The IRS will take their share from your hard-earned, tax-free retirement accounts – it’s only a matter of time.
A harsh reality? Maybe. An opportunity to think strategically about your retirement planning? Definitely.
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Because, according to retirement savings experts, there may be ideal — and less ideal — times for people to get the taxes on their IRAs, 401(k)s, 403(b)s and other tax-advantaged accounts over with, if they haven’t already done so.
Finding the right time is an art and a science, they say, and it involves cold, hard numbers and regulations. But it also involves harder-to-determine questions about a person’s future needs and taxes.
Converting retirement money to a tax-free option may not be right for everyone, says Devin Carroll, owner of the Carroll Advisory Group in Texarkana, Texas.
However, people should know what the process involves when it comes to converting a traditional IRA and other tax-advantaged accounts to a Roth IRA, he noted.
“There is no best time to do this,” said Thomas Jarecki, national director of wealth planning at KeyBank’s KEY Key Wealth Management.
But if someone wants to take the step, “there is an opportunity to be very tactical when you want to pull the trigger,” he added.
How to convert a traditional IRA to a Roth IRA
It focuses on the process of moving or “converting” money from a traditional tax-free account such as an IRA to a Roth IRA.
An IRA is funded with tax-free dollars, and the account holder pays no taxes on it until he or she withdraws money from the account. When people withdraw money from the account after age 59½, it counts as taxable income. (Of course, they can withdraw it before that age, too—but doing so will result in a 10% penalty, with some exceptions.)
IRAs require a minimum distribution, which is an amount that account holders must withdraw annually starting at age 73.
Read also: I messed up my first RMD by taking a withdrawal on three accounts. Shouldn’t only the final amount count?
A Roth IRA, on the other hand, is funded with taxed dollars. The money is withdrawn from the account without income tax because it has already been taxed.
Inflation-adjusted income limits apply to Roth contributions. Once individuals have more than $161,000 in modified adjusted gross income, they can no longer contribute to a Roth IRA. For married couples filing jointly, the limit is $240,000. Backdoor Roth conversions allow high-income households to bypass the income limits on Roth IRAs and still invest money in the accounts.
“You’re effectively paying retirement taxes up front with the Roth account,” says Katherine Tierney, a senior retirement strategist at Edward Jones.
Before age 59½, contributions can be withdrawn from the account tax-free and penalty-free. However, earnings that are withdrawn may be subject to taxes and penalties, depending on the purpose of the withdrawal and how long the account has been open.
With Roth IRAs, there are no RMDs during the owner’s lifetime because the IRS has already withheld the amount due.
Similar rules apply to 401(k) plans and other tax-deferred workplace retirement plans for those who do not roll over those accounts to IRAs at retirement.
Why convert a traditional IRA to a Roth IRA?
A good reason to do a Roth conversion is if someone expects to be in a higher tax bracket in the future and wants to lower their future tax burden, Tierney said. That could be a person who is early in their career and will make more money in the future, she noted.
It could also be someone who is close to retirement and has an income after work in mind, such as Social Security, Carroll said.
“It also makes sense for people who want to leave a tax-free inheritance to their heirs,” Tierney said. Withdrawing inherited IRAs has its own rules, but most non-spouse beneficiaries have 10 years to fully withdraw the money.
But it can be difficult to plan that far ahead, whether for retirement savings or anything else, Jarecki said. The benefits of a tax-free retirement account may sound great, but putting it into action is much harder.
“As humans, we are much more focused on the present,” he said. “The financial impact today often outweighs the potential financial benefits we could reap in the future.”
When is the best time for a Roth conversion?
Carroll said he discusses “runway periods” with his clients. These are times when they still have a path financially to pull off the maneuver, albeit not an endless one. That often starts with the loss of income from work at the start of retirement, he said. Less income means a smaller income tax bill and more wiggle room to convert funds without breaking the tax brackets.
The IRS counts the converted amount as part of a household’s modified adjusted gross income.
The runways would get shorter once Social Security, Medicare, retirement income and RMDs come in, he added. Social Security benefits – which people can start claiming as early as age 62 – could be taxable depending on how much other income a person earns. Retirement payments are also taxable.
When planning, people should also be aware that IRA conversions affect the cost of Medicare premiums, Carroll noted. And there is a two-year lookback period — so that window starts at 63, not 65, when you enroll in Medicare.
For Carroll, both consequences are costs of change “and should not be an obstacle to implementation.”
According to Jarecki, uncertainty about the future of tax law should not play too large a role in a person’s consideration of an IRA conversion.
If lawmakers cannot reach an agreement, core elements of the tax law will revert to their 2017 status when the Trump tax cuts expire at the end of 2025. That includes five of the seven tax brackets returning to higher rates.
Many questions are at stake, including who will enter the White House and which party will control Congress. Carroll and Jarecki both said they could expect higher taxes in the future, but further details are difficult to predict.
Therefore, it is good to follow the developments on Capitol Hill, said Jarecki – but one should not fixate on them.
“You should not make the decision to convert based solely on what might or might not happen in two or 20 years’ time in terms of legislative action,” he said. “That cannot possibly influence your decision on its own.”
Roth conversions are not all or nothing
Jarecki agreed that shortly after retirement could be a good time for IRA conversions — with some planning. One important aspect is saving enough money in advance to pay regular living expenses plus taxes on the conversion, he noted.
“You actually need the money to pay those taxes,” Jarecki said. It’s possible to use some of the converted funds to pay the taxes, but he and others advise against it.
If a person chooses to convert funds, the entire IRA amount does not have to be converted at once, Jarecki added. “This is not an all-or-nothing proposition.”
Tierney agreed: “You can do partial conversions — that’s a strategy we use every year.” If someone converts their funds bit by bit, Tierney says, they can see what other income is coming in during the year and convert just enough to stay in the next tax bracket.
That’s why the end of the year is a good time to think about a Roth conversion, she said. By then, you’ll have a good idea of the rest of your tax situation and a grasp of how your portfolio will perform over the course of the year. A poorly performing stock market has its problems, but it also offers a silver lining for someone doing a Roth conversion: cheaper stock valuations lead to smaller portfolios and a lower tax burden.
For someone already considering a Roth conversion, “down markets can be an attractive time,” Tierney said, because there may be an opportunity to “convert the same number of shares for a lower tax bill.”
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