Converting to a Roth IRA can be tricky business. For the right household, this is an excellent way to save money on retirement taxes. A Roth portfolio generates untaxed income, letting you keep more of your portfolio and Social Security. It also has no required minimum distributions (RMDs), maximizing your financial flexibility.
But remember that you pay income taxes on all the money you move into this account. For the wrong household, these conversion taxes can swamp any long-term gains. That’s not necessarily a deal-breaker, since tax management isn’t always your priority, but it’s important to remember.
For most households, the rule of thumb is this: A Roth conversion is more useful earlier in life than later. And it is more useful when you pay a lower tax rate now than you will in retirement.
So, for example, let’s say that you are 65 years old and retiring in two years. You have $800,000 in an IRA and are wondering if you should convert that to a Roth portfolio $100,000 at a time. Here’s are things to consider before executing such a plan.
For help setting up and executing a Roth conversion plan best suited for your goals, get matched with a financial advisor today.
What Is A Roth Conversion?
A Roth conversion is when you move money from a pre-tax portfolio, like a traditional IRA, into a post-tax Roth IRA. Once the money has been converted, you will not owe taxes on the portfolio’s returns or withdrawals, giving you a future income stream entirely free of taxes and RMD requirements.
There are two main catches to a Roth conversion. The first is known as the five-year rule. If you are under 59 1/2, you must wait five years before withdrawing any money that you convert into a Roth IRA. The second issue is conversion taxes.
When you convert money to a Roth IRA, you add the amount converted to your taxable income for the year (and, as a result, pay taxes on it). If you are older than 59 1/2, you can pay those income taxes with money from your portfolio. Below this age, you must have the cash on hand from other sources.
For example, say you convert $100,000. You are likely to pay at least $14,261 in taxes on that conversion. If you are above the age cutoff you could take that from your portfolio, leaving $85,739 invested in the new Roth.
For high-value conversions, this is often necessary. Many households don’t have the cash on hand to pay tens (if not hundreds) of thousands of dollars in conversion taxes. But remember that this isn’t just about cash flow, it’s also an opportunity cost. The money you pay in conversion taxes is money that you could have left invested.
Staggered Conversions
To minimize conversion taxes, a good approach is to use a staggered conversion. By converting a pre-tax portfolio in stages, rather than all at once, you can reduce your tax brackets and lower the amount exposed to high rates. (For a primer on how and why that works, see our article on taxation.)
Here, for example, we have an individual with $800,000. They would like to convert that money to a Roth IRA $100,000 at a time. Let’s assume that they have the median income of approximately $75,000. Here’s the tax difference between eight, $100,000 payments and one $800,000 conversion:
- $100,000 conversion per year
- Total taxable income: $175,000 per year
- Conversion taxes per year: $23,315 (the difference between taxes at $175,000 and taxes at $75,000)
- Total conversion taxes over eight years: $186,520
- $800,000 lump sum conversion
- Total taxable income: $875,000
- Total conversion taxes in one lump sum: $270,197 (the difference between taxes at $875,000 and taxes at $75,000)
Now, in this example we assume away a number of complications, such as portfolio returns during the conversion years and income changes after retirement. Still, it’s enough to demonstrate that staggering your conversion can save you a whole lot of money.
A fiduciary financial advisor can help you calculate how portfolio growth, taxes, inflation and more might affect the outcome of this strategy. Talk to a financial advisor today.
Near-Retirees Still Might Not Want To Convert
As noted above, a Roth conversion can be useful. And in this example, we might even have a clear-cut answer.
If your question is, “how can I avoid RMDs on my $800,000 IRA,” the answer is convert your money to a Roth IRA. Unless you have significant external assets, you won’t have $800,000 in the resulting Roth portfolio, but you will entirely protect this money from RMDs. If your goal is to leave this money in place or preserve a tax-advantaged inheritance for loved ones, then a Roth conversion can make this happen.
From there, converting in stages makes perfect sense. As we discuss above, this will cost far less than moving your money in one lump sum. If we assume you use this portfolio to pay its own taxes, moving $100,000 per year vs. moving the money all at once is the difference between having $613,480 in your newly converted Roth and having $529,803 in it.
However, if your goal is tax management, a Roth IRA gets more complicated. Eliminating RMDs is a popular way to try and manage taxes. Each required minimum withdrawal triggers income taxes and, if you don’t need this money yet, you might want to leave it in place. The problem is that at or near retirement, it’s very likely that you will pay more in conversion taxes than you would pay in income taxes on those long-term withdrawals. This makes this an often-unsuccessful strategy for retirees.
Kevin Caldwell, a principal with the financial advisory Golden Road Advisors, told SmartAsset, the main situation he recommends a Roth conversion for people who are near retirement is, “when the client… is never going to spend the money. Therefore, we can ‘decapitalize the IRA.’” This lets the household avoid RMDs and preserve the money for future use.
Second, he said, when Medicare surcharges are a potential issue, specifically people in the 24% tax bracket younger than 63: “[That is two] years prior to Medicare age which is the lookback for Medicare surcharges on income.” You’ll want to consider any potential complications from adding conversion income to your taxable income in this case.
A financial advisor can give you a professional opinion on whether a Roth conversion is the right option in your situation. They can also help you set up and execute an appropriate strategy. Get matched with an advisor.
The Bottom Line
If you’re nearing retirement, should you convert your pre-tax assets to a Roth IRA? It depends on what you want to achieve. If you are looking for estate or cash flow management by eliminating RMDs, this might be a good idea. But even if you stagger your conversions, it’s likely that you will pay more in conversion taxes than you will save on RMD-related income tax, so plan this move carefully.
Tips On Making A Successful Roth Conversion
- We don’t want to undersell the value of a Roth conversion. For the right household, this really can be a terrific way to boost your after-tax income in retirement… because you might not actually have any taxes. If you’re looking at a conversion, here are some strategies for making it work.
- 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.
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