Maximize Tax-Free Retirement Savings with a Roth Conversion

What is a Roth Conversion?

A Roth conversion is a transfer of retirement funds from an account with tax-deferred growth (traditional IRA) to an account with tax-free growth (Roth IRA). The taxpayer has to pay income tax on the money that is transferred now, but can make tax-free withdrawals from the Roth account in the future. However, the converted funds can grow tax-free and withdrawals in retirement are completely tax-free, which can be a significant long-term advantage.

In other words, a Roth conversion is a way to pay less taxes now rather than more later, potentially saving you thousands in taxes over time.

A tax-deferred retirement account is an account where the taxpayer can invest money now without paying taxes on the income until the money is distributed to the taxpayer. A Roth IRA, by contrast, grows tax-free and withdrawals in retirement are not taxed, giving you more financial flexibility later in life.

In what situations can you utilize a Roth Conversion?

You can use a Roth conversion in several situations, including:

#1 You have funds in one of the following accounts:

• Traditional IRA

• SEP IRA

• SIMPLE IRA

• 401(k) or 403(b)

#2 You believe the benefits of transferring current assets to a Roth IRA outweigh the tax liability associated with the Roth conversion. Benefits of holding assets in a Roth IRA include:

• Tax-free income during retirement
• Tax-free and penalty-free withdrawals before retirement (subject to limitations, addressed later)
• More tax efficient for beneficiaries to inherit
• Roth IRAs are currently not subject to required minimum distributions (RMDs) after the age of 72. Taxable RMDs can create unwanted consequences like higher taxable social security income and Medicare premiums. Note: proposed legislation would impose tax-free RMDs from Roth IRA’s valued over $10M.
• You have the financial ability to pay tax on the amount you would like to convert

Note: Proposed legislation may impose RMDs on Roth IRAs valued over $10 million.

#3 You can afford to pay taxes on the amount you want to convert.

When can a Roth Conversion benefit you?

A Roth conversion may be especially beneficial if:

• If your income is too high to make a Roth IRA contribution, you can enjoy the tax-free growth benefits of a Roth IRA through a Roth conversion
  
  • When is your income too high to make a Roth IRA contribution?
    
    • In 2022, single taxpayers with modified adjusted gross income (MAGI) of over $144k and for married filing joint taxpayers $214k
• There is no limit to converting existing (already contributed) funds to a Roth IRA. Contributions of new funds to a Roth IRA are limited to $6,000 per year ($7,000 if you’re over 50).
• If your current tax-deferred retirement plan holds assets that have decreased in value but you expect a substantial increase over time, you can pay tax on the lower value and enjoy tax-free growth
• Eliminate the risk of being subject to a higher tax rate during retirement by paying tax at your current rate
• You can decide how much extra income you want to recognize now by doing a partial conversion. A partial conversion is a great option if you only want to pick up a certain amount of income so that you don’t get pushed to a higher tax-bracket.
• Converted funds can be withdrawn tax free after a 5 year holding period is met

Keep an eye 👀 (or two) out for the following (Cons)

• No undo option: Once you convert a tax-deferred account into a Roth account, you can not move your money back to a tax-deferred account.
• Taxes due immediately: When you utilize the Roth Conversion, you will pay tax at your current rate on any amounts converted. You need to have enough savings to pay the tax immediately.
• Early withdrawal penalties: Any funds withdrawn before the five-year holding period is met will be subject to income tax plus a 10% early distribution penalty, even if you are over the age requirement (59.5) for penalty-free distributions. (exceptions apply)
• Higher current tax bracket: Recognizing more income now might push you to the next income tax bracket, as well as subject you to net investment income tax.
• High-income considerations: If you plan to leave most of the value of your retirement accounts for your beneficiaries, and they are in a lower tax bracket, you should keep in mind that the conversion might not be as effective.
  
  • If proposed legislation passes, Roth IRA conversions could be prohibited for high-income individuals and RMDs would be imposed on Roth accounts that have greater than 10 million dollars in value.

A Roth Conversion In Action

Example:

• You are a single individual and your taxable income before a Roth conversion is $180,000 (subject to a tax rate of 32% per the IRS 2022 tax rate schedule). Your traditional IRA account holds $100,000 worth of assets in January 2021. In May, 2022, the assets have decreased in value to $65,000. You expect that the value will go back up so you convert the $65,000 worth of assets from your traditional IRA account into a Roth IRA account. Since you are converting the money, you must pay tax on the $65,000 now at an approximate tax rate of 35%, or $22,750, since the $65,000 pushed you to the next income tax bracket from 32% to 35%.

Twenty years later:, 

• You are 60 years old and want to take out distributions from your Roth IRA account. The value in the account is now $1 million dollars and you want to take it all out. The distributions are not included in taxable income and are tax-free so you do not pay any tax at this time.

• In this example, the $925,000 ($1 million value at age 60 less the $65,000 value at Roth conversion) of growth will be tax-free, so you saved $301,000
  
  • $301,000 = $323,750 (which is 35% of $925,000 growth) - $22,750 (taxes paid on Roth conversion)
• If you had not done the Roth Conversion, you would have foregone the $22,750 taxes paid now, but the distribution would be included in taxable income and you would have to pay taxes on the $1 million dollars when distributed at age 60. (which would be around $323,750, using the 2022 highest tax brackets.)

This example demonstrates how a Roth conversion can maximize long-term tax savings, even if it requires paying taxes upfront.

