Roth IRA conversions can be one of the most valuable tax planning strategies in retirement. While we’ve touched on Roth IRA conversions during previous episodes of the podcast, in this episode we do a deeper dive. We explain what a Roth IRA conversion is, why you would want to consider making one in the first place, what to be aware of from a tax perspective and factors to consider before making one, the key windows where Roth IRA conversions are the most impactful (and what to be aware of during each window), and wrap up by sharing some perspective on how to view Roth IRA conversions within the context of your overall financial plan.
Outline of this episode
- What is a Roth IRA conversion and why you might want to make one [1:35]
- Why would I want to pay taxes today if I can push them to the future? [3:01]
- Determining if a Roth conversion is right for you [6:29]
- Variables to factor into the Roth conversion decision [8:57]
- Key windows that impact Roth conversions [12:49]
- The recap [18:53]
What are Roth IRA conversions and why might you want to make them?
Roth IRA conversions consist of converting money from a traditional IRA to a Roth IRA. Converting is just moving money from one account to another. It's important to understand the basic definition of the two accounts we're discussing here. A traditional IRA is an account with money that has not yet been taxed. The money in this account continues to grow tax-free over time, and in the future when you withdraw from the account, you pay taxes on each dollar you take out. A Roth IRA, on the other hand is an account with money that you've already paid taxes on. The money in this account grows tax-free and you'll never have to pay taxes on the money or its growth at any point in the future, even when you eventually withdraw from the account.
There are three main reasons why you would even want to consider making Roth IRA conversions in the first place. 1) to minimize your overall lifetime tax bill, 2) to lower the amount of required minimum distributions at age 72, and 3) legacy planning.
Does a Roth IRA conversion make sense for you?
There are plenty of situations where Roth conversions won't make sense for you based on your tax situation. Calculating how a Roth IRA conversion applies to your situation means you need to know what variables to factor into the equation. Variables you need to be aware of are your expected income from sources like Social Security, part-time work, real estate income, etc. as well as taxable income from your investments (including distributions from your pre-tax IRAs), taxable interest and dividends, or realized taxable gains in your brokerage account.
At the most basic level, you want to compare your current tax bracket to what you expect your tax bracket to be in the future. For example, you probably don’t want to convert now if your tax rate is 37% when you expect to fall into the 12% bracket in the future. On the flipside, you may not want to miss the chance to convert now if you're in the 12% bracket currently and you expect to be in the 22% bracket when you have to start taking required minimum distributions.
Age matters! Key windows that impact Roth conversions.
After comparing your current tax situation to your projected future tax situation, you will want to understand the key windows for Roth conversions. These windows are from retirement until age 65 when Medicare starts and thus need to plan around potential premium surcharges. Next is from age 65 until you start collecting Social Security. Then, from the time you start collecting Social Security until age 72, when you're required to start withdrawing from your pre-tax retirement accounts (required minimum distributions). Those three phases are in general the most impactful windows for making Roth IRA conversions. After 72, the main reason for additional Roth IRA conversions comes down to legacy planning.
Roth IRA conversions don't always make sense for every situation. Make sure you factor in everything we discussed in this episode and consult with a qualified tax or financial professional before implementing a Roth IRA conversion strategy.
Resources & People Mentioned
- Podcast episode #15: How to Minimize Your Tax Bill in Retirement
- Podcast episode #35: Explaining Social Security and How to Maximize Your Benefit
- Download our guide: Retirement Timeline – Key Dates & Opportunities
- Download our guide: Retirement Checklist – A Guide to Planning for Retirement
- Download our guide: How to Create a Paycheck in Retirement