How a Roth Conversion Could Save You Thousands

Does it ever make sense to pay taxes on retirement savings sooner rather than later? When it comes to a Roth IRA, the answer is often yes. A Roth IRA is funded with after-tax dollars, and withdrawals that are qualified are entirely tax-free. The beautiful thing about Roth IRAs is that they’re not subject to required minimum distributions (RMDs), which can give you greater control over your income tax rate in retirement. People who have a large amount of investments in tax-deferred retirement accounts are perfect candidates for a Roth conversion strategy. This is because it allows them to pay taxes in a lower tax bracket in the near term while keeping tax-free money for later in retirement when RMDs cause their tax bracket to rise.

You can’t contribute to a Roth IRA if your earned income is at or above certain limits ($144,000 for single filers and $214,000 for married couples filing jointly in 2022). But don’t fret, there’s a way around it: The Roth conversion allows you, regardless of income level, to convert all or part of your existing traditional IRA money to a Roth IRA, and while any amount you convert counts as earned income in the current year, you can use this strategy to reduce overall tax burden throughout retirement.

You must pay income taxes on any converted funds in the year of the conversion, but there are several scenarios in which that might be to your advantage:

• You believe your tax bracket will be higher in retirement. In this scenario, paying taxes at your current tax rate is preferable to paying a higher rate after you’ve stopped working. Paying higher taxes in retirement may sound farfetched, but it’s actually quite common, especially if you haven’t yet hit your peak earning years or you’ve accumulated significant savings in your tax deffered retirement accounts. When you hit RMD age many find that their tax bracket becomes higher than their working years. It could make sense to convert all or a portion of funds in a traditional IRA to a Roth today and not in the future.
• You want to maximize your estate for your heirs. If you don’t need to tap your IRA funds during your lifetime, converting from a traditional to a Roth IRA allows your savings to grow undiminished by RMDs, potentially leaving more for your heirs, who can also benefit from tax-free withdrawals during their lifetimes.
• You don’t have much tax diversification of account types. That is, most of your assets are in tax-deferred accounts. By converting to a Roth IRA, you’ll have assets that won’t be taxed when withdrawn, potentially allowing you to better manage your tax brackets and enable more personalized tax planning during retirement.
• You have irregular income streams and lower than usual income this year. For example, you might own a business that generated a net operating loss from non-passive income. This could be the perfect opportunity to convert some funds to a Roth IRA with a relatively low tax impact.

For some people, sticking with a traditional IRA or other tax-deferred accounts might be a better strategy. A Roth conversion might not be the best option in the following situations:

• You’re nearing, or in retirement and you need your traditional IRA to cover your living expenses. In this situation, if you convert savings in an IRA to a Roth IRA but may need to spend that money soon, your assets may not have time to recoup from the taxes you would have to pay.
• You’re currently receiving Social Security or Medicare benefits. If a Roth conversion were to increase your taxable income, then more of your Social Security benefits would be taxed and your Medicare costs could rise.
• You don’t have money in your taxable account to pay the conversion tax. Preferably your taxable account has assets with a high basis or no gains that need to be taxed. If you have to pay tax due on the withdrawals to fund the conversion with savings from your IRA, it would take even longer to recoup the tax loss and may negate the benefits.
• You plan on giving a substantial amount of your traditional IRA to charities. You could do this by utilizing a Qualified Charitable Distribution (QCD) to meet your RMD requirements. If you don’t plan on using your IRA assets yourself or passing them on to heirs, then a QCD could minimize or reduce the tax impact of RMDs. In this case, converting to a Roth IRA could be counterproductive, since you wouldn’t avoid taxes as you would with just a QCD.

If you decide a Roth IRA conversion is right for you, you’ll need to keep three things in mind:

• When to execute the conversion. If you have a significant balance in your traditional IRA, you may want to carry out multiple Roth IRA conversions over several years, which is called a systematic Roth conversion plan. If done correctly, this approach could allow you to convert a large portion of your savings to a Roth IRA while limiting the tax impact. For example, would aim to convert just enough to keep additional distributions from being taxed at the next higher tax bracket. Early in retirement, when your earned income drops but before RMDs kick in, can be a perfect time to implement that strategy. One problem to be cautious of is making Roth conversions when you are close (within two years) to filing for Medicare and Social Security. A Roth conversion could increase your Medicare premiums and the taxes you pay on Social Security benefits.
• How you’ll pay the resulting tax bill. We recommend paying with cash from outside your IRA for a couple of reasons:
  • Any IRA money used to pay taxes won’t be accumulating gains tax-free for retirement, undermining the very purpose of a Roth IRA conversion.
  • If you sell appreciated assets to pay the conversion tax, capital-gains taxes could further undermine the benefits of a conversion. Plus, if you’re under 59½ and withdraw money from a tax-deferred account, you’ll incur a 10% federal penalty (state penalties may also apply).
• You can’t undo a Roth conversion. Under the Tax Cuts and Jobs Act of 2017, you can no longer “recharacterize” or undo a Roth conversion. Once you convert, there’s no going back.

The decision to convert to a Roth IRA doesn’t have to be all or nothing. You may find dividing your savings between a Roth and a traditional IRA or a Roth IRA and a traditional 401(k) is the optimal solution for you. Overall, converting to a Roth IRA might give you greater flexibility in managing RMDs and will likely cut your tax bill in retirement, but be sure to consult a qualified tax advisor and financial planner before making the move, and work with an advisor each year if you choose to put into action a systematic Roth conversion plan.