Retirement savers often choose to fund a traditional IRA or 401(k) for the immediate tax break on contributions up to an annual limit. The flip side is that those withdrawals are taxable down the line, as are the investment gains.
Plus, traditional IRAs and 401(k)s impose required minimum distributions, which can create a tax headache. Those mandatory withdrawals can push retirees into higher tax brackets and force some of them to pay more for Medicare. Medicare premium surcharges assessed on higher-income retirees, called “income-related monthly adjustment amounts,” can sometimes add hundreds of dollars a month to the cost of Part B.
For these reasons, savers with large traditional IRA or 401(k) balances are often advised to look at Roth conversions, which allow you to transfer funds from these accounts into a Roth IRA. You pay taxes on the converted amount up front, and in exchange, your savings get to grow tax-free from that point forward. Withdrawals are tax-free, and you won’t be forced to withdraw at specific intervals.
But Roth conversions aren’t for everyone. You shouldn’t do one until you actually crunch the numbers.
Consider your current and future tax bracket
Roth conversions can be a strategic tax-savings move, but it’s important to make sure the math works out in your favor.
“Investors who convert assets to a Roth need to consider their federal tax bracket at the time of conversion and understand how their tax bracket may change later in retirement to evaluate the benefit of a conversion,” said Ben Maxwell, a financial adviser at Edward Jones in Fredericksburg, Virginia.
Taxes on Roth conversions are due the year you transfer funds. If your income puts you in the 24 percent tax bracket now but you expect to be in the 22 percent tax bracket in retirement, you’re paying a higher rate of tax now on that money.
Of course, tax brackets could change over time. But if your primary retirement income streams are IRA withdrawals (or, eventually, distributions and Social Security benefits, for example, you may end up in a lower tax bracket once you stop working.
Where will the money come from?
Joel Russo, owner and retirement adviser at NJ Retirement Planning in Sea Girt, New Jersey, said a big reason to skip a Roth conversion is if all your savings are locked inside tax-deferred accounts, like traditional IRAs or 401(k)s, and you don’t have extra cash in a regular bank or brokerage account to pay the tax bill. In that situation, “your pretax account could be cannibalized and hurt your overall finances,” Russo said.
When you do a Roth conversion, the Internal Revenue Service demands its cut in the same calendar year. If you have to pull extra cash directly out of your IRA to pay those taxes, you take an added hit by shrinking your portfolio. That, in turn, means less money stays in your account to compound and grow for your future.
Plus, if you’re under age 59 1/2, money taken out of an IRA to pay the IRS counts as an early distribution, slapping you with an extra 10 percent penalty. Ideally, you want to pay the conversion taxes using “outside” cash so your retirement balance stays intact and keeps growing.
Near-term financial consequences
RMDs or taxable retirement account withdrawals are included in your adjusted gross income, which, if it climbs high enough, could lead to surcharges on Medicare premiums. A well-timed Roth conversion could help you avoid that, since you won’t have to take RMDs, and any withdrawals you opt to take will be tax-free and excluded from your adjusted gross income.
But a Roth conversion could also lead to higher Medicare premiums. If you’re enrolled in Medicare or expect to enroll soon, a Roth conversion this year could lead to surcharges two years down the line, since they are based on income from two years prior.
If you’re receiving Social Security, a Roth conversion could also lead to your benefits being taxed, Russo said. These taxes hinge on a provisional income formula that includes adjusted gross income, which a Roth conversion adds to.
Look at the big picture
Roth conversions make sense for many people. And they can have benefits beyond reducing taxes in retirement.
“From an estate-planning perspective, Roth conversions may reduce the income taxes beneficiaries ultimately pay on inherited retirement assets,” Maxwell said. If your goal is to leave a significant portion of your wealth behind, a Roth conversion may be worth considering.
The key, therefore, is to think about all of the financial implications before moving forward. And consider your time horizon. Roth conversions carry a five-year holding rule before earnings can be accessed tax-free. If you expect to use the money in the near future, that may be another reason to say no to it.
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