One of the most common questions we get from clients nearing retirement is whether or not they should start converting their Traditional IRAs or 401(k)s to a Roth IRA. The answer is rarely a simple “yes” or “no”. In certain cases, a Roth conversion can save anywhere from hundreds of dollars to hundreds of thousands of dollars in total lifetime taxes paid when structured properly. However, if these are done at the wrong time and/or in the wrong amounts in any particular year, it can create an unnecessary and unexpectedly large tax bill.
The best Roth conversion strategies don’t focus on paying as little in taxes this year as possible. Instead, they will focus on your projected tax brackets and income levels over the next few decades to determine when the optimal conversion windows will appear.
The goal isn’t to pay less tax this year. The goal is to pay less tax over your lifetime. In some cases, that might mean paying more taxes in the present than what you were planning, but that doesn’t necessarily make it a bad outcome if that allows us to avoid paying even more taxes later.
If you have a portion of your retirement assets in Traditional IRAs or 401(k)s, this guide will assist you in developing a plan of how and when to pay the taxes that have been getting deferred through those accounts up to this point.
What is a Roth Conversion?
Simply put, a Roth conversion is moving money from a pre-tax retirement account (such as a Traditional IRA or 401(k)) into a Roth IRA. In these “Traditional” accounts, you generally received a tax deduction in the year that you made contribution. The taxes on both the contributions and earnings can be deferred while the money is in the account, but that means you will begin paying taxes at your ordinary income rate once withdrawals begin.
A Roth IRA works in the opposite way. To add money to a Roth IRA or Roth 401(k), the contributions must have already been taxed. With taxes already taken care of, it allows for qualified Roth IRA distributions in retirement to generally be tax-free.
By implementing a Roth conversion, you are essentially speeding up the timing of when the tax bill is due on your Traditional 401(k)/IRA assets. Since the actual taxes that you will pay on either a Traditional IRA distribution or Roth conversion are both based on your total income and tax rates for that particular year, the value of a Roth conversion truly comes down to the exact timing of when each dollar is taxed.
Why Would Anyone Voluntarily Pay Taxes Earlier?
It is a common belief that since Traditional IRAs and 401(k)s allow you to defer any growth, interest, dividends, or capital gains, that your best bet would be to defer all of this for as long as you possibly can. So why would someone want to convert money into a Roth IRA before they need to start taking withdrawals on their tax-deferred assets?
Imagine you are recently retired and have not elected to take your Social Security benefit yet. You are currently in the 12% tax bracket, and could take up to $10,000 out of your Traditional 401(k) before going up to a higher tax bracket.
If you estimate your future income with the addition of Social Security and Required Minimum Distributions, you might find out that your tax bracket will no longer be 12%, and you will be pushed into the next bracket (today, the next bracket is 22%).
In that case, if you were to take that $10,000 and convert it today instead of waiting, you could end up saving $1,000 by paying 12% in federal taxes today instead of 22% in federal taxes later. That is the fundamental idea behind most Roth conversion strategies: not avoiding taxes altogether, but finding the most favorable time to pay them.
The Advantages of Building Roth Assets
There are several reasons Roth IRAs have become a major part of retirement planning:
1. Tax-Free Growth
Possibly the most important benefit of a Roth IRA is that you have the opportunity for future qualified distributions to be taken out tax-free. The longer of an investment time horizon you have, the more valuable the compounding of tax-free assets can become.
2. Greater Flexibility in Retirement
Managing taxable income in retirement can be a challenge. During your working years, adding up your W-2 income to find out what bracket you fall into can often be very straightforward. In retirement, you begin to add income sources such as capital gains, pensions, or Social Security, all of which have their own set of rules that determine how they will be taxed. By having a portion of your assets in Roth IRAs, you can give yourself flexibility during years where you might be approaching the edge of a tax or IRMAA bracket. It can even help you avoid increasing your taxable income to maintain eligibility for certain tax deductions that you are currently receiving.
