Roth IRAs are not subject to rules on required minimum distributions (RMDs), and eligible withdrawals from Roth accounts in retirement are also free of federal income taxes. You can get these benefits for funds in your traditional IRA by transferring them to a Roth account. You now have to pay income tax on the funds you convert, but by spreading the conversions over several years you can better manage and potentially reduce your overall tax liability. Still, there’s no way to avoid taxes completely, and conversion isn’t always the best strategy. Moreover, converting a fixed percentage annually is not the only way to do this.
A financial advisor can help you figure out if and how to make a Roth conversion. Make a match with a fiduciary advisor today.
If you’re saving for retirement in a pre-tax account, such as a traditional IRA, you’ll need to withdraw money from the account once you reach age 73 (or age 75 in 2033 or later). Those RMDs are taxable as ordinary income, which can cause problems for some retirees if they need to receive taxable income when they don’t need the money to maintain their lifestyle.
For example, suppose you are 73 years old and receive $45,000 in taxable income from Social Security, pensions and other sources. If you are a single filer, this puts you in the 12% marginal bracket using the 2024 income tax brackets and your federal tax bill would be about $3,500. If you also have to take $20,000 in RMDs, your new taxable income of $65,000 will put you in the 22% bracket and your federal tax bill will increase to about $6,500.
If you convert your IRA to a Roth IRA before you turn 73, you don’t have to take RMDs. Not only will this help you manage your taxes in retirement, it will also ensure that your Roth funds can continue to grow tax-free. And you can also pass them on to your heirs tax-free, making Roth conversion a useful estate planning tool.
However, these benefits come at a price. For example, if your traditional IRA contains $500,000, the tax bill for converting the entire amount in one year could be about $145,000, using 2024 tax brackets for a single filer. Because of this, people who do Roth conversions sometimes spread the process over several years by converting a portion each year.
For example, if you turned over 10% of a $500,000 IRA annually, your income would increase by $50,000 in the first year. Assuming your taxable income from other sources is €50,000, your taxable income increases to €100,000. If you use the 2024 brackets for one filer, you will remain in the 22% bracket. Over a ten-year period, you may have the opportunity to save money on taxes instead of the lump sum conversion.
A financial advisor can help you calculate the tradeoffs for your own Roth conversion strategy and find an appropriate approach for your goals. Talk to a financial advisor today.
Despite its appeal, Roth conversion has some drawbacks and limitations and is not suitable for everyone. One of the most important considerations is whether you will be in a lower tax bracket after retirement. If so, you’re better off paying taxes on IRA withdrawals rather than paying taxes now to convert to a Roth.
Additionally, you can’t withdraw earnings from converted funds until five years after you make the conversion without incurring a 10% penalty. This is known as the five-year rule. So conversion may not make financial sense if you are nearing retirement or if you need the money for another purpose within five years, such as paying for your child’s education.
If conversion makes sense, a flat rate annually is just one approach. The idea is to only convert enough to bring your taxable income to the top of your current tax bracket. With this in mind, the dollar figure is more important than the percentage.
Also keep in mind that a decision on whether or not to do a Roth conversion relies on a number of assumptions about the future, none of which may turn out as expected. For example, you may choose not to convert because it appears that you will fall into a lower tax bracket after retirement. However, the 2017 tax cut expires in 2026, after which taxes may increase. In general, tax rates have been declining for decades and are low compared to historical averages, suggesting they may have some time to go up before they come back down.
Consider matching with a financial advisor to discuss your options for a Roth conversion.
Converting money from your IRA to a Roth IRA can be a good move if you think you’ll be in a lower tax bracket in retirement. Conversion also gives you more control over withdrawals from your retirement account, because Roth accounts are not subject to RMD rules. You’ll have to pay income taxes on the money you transfer to a Roth, but gradually converting your IRA over a period of years can help reduce your overall tax burden.
Consult a financial advisor to understand the impact taxes can have on your retirement plan. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Find out how much your RMDs will use SmartAsset’s Required Minimum Distribution Calculator.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that isn’t 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.
Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and provides marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