Key Terms

• Withdrawal = when you take money out of your retirement account before 59 1/2 (also known as an early distribution)
• Distributions = when you take money out of your Roth IRA after 59 1/2 (considered retirement income)
• RMD (Required minimum distributions) = The minimum amount you must withdraw annually from tax-deferred accounts starting at age 72.

This information is for educational purposes only and does not constitute financial advice. Consult a qualified professional before making any investment decisions.

Roth Conversion Strategies

Convert During Lower-Income Years

One of the most effective strategies for a Roth conversion is to convert when your income is temporarily lower. This could happen if you change jobs, take a sabbatical, experience a temporary reduction in income, or enter early retirement before Social Security or pension payments begin. Paying taxes on a Roth conversion during these years may cost significantly less than converting in a high-income year.

For example, if your usual income is $180,000 but you have a year where you earn only $100,000, converting $50,000 of your traditional IRA to a Roth IRA could result in a lower tax bill and maximize long-term tax-free growth.

Spread Conversions Over Multiple Years

Partial Roth conversions allow you to strategically manage your tax bracket each year. Instead of converting your entire account at once and potentially moving into a higher income tax bracket, you can split the conversion across several years.

Example: Convert $20,000 this year and $20,000 next year, rather than converting $40,000 all at once. This can help prevent higher taxes, reduce the net investment income tax impact, and give you more flexibility to adjust future conversions based on changing tax laws or account performance.

Time Conversions Around Market Dips

Market fluctuations can create opportunities for Roth conversions. If your retirement account’s value temporarily drops due to market volatility, converting at a lower account value means paying taxes on a smaller amount, while future growth in the Roth IRA will be completely tax-free.

Example: A $100,000 IRA drops to $70,000 during a market downturn. Converting now allows you to pay taxes on $70,000 rather than $100,000, potentially saving thousands in taxes while capturing full upside when the market recovers.

Consider Heir Tax Implications

Roth conversions can also play a key role in estate planning. Assets converted to a Roth IRA grow tax-free and can be inherited by beneficiaries without immediate income tax liability. This is especially beneficial if your heirs are likely to be in a higher tax bracket or if you want to minimize their future tax burden.

However, careful planning is required. High-value accounts may trigger estate taxes, and proposed legislation could affect Roth conversion rules or RMDs on Roth accounts over $10 million. Coordinating with a financial advisor ensures that Roth conversions fit your overall estate strategy.

Tax Implications of a Roth Conversion

Taxes owed on a Roth conversion are determined by multiple factors:

• Your current income tax bracket: The higher your bracket, the more tax you owe. Partial conversions can help manage this.
• Total amount converted: Larger conversions can push you into a higher bracket.
• Timing of conversion: Converting during low-income years or when market values are temporarily low can reduce taxes.
• Other sources of taxable income: Income from wages, Social Security, or other retirement accounts can affect your overall tax liability.

Remember: Roth conversions are subject to ordinary income tax rates. Planning ahead, using tax projections, and consulting a tax professional can help you avoid surprises and maximize the long-term benefits of your Roth conversion.

Roth Conversion and Retirement Planning

A Roth conversion is more than a tax strategy—it is a powerful retirement planning tool. Converting part or all of your traditional IRA or 401(k) can provide:

• Control over future taxable income: By diversifying between taxable, tax-deferred, and tax-free accounts, you can manage withdrawals to minimize taxes in retirement.
• Reduced risk of higher taxes on Social Security benefits: Since Roth withdrawals are tax-free, they do not increase your taxable Social Security income or Medicare premiums.
• Tax-free inheritance for beneficiaries: Converting to a Roth IRA ensures your heirs can access assets without paying income tax, which is particularly valuable if they are in higher tax brackets.
• Balanced retirement income: A mix of account types allows you to adjust withdrawals strategically based on your tax situation and spending needs each year.

Ultimately, a Roth conversion gives you more flexibility and control over your financial future, helping you achieve a more predictable and tax-efficient retirement.

Common Roth Conversion Mistakes to Avoid

• Ignoring current tax liability: Ensure you have enough cash outside your retirement account to pay taxes; using retirement funds for taxes can reduce the long-term benefit of a Roth conversion.
• Converting too much at once: Large conversions can push you into a higher tax bracket and trigger additional taxes such as the net investment income tax. Partial conversions spread across years can mitigate this risk.
• Overlooking the five-year rule: Converted funds must remain in the Roth IRA for at least five years before you can withdraw them tax-free (exceptions apply). Ignoring this can lead to penalties and taxes.
• Not factoring in future legislation: Proposed changes may limit Roth conversions for high-income individuals or impose RMDs on Roth accounts exceeding $10 million. Failing to plan for legislative changes could reduce the benefits of a conversion.

By understanding these strategies and pitfalls, you can make informed decisions about your Roth conversion and maximize your long-term retirement savings.

Final Thoughts on Roth Conversion

A Roth conversion can be a powerful tool for maximizing tax-free retirement income, but it requires careful planning. By strategically choosing when and how much to convert, you can reduce future tax exposure and leave a lasting legacy for your heirs.

Always consult with a financial advisor or tax professional to ensure a Roth conversion aligns with your overall retirement strategy. Talk to a CPA today.

ℹ️ If you have any questions about Roth Conversions, reach out to your tax team at tax@joingelt.com

This information is for educational purposes only and does not constitute financial advice. Consult a qualified professional before making any investment decisions.

References

Publication 590-A

Publication 590-B

Rollovers of Retirement Plan and IRA Distributions

2022 tax rate schedule

Required Minimum Distributions

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