- A Roth conversion converts funds from a Traditional retirement plan into a Roth IRA.
- You can potentially lower your tax bill with Roth conversions by doing Roth conversions at a lower tax rate now than you would be paying in during retirement.
- When using this strategy, there are many critical aspects to understand, so be sure to research and consider consulting a trusted financial professional.
While paying your taxes on time and in full is essential, nobody should be paying more than they have to. In other words, pay your fair share, but you don’t need to overpay the IRS.
And fortunately, if you’re willing to design and execute a tax minimization plan, you can save serious money in taxes in the short and long run. And one way to do that is by using a Roth conversion strategy, which we will explain in detail in this article.
First, What Is A Roth Conversion?
A Roth conversion is when you convert funds from a Traditional retirement plan (like a 401(k) or IRA) into a Roth IRA.
This process allows investors to benefit from tax-free retirement income and potential long-term savings opportunities. During the conversion process, taxes are paid on the total amount converted; however, there can be significant advantages down the line depending on your current and future tax rates.
Here Are Some Key Things To Know About Roth Conversions:
- A Roth conversion is taxable—you will pay taxes on the total amount converted.
- Taxes are due in the year of the conversion.
- You can convert as much or as little of your traditional IRA or 401k as you want—there are no limits.
- There are no eligibility requirements or income restrictions for Roth conversions—anyone can use this strategy.
How Can You Lower Your Tax Bill With Roth Conversions?
You can lower your tax bill with Roth conversions by doing Roth conversions at a lower tax bracket now than you will be in during retirement. This can seem counterintuitive at first because a Roth conversion creates taxable income in the current year, but the key is to compare your tax rates now versus your tax rates in the future.
To better understand this strategy, consider how Traditional (pre-tax), and Roth (after-tax) accounts work.
With Traditional accounts, you contribute money before you pay taxes, then you pay taxes on the full withdrawal during retirement. Roth funds are the opposite—you contribute money you’ve already paid taxes on, then your withdrawals are tax-free during retirement.
So, if you can convert your funds from Traditional to Roth at a lower tax bracket today than you would be paying on those same funds during the future, you have effectively saved the difference in tax rates.
Let’s look at an example.
Imagine you have $1,000,000 in a Traditional IRA and anticipate being in the 32% tax bracket during retirement because of your Social Security income, required minimum distributions (RMDs), and income from a rental property. But imagine that you have started to downshift your work as you approach retirement and are currently in the 12% tax bracket. If you decide to Roth convert part of your funds, you effectively save 20% in taxes on any amount you can convert while staying in the 12% bracket. And even if you convert enough to push you into the 22% or 24% bracket, you’re still saving 10% or 8%, respectively.
On a $50,000 Roth conversion, you’d save $10,000 at the 12% bracket, $5,000 at the 22% bracket, or $4,000 at the 24% bracket.
And if you multiply that out over a number of years, you could save significant money in taxes using this strategy.
But before you go all in, there are some essential things to consider when using a Roth conversion strategy. Here’s what you need to know:
What Are Some Things To Look Out For When Using A Roth Conversion Strategy?
1. The Roth Conversion 5-Year Rule.
The Roth conversion 5-year rule requires you to wait 5 years before withdrawing any of the principal of the funds you’ve Roth converted, regardless of your age, or you will face a 10% penalty. (The full amount of your Roth conversion is considered ‘principal.’)
Once you’ve met the 5-year waiting period for a Roth conversion, you can withdraw the principal (not any subsequent earnings) of the conversion, penalty and tax-free. (Note: earnings cannot be withdrawn penalty and tax-free until age 59.5 or if a penalty or exception applies.)
Unfortunately, there is no way around this rule, and each conversion has its own 5-year waiting period that begins on January 1st of the year of the conversion. For example, if you do a Roth conversion in December of 2023, you must wait until January 1st of 2028 to withdraw the conversion amount penalty and tax-free.
So, if you need the funds before 5 years, this may not be a viable strategy for you.
2. Roth Conversions Are Final.
Before the Tax Cuts and Jobs Act passed in 2017, you could undo or “recharacterize” your Roth conversion if you decided later you wanted to unwind your decision. But that’s no longer an option, and Roth conversions are now irrevocable. So, be sure your mind is set before you convert any funds from Traditional to Roth. In addition, this is one reason why it may be wise to wait until the end of the year to do Roth conversions because then you can avoid any unexpected tax surprises or income that could change your tax situation for the year.
3. You Don’t Have To Sell Your Shares To Do A Roth Conversion.
It’s a common misconception that you must sell your shares in your Traditional account to convert them to Roth funds. Fortunately, that’s not the case, and you can simply convert the shares of stocks, bonds, mutual funds, or ETFs directly from your Traditional to your Roth account. This eliminates the risk that the market goes up while your money is tied up in the conversion process.
4. Increased Income Can Affect Other Areas.
Next, as you consider using a Roth conversion strategy, it’s essential to understand how it can impact your overall tax and financial situation.
For example, if you are eligible for Medicare, your rates for Part B and Part D can increase based on your income. So, if you use a Roth conversion strategy that drives your income above the next threshold, you could pay more for Medicare coverage.
In addition, if you’re receiving Social Security benefits, more of your benefit could become taxable depending on your income. For example, if a married couple filing a joint return has a combined income of less than $32,000 for the year, none of their Social Security benefits are taxable. But, if they use a Roth conversion strategy and their income is between $32,000 and $44,000, 50% of their Social Security benefits would be taxable. If their income exceeds $44,000, 85% of their benefits would be taxable.
So, when considering a Roth conversion strategy, look at all the various aspects of your financial situation and understand the impacts it can have.
Consider Taking Advantage Of Today’s Low Rates While You Can.
Lastly, as you think about whether or not this strategy is right for you, consider the current tax rates as well.
Currently, under the Tax Cuts and Jobs Act, the tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. But, the current tax rates are set to expire at the end of 2025 and will increase to 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
So, using a Roth conversion strategy may be worthwhile to take advantage of these lower rates while they’re here. Remember, if you can get money from Traditional to Roth accounts now at lower rates than you would take that money out in the future, you’ve just saved yourself in taxes.
Consider The Help Of A Professional.
While there’s no doubt you can strategize and execute a Roth conversion strategy on your own, it can help to have a second set of eyes.
It may be worthwhile to consider the help of a trusted professional or financial advisor. With an expert’s evaluation and guidance, you can ensure your Roth conversion strategy will effectively lower your tax bill during your lifetime.
