Staggering your Roth conversions can save a lot of money.

Under the right circumstances, a Roth IRA can be the best retirement account for tax management. On the back end, you simply can’t beat the offer of no income taxes or required minimum distributions (RMDs) in retirement. The catch is the front end, when you pay taxes that might otherwise have boosted your portfolio.

If you’re making a Roth conversion, you’ll incur conversion taxes. A good way to help manage this is by staggering your conversions, moving a little bit at a time to minimize your tax brackets.

For example, say that you’re 50 years old with $650,000 in your 401(k). A Roth IRA will have plenty of time to keep growing tax free before you retire in, say, 10 to 15 years. How would it work if you move just enough income each year to stay under the mid-tier 24% tax bracket? How about if you move enough to stay within 24%? 

Here are some things to think about. A financial advisor can also give you personalized guidance based on your circumstances and goals.

What Is a Roth Conversion?

A Roth conversion is when you move assets from a pre-tax retirement account into a Roth IRA. 

A Roth IRA is a post-tax retirement account. This means that you fund it with money on which you have already paid income taxes. You get no tax breaks related to funding the Roth account. However, you then pay no further taxes on these assets. The funds grow tax-free, like with all retirement accounts, and in retirement you can withdraw this money with no income taxes. This can make a Roth IRA the best retirement account on the market for the right investor.

Roth conversions are when you move money from an existing, qualified pre-tax retirement account, like a 401(k) or a traditional IRA, and put it in a Roth IRA. There is no limit to how much money you can convert, so long as it comes from a qualified pre-tax portfolio. Mechanically, this is a simple transfer. You either direct deposit the assets from one account to the other, or you withdraw the funds and then deposit them in the other account.

When you make a Roth conversion, you add the entire amount converted to your taxable income for that year. For example, say that you convert $100,000 from your 401(k) to a Roth IRA in 2024. Your taxable income for 2024 would increase by $100,000. This means that part of making a Roth conversion is ensuring you have the cash on hand to pay the increased taxes. If you are over the age of 59 1/2, you can take that cash from the funds you are converting, which will in turn reduce your portfolio’s capital. If not, you will need cash from other sources.

Staggered Roth Conversions

The most common way to manage conversion taxes is a practice known as staggered conversions. This is when you convert money in smaller amounts each year to keep your taxable income lower. This, in turn, helps keep down your tax brackets, so that your money gets taxed at a lower overall effective rate. 

For example, let’s say you have $100,000 to convert. Using the 2024 tax brackets as an example, the 12% tax bracket applies to individual income between $11,600 and $47,150. The 22% tax bracket begins at income above $47,150. For the sake of example, we can set aside any other household income. 

If you convert $100,000 all at once, you will pay taxes up to 22%, for an approximate effective rate of 13.79% and taxes of $13,007. On the other hand, say you convert your money over in $47,150 installments (with a $5,700 remainder in the third year). This would expose your money to a maximum 12% tax rate, for an effective rate of 8.01% and total taxes of $7,552. You almost halve your taxes with staggered, installment conversions as opposed to a lump sum in this case.

However, when it comes to installment conversions, many investors forget a critical issue: Your money will continue growing while you make these conversions. For the Roth account, this means that the sooner you convert your funds, the more untaxed growth you will enjoy. For the pre-tax account, this means that the longer you take to convert your funds, the more taxed money you will ultimately need to convert.

A financial advisor can help you plan and execute a Roth conversion. Get matched today.

How Should You Convert a $650,000 401(k)?

So, let’s return to our question. You’re 50 years old with $650,000 in your 401(k). We’ll assume that you are an unmarried individual and that your portfolio grows at a stable 8% mixed-asset rate of return. (There are no guarantees with investing. We will just use this number for the sake of example.) 

First, should you convert your money each year up to the 24% income bracket? It’ll depend on your circumstances, including the other taxable income you are living on each year.

The 24% tax bracket ends at $191,950 in our example, so you will need to keep your combined (earned and converted) taxable income at or below this number to stay below the 32% bracket.

Or, say you want to make this conversion over 10 years, so that it is finished by the time you turn 60. To do this, you will need to account both for your current portfolio and any growth during that time, while still balancing your tax brackets by monitoring your earned and converted income.

So, in the alternative, should you convert your money each year to stay within the 24% tax bracket? That is, should you convert only enough to stay within this bracket? 

This plan makes sense, but depending on your income it might still be tight. The 24% bracket is one of the tax code’s odd cliffs, with the next bracket jumping all the way up to 32%, so you’ll save real money by sticking to 24%.

However, you still need to consider your timeline. If you want to convert your money in less than 10 years, even staying within 24% might require an unrealistically low level of earned income. For example, say that you want to convert this entire portfolio within five years. This would require withdrawals of slightly more than $160,000 per year, accounting for portfolio growth. That’s only possible if you make less than $31,950 per year. 

Within the 24% tax bracket this plan is possible, but it depends entirely on your time frame. If you want to convert your assets before age 60, this still might require less household income than you’re likely to have.

Consider speaking with a financial advisor for help building and executing a plan for your retirement income and taxes.

The Bottom Line

A Roth IRA conversion can be a great way to manage your taxes, but it’s important to fully understand the implications of this move. For example, when you plan the timeline of your conversion, don’t forget to account for offsetting portfolio growth. Otherwise, you might find yourself relying on unrealistic assumptions.

Tips on Retirement Portfolio Tax Management

• On the subject of often-overlooked tax issues, state taxes are an often-overlooked tax issue. If you live in an income tax state, make sure you plan for the bite that state taxes will take out of your portfolio income, otherwise you might have a nasty surprise come retirement. 
• A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.

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