k) side of the account. This has the effect of adding money to my W-2, increasing the taxes owed in April. This in turn, reduced a potential high refund, but also allowed me to painlessly get more money into my Roth 401(k).
Money is Fungible
To be sure: money is fungible. It can be used for more than one project. I could have also simply received the higher refund and then used those funds to deposit into my Backdoor Roth. But, this doesn’t get me more Roth money in my 401(k), and it puts that refund at risk of being spent. This was a surefire way to get more Roth money into my 401(k) while reducing the refund.
How much to convert? Take your marginal tax rate and multiply it by how much you want to convert to get close to what taxes you’ll owe on the conversion. I highly recommend looking at TaxCaster. If you find yourself looking at a large refund, know that you have options besides getting a lot of money back in April.
Estimate
Also, the TCJA changed W-4 forms, so use the IRS estimator to make sure you are getting the smallest refund possible. Hint: There are no more “withholdings”. Fill out the estimator and it will let you print a PDF of your updated numbers which you can then update with your employer.