Late-in-life Roth conversions can take some tricky math.
As you approach retirement, one of the most important questions will be how to manage the taxes on your retirement income. For households that rely on pre-tax portfolios, like a 401(k) or a traditional IRA, this means anticipating ordinary income taxes on all of your withdrawals. It also means anticipating the necessary withdrawals associated with the IRS’ Required Minimum Distributions (RMD) rule.
As a result, it’s common for people in their 60s to at least consider converting their money to a Roth IRA. This can have significant upsides. It will eliminate your taxes in retirement, along with your RMD requirements, and will even improve the after-tax value of your estate.
The problem is that, as you close in on retirement, a Roth conversion can get very expensive. You will pay quite a lot of up-front conversion taxes in exchange for those long-term income tax savings.
To look at this, let’s say that you’re 62 with $900,000 in your 401(k). In this case, will you save money by converting your portfolio to a Roth IRA $90,000 per year? Here are some things to think about. You should also consider speaking with a financial advisor for personalized guidance.
RMD and Pre-Tax Portfolio Taxes
Every pre-tax retirement portfolio, including 401(k)s and traditional IRAs, have two major issues that households should keep an eye on.
First, these portfolios are taxed as ordinary income when you take withdrawals in retirement. This means that you pay taxes at income tax rates, instead of the special lower rate ordinarily reserved for investments and capital gains. These taxes apply to your entire withdrawal, not just the portfolio’s gains, as your original contributions were tax deferred.
Second, all pre-tax portfolios have what are called Required Minimum Distributions (“RMDs”). This is a minimum amount that you must withdraw from each pre-tax retirement account that you hold. Currently, required minimum distributions begin at age 73, meaning that you must begin taking these minimum withdrawals in the year that you turn 73. The exact amount you must withdraw is based on a combination of your portfolio’s value and your age.
Required minimum distributions are a form of tax planning by the government. This is an IRS rule intended to make sure you begin triggering tax events on your pre-tax portfolios so it can collect planned revenues, and the penalty for not taking your full RMD is assessed on your taxes.
Roth Conversions and Retirement Taxes
The easiest way to avoid both taxes and RMDs is through a Roth IRA.
Post-tax portfolios do not have required minimum distributions. This is because you do not pay any taxes on the money you withdraw from these accounts.
To take advantage of this, many households consider what is called a Roth conversion. This is when you transfer money from a qualifying pre-tax portfolio, such as a 401(k) or an IRA, to a post-tax Roth IRA. You can convert any amount of money you want, so long as it comes from a valid pre-tax account. Once the money has been moved to a Roth IRA, it will grow tax-free and you will have neither income tax nor RMD requirements in the future.
The catch to a Roth conversion is that you do have to pay up-front conversion taxes. When you convert money to a Roth portfolio, you include the entire amount converted as taxable income for the year in question. This increases your taxes for the year proportionally.
For example, let’s say you’re an individual making $75,000 per year. Ordinarily, you would owe around $8,761 in annual income taxes. However, say that this year you convert your $900,000 401(k) to a Roth IRA. This would bring your taxable income to $975,000 for the year, and you would owe total income taxes of $315,958.
If you are older than 59 1/2 you can withdraw money from your portfolio to pay these taxes. Here, for example, your Roth conversion could raise your taxes by an estimated $307,197 for the year. If you take that from your portfolio, you would have $592,803 left in your Roth IRA after taxes. If you are not older than 59 1/2, or if you’d like to leave your money in place, you will need to have another source of funds to pay these taxes.
A fiduciary financial advisor can help you navigate Roth conversion rules and calculations based on your own circumstances and assumptions. Use this free tool to get matched.
Staggered Roth Conversions
As we illustrate above, conversion taxes can be a huge drawback to a Roth conversion.
Specifically, the closer you are to retirement, often the more likely it is that the costs of conversion taxes will outweigh your future tax savings. You are likely to be in a higher tax bracket late in your career, you will transfer more money if you are nearing retirement, and your Roth IRA will have less time for tax-free growth.
One way to help manage that is through what’s called a staggered conversion. This is when you convert smaller amounts of money in stages, rather than a large amount of money all at once.
The key advantage to a staggered conversion is that it can help keep your tax brackets low. The more money you convert, the higher your taxable income and the higher your resulting tax brackets. This means you will pay higher taxes per dollar converted than you would by converting less at a time. By converting your money in smaller, staggered amounts, you can keep your tax brackets lower.
Take our example here. If you convert all $900,000 at once you will push your taxable income to the 37% bracket, with an effective tax rate of 32.02% overall (setting aside your ordinary income for the year). On the other hand, if you convert just $90,000, that would only fall into the 22% tax bracket and a 13.40% effective rate.
Again, setting aside your income, each $90,000 conversion would trigger $12,061 of income taxes. This would come to $120,610 over 10 years, less than half the $307,197 in conversion taxes you would pay by making this move all at once.
Should You Make a Roth Conversion?
So, should you convert your money? It depends on your goals. If you are approaching retirement, you might spend more money on conversion taxes than you will save on income taxes and RMD requirements. If you are looking to maximize the value of your estate, however, you will usually preserve the most wealth for your heirs by allowing them to inherit a tax-free Roth IRA.
To understand that, let’s look at your $900,000 401(k). For ease of use, we will assume away both inflation and portfolio growth, although in real life neither are trivial concerns.
Let’s assume that your income is the rough median of $75,000 per year. If you convert $90,000 per year, this would push your annual taxable income to $165,000. Your tax bracket would tick slightly up from 22% to 24%, and you would pay conversion taxes of approximately $20,915 per year ($29,676 total taxes – $8,761 of income taxes at $75,000 of income).
Over 10 years, this would come to a total of $209,150 in conversion taxes, leaving you with $690,850 in a Roth IRA at age 72.
Let’s further assume that you use a standard 4% withdrawal strategy, meaning you take 4% from this portfolio each year for 25 years. With our post-conversion Roth IRA this would give you approximately $27,634 of after-tax income each year ($690,850 * 0.04). With your traditional IRA, you would have an estimated $33,652 of after-tax income each year ($900,000 * 0.04 = $36,000 – $2,438 of taxes).
So in this case you might have more income by leaving your money in place, and that’s before we even account for lost growth and opportunity cost due to the conversion taxes. However, these examples are simplified and don’t account for some dynamics like portfolio growth, inflation and your own income level and retirement needs. For tailored help, consider speaking with a vetted fiduciary advisor.
There are many ways to look at it, but in most cases the result is the same. By the time you reach your 60s, your retirement accounts have grown large enough to trigger very significant conversion taxes. At the same time, a new Roth portfolio will have little (if any) time to enjoy untaxed growth that would offset those taxes. The upshot is that it’s rare to save money on taxes by making a late-career conversion, but it can be a great boon for the right individuals.
The Bottom Line
A Roth IRA can certainly help you manage your taxes and RMD withdrawals in retirement, by eliminating them altogether. However, as you approach retirement, make sure that your long-term savings will actually exceed your up-front conversion taxes, otherwise you might pay a hefty premium for that ease of mind.
More Tips
- Roth IRAs are a fantastic financial vehicle, but they’re particularly useful if you time them well. Perhaps more than any other retirement account, these will be most valuable to you early in life, when you can maximize the tax advantages.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.