How Roth Conversions Can Help You Save During Retirement

06.22.22 | Personal Finance

Since they were first introduced in 1998, Roth IRAs have been a popular way to generate future tax-free growth and income. You can do this by contributing to a Roth IRA on an ongoing basis or converting traditional IRA or other pre-tax retirement account assets into a Roth account.

Roth conversions can help you save during retirement by reducing your future tax burden, but they also require careful planning. Let’s explore the benefits of Roth conversions and when it makes sense to incorporate them into your retirement plan.

Differences Between Traditional IRA and Roth IRA

To understand the benefits of a Roth conversion, it helps to understand the difference between a traditional IRA and a Roth IRA.

The primary difference has to do with when the money is taxed.

  • Money put into a traditional IRA is not taxed. Earnings grow tax-deferred, and when it’s time to begin distributions, that money is taxed as ordinary income.
  • Roth IRA assets are taxed before going into the account and earnings grow tax-deferred. Distributions from a Roth IRA are tax-free as long as they meet two criteria: 1) the account holder is age 59.5 or older and, 2) the Roth IRA has had money in it for at least five years. Taxes or penalties may apply if a distribution does not meet these two requirements. You can find all the rules for Roth IRAs on the IRS website.

A retiree withdrawing money from a 401k or IRA must pay taxes on it, just as you would if you earned that income from a job. Depending on the size of the 401k or IRA, Required Minimum Distributions RMDs (which begin at age 72 and increase with age), may actually lead to higher income and taxes later in retirement. In fact, for diligent savers this is often the case. Roth conversions can help you avoid that scenario.

Key Benefits to Roth Conversions

The main benefit of converting a traditional IRA to a Roth IRA is that the account’s future growth can be spent tax-free as a qualified Roth distribution. While a Roth conversion does require you to pay taxes today, it can help reduce your future tax liability. Because Roth assets allow for tax-free distributions in retirement, they offer more control of income and corresponding tax liability. Unlike traditional IRAs, Roth IRA assets are not subject to required minimum distributions at age 72. This means your money may grow tax-free for longer.

Other benefits that make Roth conversions an attractive option:

  • Tax-free growth and withdrawals
  • Tax diversification or hedge against rising tax rates
  • Heirs can inherit Roth assets tax-free
  • May lead to lower taxes over one’s lifetime
  • May lead to lower Medicare premiums paid over one’s lifetime

When do Roth Conversions Make Sense?

Roth conversions do come with a “catch.” The value of the conversion must be reported as income (and taxed) today. In extreme cases, a large enough conversion can create enough taxable “income” to drive the IRA owner into a higher tax bracket and it becomes “wealth destructive”—meaning they pay more in income tax than if they stayed with a traditional IRA.

Fortunately, there is no minimum or maximum amount on how much must be converted. Roth conversions can be customized depending on your financial goals and income. Often, doing a partial conversion or a series of smaller conversions is the best way to maximize the long-term value and minimize lifetime taxes. Roth conversions may be a good strategy if:

  • You’re entering “low-income” years (common for those entering retirement)
  • You just retired and can manage your taxable income
  • Your income in the future may be higher than your income today
  • Tax rates will be higher in the future than they are today
  • Most of your savings are in pre-tax accounts (converting some to Roth may provide a hedge against higher tax rates or offer diversification)

For those transitioning into retirement, the years after employment income ends, but before Requirement Minimum Distributions (RMD) kick in can be a good time for partial Roth conversions. A retiree in their early 60s might do partial Roth conversions once a year and par down the size of their pre-tax IRA. By the time they begin RMD at 72, there isn’t much of a pre-tax IRA left.

Other Considerations

Roth conversions are not a good fit for everyone. They are highly dependent on your individual circumstances, retirement account assets, and financial goals. Here are a few other considerations around Roth conversions.

Balancing Conversions
Small, regular conversions can help “top off” the current marginal tax bracket. It’s important to find a balance by keeping the converted amount low enough to avoid pushing you into a higher tax bracket, but not so low that the remaining balance in the traditional IRA (plus compounding growth) causes it to be exposed to top tax brackets in the future.

Conversions are Final
Roth conversions should be part of an overall income and distribution plan, or at least be discussed for those approaching or in retirement. Conversions are final, so it is extremely important to confirm the conversion amount. Once a conversion is executed it can no longer be recharacterized like it could in the past.

Paying the Tax
The benefits of a Roth conversion are much greater for those who have adequate cash (whether in a non-retirement account or savings/checking account) to pay the tax.

Five-Year Clock
One of the most overlooked aspects of Roth conversions is that each one has its own five-year clock. Withdrawing money from a Roth IRA that has been in the account for less than five years means you may owe tax on the earnings portion of the distribution.

Medicare Monthly Premiums
Roth conversions increase one’s ordinary income which may impact the monthly premium for Medicare for those age 65 or older. While Roth conversions may cause those premiums to increase for a few years, it could lead to lower premiums overall by reducing taxable income later in retirement.

Plan for a More Confident Financial Future

At Midwest Capital Advisors, we build customized financial plans designed around each individual and their financial goals. Contact us anytime if you’re planning for the future or approaching retirement and are unsure about the best time to do a Roth conversion. Our advisors are here to help you plan for a more confident financial future.

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