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Converting a traditional IRA to a Roth IRA can help you minimize taxes in retirement. But executing the conversion strategically is the key to maximizing the benefits. A recent Schwab retirement planning report recommends three tactics to lower your Roth conversion tax bill: maximize your current bracket, spread conversions over several years, and start planning for tax changes early. All can be effective retirement planning tools, but a Roth conversion comes with costs, limits, and risks and may not be optimal for everyone.
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A Roth conversion allows you to transfer money from a traditional IRA to a Roth IRA and pay income taxes on the amount converted. This can benefit you in retirement by allowing you to grow your savings and withdraw tax-free. It’s a smart strategy if you expect to be in a higher tax bracket later or want to avoid required minimum distributions (RMDs) on traditional IRAs.
The mechanics of Roth conversion are not particularly difficult, and the institution that manages your Roth account can help you. But it’s up to you to make sure you don’t pay too much tax. The Schwab Center for Financial Research recently offered three possible ways to reduce the tax burden of your Roth conversion:
1) Maximize your current tax bracket with a partial conversion. This prevents you from being bumped up to the next bracket by adding smaller amounts to your taxable income each year. For example, if you fall into the 24% bracket, you convert just enough money to bring your current taxable income to the threshold of the next bracket.
2) Spread conversions over multiple years to manage the tax impact. As with the previous strategy, it tries to avoid being bumped into the next bracket by adding smaller amounts to your taxable income each year. Stay strategic to maximize each year’s bracket.
3) Think about tax changes early. If you think tax increases are coming, you can convert more now to avoid higher rates later. Convert before the end of the year to account for income fluctuations.
To see how this might work, consider a hypothetical example of a single retirement saver who has $200,000 in a traditional IRA. They think their tax rates will be higher when they retire, so they’d like to convert that to a Roth. They earn $150,000 annually, which puts them in the 24% category. For example, in tax year 2023, the next bracket starts at $182,101, with a rate of 32%, and the bracket above that is 35% and applies from $231,251.
If they were to convert the entire $200,000 into a Roth IRA in one year, their tax liability specifically for that money would be broken down as follows:
On the first $32,100, they would owe 24%, or $7,704
On the next $49,150, they would owe 32%, or $15,728
Of the remaining $118,750, they would owe 35%, or $41,562
In total, they would owe $64,994 in income taxes on the entire $200,000 one-time conversion.
If they used a gradual conversion strategy, they could convert $32,100 this year to increase their income to $182,100. This fills her 24% bracket without moving to the higher rates. At the marginal rate of 24%, she pays about $7,704 on the money converted.
Assuming their income and tax brackets don’t change, they can repeat this over the next few years to gradually move the entire $200,000 in their IRA to a Roth.
Without changing the brackets, they could convert $32,100 in each of the first six years and pay $7,704 in taxes for a total six-year tax bill of $46,224. In the seventh year, they were able to convert the remaining $7,400 and pay $1,776 in taxes.
Their total seven-year tax bill for the gradual conversion would be $48,000. That represents a hypothetical tax savings of $16,994, although in reality the tax brackets and their annual earnings would likely shift and produce a slightly different schedule of withdrawals and results.
A financial advisor can help you determine the tax implications of your own Roth conversion.
While a Roth conversion can be a smart move, it is not without potential drawbacks. For example, while Roth conversions can optimize your retirement taxes, they now come with additional tax costs.
Also keep in mind that Roth conversions are irreversible. You can’t reverse it and move money back into a traditional IRA or other pre-tax retirement account.
Finally, if you are under age 59.5, withdrawing money from an IRA is considered an early withdrawal. That means the money you want to convert will have to pay a 10% penalty on top of any taxes owed before you can deposit it into a Roth account.
Roth conversion can make sense, but it’s not always the right move for every retirement saver. Before deciding to make a conversion, you should carefully consider your individual circumstances.
In particular, look at your current tax bracket versus your projected retirement income and tax rates. Weigh the benefits of tax-free pension withdrawals against paying conversion tax now. Adjust conversion years to lower income. For larger IRAs, discuss partial conversions with a professional. You can match a financial advisor with SmartAsset’s free tool.
Strategic partial Roth IRA conversions can optimize your retirement taxes. But do the analysis to see if the conversions align with your overall savings and tax picture. Seek the help of a financial advisor to run the numbers. With the right plan, you can take full advantage of this IRA planning tool.
You may want to consider working with a financial advisor to project your retirement income and tax rates and see if a Roth conversion can work. 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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