Roth conversion is a strategy that involves converting all or part of your traditional IRA or 401(k) into a Roth IRA. By doing so, you pay regular income taxes on the converted amount in the year of the conversion, but you can enjoy tax-free withdrawals of contributions and earnings in retirement, as long as you meet certain rules. Roth conversion can be a powerful way to optimize your taxes for future retirement, especially if you expect to be in a higher tax bracket later or want to leave a tax-free legacy to your heirs. However, Roth conversion is not a one-size-fits-all solution, and it requires careful planning and analysis. In this article, we will explain the basics of Roth conversion, and some factors to consider before deciding whether and how much to convert.
What is Roth conversion and how does it work?
A Roth conversion is a taxable event that occurs when you move money from a traditional IRA or 401(k) to a Roth IRA. A traditional IRA or 401(k) is a tax-deferred account, which means you do not pay taxes on the contributions or the earnings until you withdraw them in retirement. A Roth IRA is a tax-exempt account, which means you pay taxes on the contributions, but not on the earnings or the withdrawals, as long as you follow the rules. The rules for Roth IRA withdrawals are:
- You must be at least 59 1/2 years old
- You must have held the Roth IRA for at least five years
- You must not exceed the annual contribution limit, which is $6,000 for 2023, or $7,000 if you are 50 or older
When you convert money from a traditional IRA or 401(k) to a Roth IRA, you have to pay income taxes on the converted amount in the year of the conversion, based on your marginal tax rate. For example, if you convert $10,000 from a traditional IRA to a Roth IRA in 2023, and you are in the 22% tax bracket, you will owe $2,200 in taxes on the conversion. However, once the money is in the Roth IRA, it will grow tax-free, and you will not have to pay any taxes on the withdrawals in retirement, or on the inheritance you leave to your beneficiaries.
Why should you consider Roth conversion?
Roth conversion can be a beneficial strategy for optimizing your taxes for future retirement, for several reasons:
- You can take advantage of lower tax rates now, and avoid higher tax rates later. If you expect your income or tax rates to increase in the future, due to factors such as inflation, tax law changes, or higher required minimum distributions (RMDs) from your traditional IRA or 401(k), converting some or all of your traditional IRA or 401(k) to a Roth IRA can help you lock in lower tax rates now, and save on taxes later. For example, if you are in the 12% tax bracket now, but expect to be in the 24% tax bracket in retirement, converting $10,000 from a traditional IRA to a Roth IRA will cost you $1,200 in taxes now, but save you $2,400 in taxes later.
- You can reduce or eliminate RMDs from your traditional IRA or 401(k). Unlike traditional IRA or 401(k), Roth IRA does not have RMDs, which are the minimum amounts you have to withdraw from your tax-deferred accounts every year after you turn 72. RMDs can increase your taxable income and push you into a higher tax bracket, or trigger additional taxes on your Social Security benefits or Medicare premiums. By converting some or all of your traditional IRA or 401(k) to a Roth IRA, you can reduce or eliminate your RMDs, and have more control over your income and taxes in retirement.
- You can leave a tax-free legacy to your heirs. If you want to pass on your retirement savings to your beneficiaries, a Roth IRA can be a more tax-efficient option than a traditional IRA or 401(k). Your heirs will not have to pay any income taxes on the inherited Roth IRA, as long as they follow the rules for withdrawals. However, they will have to pay income taxes on the inherited traditional IRA or 401(k), and they will also have to take RMDs from the inherited account, based on their own life expectancy. This can reduce the value and the longevity of the inheritance.
How much and when should you convert?
The amount and the timing of Roth conversion depend on your personal situation and goals, and there is no simple formula to determine the optimal strategy. However, here are some factors to consider before deciding whether and how much to convert:
- Your current and future income and tax rates. You should compare your marginal tax rate in the year of the conversion with your expected marginal tax rate in retirement, and see if converting makes sense for you. Generally, Roth conversion is more beneficial if you expect to be in a higher tax bracket later, or if you expect tax rates to increase in the future. However, you should also consider the impact of the conversion on your current income and taxes, and make sure you can afford to pay the tax bill without dipping into your retirement savings or incurring penalties.
