You can reduce the impact that taxes have on your retirement by converting pre-tax savings into Roth assets. Doing so will not only unlock future tax-free growth, but also allow you to minimize or avoid required minimum distributions (RMDs).
However, converting a large IRA balance at once, such as $650,000, would trigger a significant tax bill in the year of the conversion. Instead, you may be able to reduce your overall tax burden by gradually converting your IRA over several years. This doesn’t eliminate taxes, but it does give you some control over the timing and amount of taxes you pay. It can also be useful in estate planning, as your potential heirs would inherit tax-free assets. Consult a financial advisor to determine if a Roth conversion strategy makes sense for you.
Anyone saving for retirement using a traditional IRA, 401(k), or similar pre-tax account should begin withdrawing their funds after age 73 (75 for those who turn 74 after December 31, 2032 ). Although RMDs are required for pre-tax accounts, some retirees prefer not to take them if they don’t need the income. That’s because when income from mandatory withdrawals is added to their other income, it can push them into a higher income tax bracket and increase their overall tax bill.
For example, let’s say you have $650,000 in a traditional IRA at age 64. If your account grew at an average rate of 7% per year, it would be worth approximately $1.19 million by the time you reach age 73. the first annual RMD would be approximately $45,000.
But if you have $75,000 in taxable income from other sources and your tax filing status is single, your $45,000 RMD would push you into the 24% tax bracket (assuming 2024 tax rates) and increase your income taxes.
A financial advisor can help you plan RMDs and explore other tax planning strategies for retirement.
Converting a traditional IRA to a Roth IRA can unlock tax-free investment growth and help a retiree avoid or reduce RMDs.
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Because Roth accounts are not subject to RMD rules, converting a traditional IRA to a Roth account is a way to avoid RMDs and the potentially burdensome taxes on unwanted income in retirement.
But a Roth conversion can also be expensive, because the money you convert is treated as taxable IRA withdrawals in the year the conversion is completed. For example, converting a $650,000 IRA to a Roth at once would automatically increase one filer’s marginal tax rate to 37% – the highest marginal tax rate in 2024. Converting $650,000 alone would result in an income tax bill of approximately $200,000, excluding any income taxes. other income taxes you may pay.
You may be able to manage and potentially reduce these taxes by gradually converting your pre-tax retirement savings over a number of years. The idea is to convert just enough pre-tax money each year to keep your taxable income within your current marginal tax bracket. For example, if you have €75,000 in taxable income, you will fall into the 22% bracket in 2024. Converting $25,525 from your IRA would increase your income to $100,525 – the highest point of the 22% bracket.
As you gradually convert your traditional IRA into a Roth account, the remaining amount in your IRA will naturally continue to grow. By the time you reach age 73, your IRA would still contain a significant amount of money. However, your RMD will be reduced, giving you more tax flexibility in the future. If you are unsure how much to convert and when, discuss this with a financial advisor.
A retiree meets with his financial advisor to discuss Roth conversions and their impact on RMDs.
Conversion is a powerful tool. Among other benefits, once you convert money from your IRA to a Roth, you can pass it on to heirs tax-free. Still, you can’t completely avoid paying taxes on IRA withdrawals using Roth conversion or other means. Roth conversion can only help you manage and potentially reduce income taxes on withdrawals from your savings.
Any Roth conversion strategy also makes a number of assumptions that may not prove accurate. For example, tax brackets adjust annually, so when you start using RMDs, the tax brackets will be different. Likewise, investment returns fluctuate and may not be generated as expected.
The five-year rule for Roth conversions is another important consideration. The rule requires that you wait five years after a Roth conversion before you can withdraw the money or face a 10% early withdrawal penalty. On the other hand, in our hypothetical scenario, this provision would not apply to you, as people age 59 ½ or older are no longer subject to the early withdrawal rules.
Finally, Roth conversions may make the most sense if you expect to be in a higher tax bracket in retirement. If your marginal tax rate drops in retirement, you may be advised to keep the money in your IRA and pay taxes on the withdrawals later. That’s where working with a financial advisor and planning ahead can potentially pay dividends.
A strategy to gradually convert money from an IRA to a Roth account can help you manage and minimize the taxes you pay on the conversion. The basic idea is to convert enough money each year to bring your taxable income to the top of your current tax bracket, but no more. This avoids the large one-time tax hit of converting the entire IRA at once, while moving as much money as possible into the Roth account where it is not subject to RMDs. Avoiding RMDs is a benefit of Roth conversion, but the strategy can also potentially help with estate planning.
To calculate your RMD, you must first look up your account balance (as of December 31 of the previous year). Most people will then divide that value by the ‘life expectancy factor’ that corresponds to your age. You can find this figure on the IRS Uniform Lifetime Table. For example, a 73-year-old has a life expectancy factor of 26.5. As a result, they would divide their account balance by 26.5 and get their RMD amount for that specific year. Meanwhile, SmartAsset has an RMD calculator that can help you estimate how much your first RMD will be and when it should be taken.
If you plan to avoid RMDs, a financial advisor can be an important source of information and insight. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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