3. No Required Minimum Distributions (RMDs)
Traditional IRAs and 401(k)s eventually require annual withdrawals. Currently, that is set to age 73 for those born before 1960, and age 75 for those born 1960 or later. Roth IRAs do not have this requirement, which means you can potentially allow funds to grow tax-free for longer. This also means you would not be forced to realize taxable income in a year where you don’t need it.
4. Estate Planning Benefits
Many retirees, especially if they are only taking RMDs from their investments, will ultimately discover that they are not on pace to spend every dollar that they’ve saved. For those who are planning to leave behind assets to children or grandchildren, Roth accounts can be a valuable tool when building out your estate plan.
Although inherited Roth IRAs are still subject to distribution rules, those distributions can often times be received on a tax-free basis if the applicable requirements are met. By contrast, Traditional IRA distributions are taxed to beneficiaries at their own ordinary income rates.
In certain cases, it could make sense as the parent or grandparent to pay additional taxes at your current rate today so that your children/grandchildren can avoid paying inherited IRA distribution taxes at a rate higher than yours. This can often be true when parents are in the later years of retirement while their children are still in their prime working years.
5. Roth Conversions Can Reduce Future Required Minimum Distributions
Every dollar converted today is one less dollar that will eventually be subject to RMDs. As more dollars are converted, Traditional IRA balances will be reduced (or, at the very least, grow at a slower pace). Since RMDs are calculated each year based on the previous year’s ending value, every dollar converted in advance of RMD age would help lower that required amount for every year going forward. Even if that does not cause you to completely avoid any future tax bracket or Medicare premium increases, it could at the very least delay when those increases come.
When Should Someone Actually Consider a Roth Conversion?
There isn't a universal answer because every family's financial situation is different. Your current tax bracket, future retirement income, Social Security strategy, investment accounts, estate planning goals, and even where you live can all influence whether a Roth conversion is beneficial.
That said, there are several situations where Roth conversions often deserve a closer look.
1. During the Years Between Retirement and Required Minimum Distributions
For many individuals, the years immediately after retirement may present the greatest opportunity for Roth conversions. This is because your paycheck has stopped, your Social Security might not be activated yet, and RMDs have not started. Especially if you have significant assets in taxable investment or bank accounts, you could find yourself in a significantly lower tax bracket compared to either your working years or your post-RMD age years.
These years of lower income create an opportunity to intentionally recognize income through Roth conversions while paying taxes at relatively favorable rates. This window generally only lasts for a handful of years, so it is crucial to know where your taxable income will fall before it begins. Once those additional income sources eventually begin, there is far less flexibility to get back down to those low brackets in the future.
2. When You Expect Your Future Tax Rate to Be Higher
One of the biggest misconceptions about Roth IRAs in general is that tax-free growth is always better than tax-deferred growth. The reality is that tax-free growth is only superior in situations where the tax rate paid during the contribution years was lower than the tax rate that would have been paid during the distribution years.
Many retirees assume they’ll automatically be in a lower tax bracket once they stop working and no longer have earned income. That can certainly be true, but it is not always the case. We see plenty of examples of individuals who have high Social Security benefits, great pensions, or have saved a significant amount of money in Traditional IRAs/401(k)s already. In those examples, it is fairly common to reach a point where the highest tax bracket you are projected to be in will be the one you enter once all of your retirement income sources turn on. A Roth conversion can be used to counter this, and those who are still working could also utilize more Roth IRA/Roth 401(k) contributions to lower future projected tax bills.
3. During a Market Decline
A rarely discussed strategy for Roth conversion timing is to set up the conversion during a period where the market is noticeably down from its all-time high. Here is an example: say you own 100 shares of a fund tracking the S&P 500 trading at $100 a share. This gives you a current market value of $100,000. Over the next six months, the S&P 500 declines significantly, and the share price of your fund goes from $100 to $50, leaving you with $50,000 in total market value. If you convert these shares to a Roth IRA today, you would pay taxes on $50,000. However, if the S&P 500 were to return back to its original value a year later, you would have $100,000 in your Roth IRA that could be distributed tax-free down the road. We of course never know when market declines will happen or how long they will last. But for those who are already considering a Roth conversion, getting the taxes paid when prices are down could prove to be advantageous over a long period of time.