- Your retirement date and withdrawal strategy. You should consider when you plan to retire and start withdrawing from your retirement accounts, and how much you will need to withdraw each year. Generally, Roth conversion is more beneficial if you have a longer time horizon to let the Roth IRA grow tax-free, and if you do not need to withdraw a lot from your retirement accounts in retirement. However, you should also consider the opportunity cost of paying taxes now instead of investing the money, and the potential tax diversification benefits of having both tax-deferred and tax-exempt accounts in retirement.
- Your estate planning goals and beneficiaries. You should consider whether you want to leave a legacy to your heirs, and who your beneficiaries are. Generally, Roth conversion is more beneficial if you want to leave a tax-free inheritance to your beneficiaries, and if your beneficiaries are in a higher tax bracket than you. However, you should also consider the impact of the conversion on your own retirement income and security, and the trade-off between paying taxes now and leaving more to your heirs later.
What are some tax-efficient strategies for Roth conversion?
If you decide to convert some or all of your traditional IRA or 401(k) to a Roth IRA, here are some tax-efficient strategies to consider:
- Max out your bracket. You can convert an amount that will fill up your current tax bracket, without pushing you into a higher one. For example, if you are single and make $50,000 a year, which puts you in the 12% tax bracket, you can convert up to $12,550 ($62,550 – $50,000) and still stay within the 12% bracket. This way, you can take advantage of the lower tax rates now, and avoid higher tax rates later.
- Spread it out. You can break up the conversion across multiple years, to make the tax hit easier to manage, and to reduce the overall tax you pay on the conversion. For example, if you want to convert $100,000 from a traditional IRA to a Roth IRA, you can convert $20,000 each year for five years, instead of converting the whole amount in one year. This way, you can avoid a large spike in your income and taxes in any single year, and you can also benefit from the compounding effect of the Roth IRA over time.
- Get ahead of tax changes. If you anticipate changes to the tax law that will adversely affect your future taxes, you can convert some or all of your traditional IRA or 401(k) to a Roth IRA in the year preceding the change, to avoid paying more tax on the conversion than necessary. For example, if you expect the tax rates to increase in the next year, you can convert more in the current year, to lock in the lower tax rates. However, you should also be aware of the potential risks of converting based on uncertain tax projections, and the possibility of tax law changes that could favor traditional IRA or 401(k) over Roth IRA in the future.
How to model Roth conversion strategies in the NewRetirement Planner?
The NewRetirement Planner is a system that puts the power of financial planning into your own hands. It has a very unique tool, the Roth Conversion Explorer, that is designed to help you identify the amount and timing of Roth conversions over future years. The Explorer is a powerful tool that runs a “greedy-type” algorithm to determine Roth conversion strategies that meet the goals and parameters that you define in the tool and in your overall financial plan. You can use the Explorer to model different scenarios and compare the outcomes of different Roth conversion strategies, such as:
- Maximize your estate at longevity
- Maximize your estate while staying within a certain tax bracket
- Minimize lifetime tax liability
- Convert up to an IRMAA bracket (Income Related Medicare Adjustment Amount, an extra Medicare fee that is charged to high earners)
To use the Explorer, you need to make sure that the data in your plan is accurate and up to date, and that you have set up your assumptions and preferences for inflation, rates of return, longevity, tax rates, and withdrawals strategy. Then, you can access the Explorer from the Dashboard, under the Roth Conversion section. You can select your conversion goal, and the Explorer will run the algorithm and show you the suggested conversion amounts and years, as well as the impact on your net worth, income, taxes, and spending over time. You can also see the graphs and charts that illustrate the effects of Roth conversion on your plan.
The Explorer is a flexible and interactive tool that allows you to adjust the parameters and see the results in real time. You can change the conversion goal, the start and end year of the conversion, the maximum tax bracket or IRMAA bracket, and the conversion amount limit. You can also exclude certain accounts from the conversion, or manually enter your own conversion amounts for each year. You can also compare the suggested conversion strategy with the baseline scenario of no conversion, or with another conversion scenario that you have saved.
The Explorer is not a definitive answer, but a guide to help you explore different possibilities and outcomes. You should always consult with a qualified tax professional before making any Roth conversion decisions, as there are many factors and implications that the Explorer cannot account for. The Explorer is based on the data and assumptions in your plan, which may change over time. You should also review your plan regularly and update it as needed, to reflect your current and future situation and goals.
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