A man calculates how much you will pay in income taxes if he converts his traditional IRA to a Roth IRA.
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There is no way to completely avoid paying income taxes when you convert a traditional IRA to a Roth account. However, with smart financial planning, you can reduce the impact of those taxes.
By converting your portfolio into segments rather than all at once, you can keep your taxable income low and avoid moving into a higher tax bracket. This, in turn, can reduce the amount you pay for each dollar converted over time.
Let’s say you have $845,000 in a traditional IRA that you want to convert to a Roth IRA, while also reducing the tax burden on the conversion. Here’s how to think about it.
A financial advisor can help you convert your retirement savings into a Roth IRA and manage your investments. Contact a fiduciary advisor today.
A Roth conversion requires you to pay income taxes on your pre-tax assets as you move them into a Roth IRA.
There are generally two types of tax-advantaged retirement accounts: pre-tax and after-tax.
Pre-tax accounts, such as 401(k)s and traditional IRAs, offer a tax deduction at the time of the investment. Each year you can invest up to the annual IRS contribution limit and pay no taxes on that money, making it cheaper to save more. You then pay income tax on all withdrawals (including the original contributions) at retirement.
After-tax accounts, such as Roth IRAs, offer a tax benefit at the time of withdrawal. Each year you can contribute up to the annual limit with money on which you have already paid income tax. You then pay no tax on your withdrawals upon retirement.
A Roth conversion is when you transfer money from a pre-tax portfolio to a Roth IRA, paying income taxes on the money you convert. Once you make this conversion, your portfolio will grow and function according to the rules of a Roth IRA.
Unlike Roth IRA contributions, which are limited to the annual IRA contribution limit ($7,000 in 2024), there is no limit for Roth conversions. You can make as many conversions as you want each year, for any amount. For example, let’s say you have $845,000 in a traditional IRA. You can convert the entire amount in one year, but you can also convert it little by little over a number of years.
Anyone nearing retirement should be aware that Roth conversions have a five-year rule: money converted cannot be withdrawn for at least five years (unless you are age 59.5 or older). If you withdraw the converted funds before the cooling-off period ends, you will be charged a 10% early withdrawal penalty. However, a financial advisor can help you determine how and when to make a Roth conversion.
Tax-free growth is the main benefit of a Roth conversion. Once you move your money into a Roth account and pay the required taxes, your balance will not be taxed. And when you withdraw the money, you don’t pay taxes on the distributions (as long as you stick to the five-year rule). For this reason, a Roth portfolio also has no required minimum distribution requirement (RMD), allowing you to leave this money invested indefinitely.
However, the tax-free growth comes at the expense of paying income tax in advance.
For example, suppose you convert an $845,000 traditional IRA into a Roth IRA all at once. You add €845,000 to your taxable income for that year. For an individual filer, even with no other reported income, this would mean facing a 37% marginal tax rate and more than $265,000 in federal income taxes.
Households over age 59.5 may withdraw money from their portfolios to pay those taxes, reducing the value of their retirement accounts. If you’re younger, you can’t use your portfolio to pay its own taxes without incurring a 10% penalty. This will save your retirement account, but you will need to have a potentially significant amount of cash on hand to cover the tax bill. A financial advisor with tax expertise can help you plan for the taxes associated with a Roth conversion.
A woman drinks a cup of tea while discussing retirement planning with her friend.
As you can see, you can’t avoid taxes on a Roth conversion. You can reduce their impact.
In general, the best way to manage Roth conversion taxes is through planned, staggered conversions. Instead of moving your entire portfolio at once, convert it into small, more manageable chunks.
You can structure your conversion around the taxes you are willing to pay each year. For example, you can set aside $10,000 to pay conversion taxes in a given year and then work backwards to determine the right amount to match your savings.
You can also structure conversions to avoid moving into a higher tax bracket. For example, you can ensure that you ‘top up’ your current tax bracket each year, ensuring that your conversion does not move you into a higher tax bracket. This allows you to keep the income tax on your conversion as low as possible.
At the same time, you can take advantage of years in which you have less income and a lower marginal tax rate. For most households, it may be beneficial to wait until retirement, when income and tax rates typically decline. A financial advisor can help you find a Roth conversion strategy that is right for your financial situation.
Let’s say you have $845,000 in a traditional IRA. As we noted above, converting that much money into one lump sum, even without additional income, would put you in the 37% tax bracket. You can instead make partial, periodic conversions with the aim of supplementing your current bracket with additional income from annual conversions.
For example, suppose you earn €50,000 per year. In 2024, the tax brackets for private individuals are:
12%: $11,600 to $47,150
22%: $47,150 to $100,525
24%: $100,525 to $191,950
32%: $191,150 to $243,725
35%: $243,725 to $609,350
37%: $609,350+
As always with tax brackets, keep in mind that every dollar of income is taxed at the rate of its bracket. So a Roth conversion that increases your marginal tax rate from 24% to 32% does not increase taxes on all your income, only on the converted funds above $191,950.
If you had an annual income of $50,000, you were in the 22% tax bracket. So if you convert $50,525 per year from your traditional IRA to your Roth IRA, your taxable income would increase to $100,525. This fills in but does not exceed the 22% bracket, and the converted money would generate $11,115 just in additional taxes (22%).
At this rate, without factoring in portfolio growth, you could turn over $845,000 over the course of 16 years. and potentially pay significantly less income tax compared to converting a lump sum.
The point is this: the best way to manage your Roth conversion taxes is with a smart conversion schedule. By keeping your rollovers within your current tax bracket each year, you can minimize the tax burden of your Roth conversions.
There’s no way to avoid income taxes on a Roth conversion, but you can prevent your marginal tax rate from skyrocketing by making a series of strategic, partial conversions. By converting just enough each year to keep you in your current tax bracket, you can prevent your taxes from rising unnecessarily.
Roth IRAs don’t just offer the promise of tax-free income in retirement. They also help you avoid required minimum distributions (RMDs) and the tax bills that come with these mandatory withdrawals, which begin at age 73. If you have pre-tax accounts such as a traditional IRA or 401(k), it can calculate of your potential RMDs will give you a better idea of ​​what your income and tax situation could look like in retirement.
A financial advisor can help you draw up a comprehensive retirement plan. 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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