Transferring money from a pre-tax retirement account, such as an IRA, to an after-tax Roth IRA is a step that many retirement savers may want to consider. A Roth conversion, as the move is called, has many benefits. It can help you avoid required minimum distributions, or RMDs, in retirement, as well as taxes on your retirement withdrawals. There are even some estate planning benefits. Gradually converting IRA funds into Roth funds is a popular refinement of the technique because it can save on taxes now and allow for tax-free withdrawals later. However, converting 20% of your IRA to a Roth account each year may or may not be an optimal approach. And in some cases it may be more efficient not to convert at all. A financial advisor can help you identify a promising strategy for financing your retirement, but here are some things to consider.
Roth conversions offer a lot of appeal to retirement planners. Roth accounts are not subject to Required Minimum Distribution (RMD) rules, so retirees don’t have to make mandatory withdrawals that could increase their tax liability after they stop working. Additionally, Roth withdrawals do not incur income taxes after age 59 1/2, so they do not affect the tax on Social Security benefits, among other benefits. Roth accounts can also provide tax-deferred transfers of assets to heirs, making them popular for estate planning.
For many savers, the main concern is whether the pension saver will fall into a higher tax bracket after retirement. If they are in a lower tax bracket, the Roth may not make sense. That’s because any funds converted from a pre-tax retirement account, such as an IRA, are taxed as ordinary income when the conversion occurs. With that in mind, if a saver expects to be in a lower income tax bracket in retirement, as is often the case, they won’t save money by paying taxes at a higher rate now. A financial advisor can help you devise an appropriate tax strategy for your Roth conversion.
Because money transferred from an IRA to a Roth is treated as taxable income when the conversion occurs, converting a large IRA at once can become very expensive. Gradual conversion is a popular approach. Spreading the conversion over several years can prevent the taxpayer from moving into a higher bracket, thereby reducing the current and overall tax burden.
When designing a Roth conversion plan, aiming to convert a percentage each year may also not be the best approach. That’s because the dollar amount of the conversion, not the percentage, affects current taxes. The typical approach is to convert only enough IRA funds each year to bring the taxpayer’s income to the top of the current bracket.
The amount converted in a tax year is added to your other income, such as wages and self-employment income, to ultimately determine your adjusted gross income (AGI). Your AGI determines your tax bracket. For example, under 2024 marginal tax rates, if you earned $150,000 in salary with no other income, you could convert up to $41,950 (the upper limit of the 24% bracket, $191,950, minus $150,000 salary) this year before hitting the limit of $150,000. Tax bracket of 32%.
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That way, while the tax bill goes up, the tax rate won’t increase. Over the years, converting a significant IRA can save significantly on the overall tax bill. Consider a match with a financial advisor who can help you plan and implement a Roth conversion strategy.
It’s probably also a good idea to approximate a Roth conversion with some elasticity. That is, instead of converting a fixed amount every year, you should be willing to adjust the amount based on your current situation. For example, if your income one year is lower than a normal year, you may be able to convert a larger amount of IRA funds that year without moving into the next tax bracket.
Also keep in mind that because Roth conversions are treated like ordinary income, this strategy can impact many other aspects of your financial life. These include taxes on Social Security benefits, what you pay for Medicare Part B coverage, health insurance subsidies from the Affordable Care Act, and more. Also keep in mind that once you open a Roth account and convert money into it, you will have to wait five years before you can withdraw the money without penalty. This means that individuals nearing retirement who need the money right away may need to reconsider. Developing a comprehensive plan for Roth conversion requires comparing the likely outcomes of multiple scenarios to see which offers the most benefit.
For personalized assistance, contact a financial advisor who can help you navigate Roth conversions and more.
Converting IRA funds to a Roth account makes sense for some retirement planners because of the way it avoids RMDs and allows for tax-free withdrawals. And gradually converting a portion of the IRA each year can save on current and future taxes. However, conversion may not be right for everyone, so extensive consideration is appropriate.
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Coming up with an optimal Roth conversion strategy typically requires running multiple what-if scenarios that take into account a wide range of tax issues. A financial advisor can help you with this. Finding a financial advisor does not have to be difficult. 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.
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Use SmartAsset’s RMD calculator to project the future amount of your required withdrawals from your retirement account.
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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.
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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.
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