Retirement planning can be complicated. It involves balancing income, taxes, and financial security. Roth IRA conversions have become a popular strategy for retirees and those nearing retirement. By converting pre-tax savings into a Roth IRA, you can enjoy long-term tax benefits, estate planning perks, and more financial freedom.
As 2024 ends, this strategy is worth considering if you want to optimize current tax laws. This article explores why timing is key for Roth conversions, the benefits of converting in retirement, and important factors to consider when deciding.
Key Takeaways
Roth IRA conversions can provide long-term tax benefits, estate planning perks, and more financial freedom for retirees.
- Convert pre-tax savings to a Roth IRA between retirement and age 72 to reduce taxes on converted funds.
- Consider converting to a Roth IRA if you expect to be in a higher tax bracket later or have high balances in pre-tax accounts like traditional IRAs or 401(k)s.
- Split up conversions over a period of years, consider the five-year rule, and evaluate future tax rates before deciding on a Roth IRA conversion.
What is a Roth IRA Conversion
A Roth IRA conversion means shifting money from a pre-tax retirement account, like a traditional IRA, SEP IRA, SIMPLE IRA, or 401(k), into a Roth IRA. Doing this means you’ll pay taxes on the money now, but it will grow tax-free in the future. This can be particularly beneficial at certain times in life, such as early retirement before you have to take required minimum distributions.
The Roth conversion sweet spot
Many financial experts suggest that the best time to convert to a Roth IRA is between retirement and age 72, when required minimum distributions start. During this period, retirees usually have lower taxable incomes since they aren’t earning wages and haven’t started mandatory withdrawals from their retirement accounts.
With a lower income, the taxes on converted funds are reduced, making Roth conversions appealing. Tricia Rosen, a certified financial planner, advises starting conversions early for better tax planning and to avoid last-minute stress.
If you wait too long to start converting, you might face challenges. Financial institutions often get busy with year-end tasks like Roth conversions, tax strategies, and charitable donations, which might cause delays. Ashton Lawrence, a director at Mariner Wealth Advisors, recommends starting these discussions early in the year. As the year progresses, you can get a clearer picture of your income and tax bracket.
The timing of a Roth IRA conversion is also influenced by tax laws. The Tax Cuts and Jobs Act of 2017 reduced individual tax rates, but these cuts will end after 2025. If Congress doesn’t act, tax rates will increase, so retirees have a good reason to finish Roth conversions while current rates are low. This may be one of the last chances to benefit from today’s lower rates before they rise.
On the other hand, converting to a Roth IRA increases your adjusted gross income, which can impact taxes. A higher AGI might change your eligibility for tax credits and could raise your Medicare Part B and D premiums.
Benefits of Roth IRA conversions for retirees
Tax-Free Income in Retirement
One major benefit of Roth IRA conversions is creating a tax-free income stream for retirement. Roth IRAs use after-tax dollars, so your withdrawals aren’t taxed. This can be really useful for unexpected expenses like medical bills or long-term care.
No required minimum distributions
A big plus of a Roth IRA is that it doesn’t have required minimum distributions. With traditional IRAs and other pre-tax retirement accounts, you’re forced to start RMDs at age 72. This can increase your taxable income and might bump you into a higher tax bracket. But with Roth IRAs, there are no RMDs. You can let your money stay invested and grow tax-free for as long as you want. This makes Roth IRAs a great option for estate planning. You can leave a larger, tax-free inheritance to your heirs without them having to take taxable distributions.
Anticipating future tax rates
Roth IRA conversions are also helpful for those expecting to be in a higher tax bracket later. By converting now, retirees can dodge higher taxes later.
Additionally, people with big balances in pre-tax accounts like traditional IRAs or 401(k)s might face high taxes when RMDs kick in. John Moore, a retired engineer, realized how RMDs affected his taxable income and found that converting part of his savings to a Roth IRA eased this burden.
Ideal candidates for Roth conversions
If you’re a retiree with part-time income or haven’t started Social Security yet, you’re in a good spot to think about Roth conversions. Since your taxable income is lower, converting money from pre-tax accounts lets you keep within your current tax bracket while planning for tax-free income later. Financial advisors often recommend “filling up” tax brackets—convert just enough to stay in your current tax bracket. This way, you get the benefits of a Roth conversion without a big tax bill now.
Drawbacks and important considerations
Upfront tax bill
While there are many benefits to a Roth IRA conversion, it does come with some challenges. One major issue is the tax bill that you’ll owe when you switch pre-tax retirement funds to a Roth. The entire amount you convert gets counted as income, which means you’ll need to pay taxes on it that year. This can be quite a hit to your wallet, especially if you’re converting a large sum.
To ease this tax shock, financial experts suggest splitting up your conversions over a period of years rather than doing it all at once. By spreading it out, you can help control the impact on your income and possibly keep your tax rate more manageable. Luis Rosa, the founder of Build a Better Financial Future, advises that if you don’t need to use the Roth funds for at least five years, gradually converting your account can help manage taxes while still reaping the benefits of tax-free growth.
The five-year rule
Another point to consider is the “five-year rule.” This rule states that Roth accounts must be open for at least five years before you can take out earnings without paying taxes. This rule applies to each conversion separately, so if you convert in 2024, you can’t withdraw earnings tax-free until 2029.
While you can take out your original contributions anytime without penalty, it’s important to plan to avoid taking out earnings too early. Also, once you do a Roth conversion, you can’t undo it, so make sure to think about your future tax situation before you decide.
Evaluating future tax rates
If you’re a retiree who expects your tax rate to be lower in the future, a Roth IRA conversion might not be the best choice for you. Keeping your money in a traditional IRA and paying taxes on withdrawals as needed might make more sense. This can be especially true if you plan to leave your retirement funds to a charity since charitable donations from traditional IRAs can avoid taxes for your heirs. Also, if you have a small taxable income that keeps you in a low tax bracket during retirement, converting to a Roth might not be worth it.
State tax considerations
Think about where you plan to live in the future. State taxes can affect how much a Roth conversion costs you. For example, if you move from a state with high taxes to one with no income tax, you might save money by waiting to convert after you move. So, it’s important to consider both federal and state taxes when planning a conversion.