4. During an Unusually Low-Income Year
Life inevitably evolves in ways that we could not have predicted or planned for. Maybe you or your spouse loses their job. Perhaps one of you finds a better role, takes on a new career path, or starts your own business. In any of these cases, you will likely find extreme income volatility that potentially lasts for multiple years. Rather than viewing these years as a temporary anomaly, they can create valuable planning opportunities to take advantage of realizing income in tax brackets that you were previously expecting to be filled.
Roth Conversions are Usually Not an “All or Nothing” Decision
Almost every Roth conversion will not result in all of someone’s Traditional assets being converted to Roth assets within one tax year. Since each dollar of the conversion is taxed as ordinary income, there will generally not be enough room within your current bracket to pay taxes on your Traditional assets all at once. Instead, many retirees benefit from completing small conversions within their current bracket over multiple years (and possibly even decades) to ensure that the tax rate on the conversions won’t exceed any future tax rates that they would have been liable for. As a reminder, the goal is not to eliminate taxes; rather, we are looking to recognize income at the most favorable tax rates that you are projected to have.
Understanding Tax Bracket Management
This is where Roth conversion planning becomes much more strategic. We have a progressive tax system, which means that different portions of your income are taxed at different rates. Rather than accidentally allowing a large Roth conversion to spill into higher tax brackets, many retirees intentionally convert only enough each year to remain within a particular bracket. Think of this bracket as a bucket: once you earn income throughout the year, the bucket gradually fills. Once it’s full, additional income begins spilling into the next (and higher) tax bracket.
The planning opportunity comes from deciding how full you want the bucket to become before stopping the conversion. For some retirees, it might make sense to convert only enough to remain within their current bracket. For others, intentionally using part of the next bracket may still produce better lifetime results. The important point is that these decisions need to be intentional ones made based on each specific year’s income projections.
Looking Beyond Federal Income Taxes
Federal tax brackets are a major factor when considering Roth conversions, but there are other variables to consider with this decision as well. Higher taxable income could affect Medicare premiums, taxation of Social Security benefits, state income taxes, certain credits or deductions, and net investment income taxes.
This is the reason why simply looking at federal tax rates for this year can’t help you make your Roth conversion decision alone. Similar to most other financial planning topics, these decisions revolve around considering your full financial picture year-to-year.
A Roth Conversion Isn’t Just a Tax Decision
Roth conversions can certainly create the potential to pay less taxes on your retirement assets. However, another major goal of these conversions is creating flexibility. Having money in Traditional IRAs, Roth IRAs, taxable investment accounts, cash, and even Health Savings Accounts will give you more options as you approach each individual tax year.
Changing tax laws, unexpected expenses, medical issues, charitable goals, or market conditions could all change future withdrawal strategies. While we can’t predict exactly what the future holds, having assets in multiple account types ensures that you have the flexibility to adapt to whatever changes may come.
The Bottom Line
A successful Roth conversion strategy doesn’t begin with asking whether or not you should do a Roth conversion. The right question to be asking is: “What am I trying to accomplish?”
Whether you want to reduce future RMDs, lower lifetime taxes, reduce the tax bill for future beneficiaries, or lower your Medicare premiums, the goals you are trying to accomplish need to shape the strategy that you build.
Rather than narrowly focusing on one singular subject, retirement planning is based around combining thoughtful investment management, tax planning, withdrawal strategies, Social Security decisions, and estate planning into one coordinated plan. A Roth conversion strategy can be an important piece of that puzzle, but it’s still just one piece. When viewed in the context of an overall financial plan, Roth conversions become much easier to evaluate. The rules and considerations won’t change, but the purpose will become much more clear.
Matt J Black,CFP®, AAMS®
mblack@larsonfs.com
913-428-2233