I often tell the individuals I work with that the only way to reduce their tax bill in retirement is to spend less money if they have no tax-free savings or income to look forward to. This is often enough to begin an engaged discussion about the potential benefits of Roth contributions and conversions. If you are early on in your income earning potential and/or career, Roth contributions and conversions can make a lot of sense. If you are in the latter phases of your career, with a high income and in a high marginal tax bracket, Roth contributions and conversions might not seem as beneficial and once we reach retirement, many of us abandon the concept of a Roth altogether. Depending on your situation, this may not be in your best interest.

Today, we’ll focus on Roth IRA conversions in retirement. I’ll start by first defining what a Roth IRA conversion is. Then I’ll provide you with some of the key decision-making factors to consider that may help you determine if Roth IRA conversions in retirement are a good tactic for your retirement tax planning strategy.

What are Roth conversions?

A Roth conversion is when you transfer money out of a pre-tax retirement account and into an after-tax Roth account. Typically, every dollar you convert is taxed as ordinary income unless the pre-tax account was funded with after-tax dollars. The reason individuals convert money into a Roth is because they believe that paying taxes on their savings now in exchange for tax-free withdrawals of their principal, interest and growth in the future, will save them tax money.

I’ll give you an oversimplified example of this benefit. Let’s say individual A is currently in the 24% tax bracket but due to their expense needs in retirement and the amount of taxable income they expect to produce to meet those needs, they believe their tax bracket will go up to 32%. They perform the Roth conversion today to save 8% on their tax bill in the future. You can use a Roth conversion calculator like this to illustrate the benefit you can derive based on your investment time-line, estimated tax rate difference, and average returns.

When do Roth conversions in retirement make sense?

Here are a few windows of opportunity where Roth conversions in retirement can be a good strategy for you.

Retiring before age 65 (pre-Medicare): If you retire prior to age 65 and expect to be in a low-income producing phase of retirement relative to where you were when you stopped working and you are not within the 2-year lookback for Medicare means testing, you could have a great opportunity to convert to Roth and not adversely impact your Medicare costs. Under this scenario, your ideal Roth conversion window is your year of retirement until age 62.

Between retirement and when you start taking Social Security and/or pension income: Once Social Security and/or pension income begins, the increase in taxable income can make the tax benefit of Roth conversions less beneficial. However, it might mean smaller conversions rather than no conversions. There is also an argument for deferring Social Security benefits, which might allow you to do more Roth conversions while increasing your monthly Social Security benefit (up to an 8% guaranteed increase per year after your full retirement age). This tends to make the most sense for individuals who have sufficient savings to live off of and expect to live a life well into their 80s. You can read more about that here.

Until you reach the required minimum distribution (RMD) age: The goal is to strategically convert your pre-tax retirement assets into Roth to avoid large RMDs that can make it harder to control your tax bill in the future. Depending on your situation after you reach this age, Roth conversions might not save you more in taxes down the line. Of course, every individual’s tax situation and life expectancy vary, so you want to make sure you update your Roth conversion strategy as your situation, expectations and needs change.

When you intend to pass down tax-free assets to your heirs: In this scenario, you might be financially well prepared for your own retirement and focused on passing down some of your wealth in a tax-efficient manner for your heirs. You may be happy to pay those taxes upfront for them, so they receive a tax-free asset, especially if you think that tax rates could be a lot higher for your heirs when they expect to withdraw.

When do Roth conversions not make sense in retirement?

When you expect to pay a lower tax rate throughout retirement: Your tax bill in retirement could be lower for several reasons. For savers, this occurs mainly because you are generating a lot less taxable income to meet your lower expense needs. During your working years, your tax rate might have been higher because of your earned income, which allowed you to save a lot. Now that you are retired, you only need enough money to cover your expenses. In addition, if you already have sufficient savings in low tax (i.e. taxable accounts with mainly long-term capital gains) or tax-free accounts (i.e. a Roth), there may not be an additional benefit for you to convert more pre-tax income into Roth.

Another thing to keep in mind when crunching the numbers is that your income is not taxed at 100% of your marginal tax rate. For example, if you file married filing jointly and were to generate $120k of taxable income in 2023, you’d only have $92,300 in taxable income after the $27,700 standard deduction. The first $22,000 is taxed at 10%, then the next $67,450 is taxed at 12%, with only $2,850 being taxed at 22%. Your effective tax rate would be about 10.9% of your taxable income. You can see your marginal tax bracket and effective tax rate here.

If you still have a child in college: A Roth conversion would increase your reported income and potentially reduce your child’s financial aid eligibility on the FAFSA. One thing to note is that because the FAFSA looks at your tax returns 2 years in arrears, you might want to re-evaluate this decision during their second to last year of school to determine if Roth conversion might continue to make sense or not since their eligibility shouldn’t be impacted based on current FAFSA rules.

As you can see, there are good reasons to convert and not to convert to a Roth. To make the best decision, you’ll want to weigh the factors that apply to your specific situation both now and as things change throughout your retirement life. If you need help, be sure to reach out to a qualified financial or tax professional to help you understand what might make sense for you both now and in the years to come.

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