Roth Conversions: When and How to Use Them

Many of you know that I view Roth IRAs as simply the best type of retirement account. However, there are instances where it does not make sense to overfund a Roth IRA. In this post, I want to share the top three reasons I see for clients in retirement to limit the funding of a Roth IRA.

But first – what is a Roth IRA? It is a retirement account like a traditional IRA where dollars grow tax deferred. Unlike a traditional IRA, distributions from a Roth IRA are tax free after age 59.5 or five years post account opening and there are no required minimum distributions(“RMDs”) for the account holder.

Roth IRAs are traditionally funded with after tax dollars during working years. There are three ways to fund a Roth IRA. First, if you fall below certain income limits you can make a regular contribution. Second, you can fund an After-tax or a Roth 401(k) retirement account and roll it over into a ROTH IRA. And last, you can do what’s called a Roth Conversion where you pay the taxes on dollars you convert today and defer those funds in the Roth IRA.

For many, Roth Conversions are possible during retirement. Typically, we strongly encourage clients to aggressively convert funds into a Roth IRA during the years of early retirement until age 72. Post this age, we work with clients to calculate a preferred range of conversion based on income tax brackets and estate planning goals. Two benefits of Roth Conversions during retirement include reducing future RMDs and potentially avoiding a Medicare part B IRMA premium increase.

The table below highlights the price increase in Medicare part B based on income:

From an estate planning standpoint, Roth conversions can also be a strategy to reduce future taxes for a surviving spouse. Let’s look at an example: a married couple (same age) has no other income producing assets during retirement and live solely on the RMD. Most of the time from a tax perspective, the couple will find themselves taking the standard deduction. If that is the case if one spouse passes the RMD amount is still the same. Yet the surviving spouse will pay more income taxes! This is due to the fact the surviving spouse will now be filling as single individual. Tax brackets for single individuals are essentially half of a married couple. In addition, there is a loss of one standard deduction. Combined, these changes often result in an increase of 20-30% in taxes on the same income. And, to compound the tax increases, Medicare Part B premiums would also go up.

Given the example above, having a well-defined strategy around Roth Conversions is essential to good retirement planning. While there are clear benefits to conversion, it is also important to understand instances in which aggressive conversions are not beneficial. Below are three reasons I see with my clients around limiting conversions to a Roth IRA and the importance of creating a strategy around timing of conversion.

  1. A potentially lower tax bracket during later retirement. Say you live in New Jersey while working and want to move to Florida when you retire, where there is no state income tax. It may not be in your best interest to convert large dollar amounts into Roth IRAs during early retirement. Or, if you start a second career owning a business, many of the startup costs can be deducted against ordinary income and IRA RMDs.
  2. Charitable gift at death: If you have any charitable inclination Traditional IRAs are the best asset to give since the contributions were pre-tax. Nonprofit or 501© organizations are exempt from paying taxes on any assets. So, you would want to limit the amount you convert to Roth to maximize this benefit to the charity. Keep in mind that IRAs move outside any trust document unless the trust has see through provisions to handle IRAs. For our clients we focus on qualified charitable distributions from IRAs while living and equalize their estate between their family via their Trust assets. We can help identify the appropriate amount to convert and maintain legacy goals.
  3. Adult children are in a lower tax bracket than parents. It is often the case that if your beneficiaries are in a lower income bracket than you currently are, it may not be wise to pay taxes at your higher income tax bracket rates. For example, if an individual has $900,000 in an IRA at death and has 3 children to which he / she wants to gift equally, each child would inherit $300,000. Because of the Secure Act each beneficiary has 10 years to take distributions from that IRA. If the beneficiary is able to stretch distributions over all ten years then we are only talking about $30,000 more in income per year. Since the tax brackets are now also wider for most, the beneficiaries will have a higher probability of staying within the same income tax bracket.

As stated above, having a well-defined strategy around Roth Conversions is essential to good retirement planning. While there are clear benefits to conversion, it is also important to understand instances in which aggressive conversions are not beneficial. Working together we can formulate a plan that makes sense for you.

Related: Being Prepared: Planning for Diminished Capacity