One of the key benefits of a Roth IRA (Individual Retirement Account) is that while taxes are paid upon contribution, withdrawals that meet the criteria during retirement can be tax-free. Many individuals have been contributing to traditional IRAs or 401(k) retirement plans for decades to take advantage of the upfront tax benefits, with the intention of paying taxes when withdrawing during retirement.
Fortunately, there is another option known as a “Roth conversion.” Simply put, it allows you to transfer funds from a traditional IRA to a Roth IRA, with the condition that you must pay taxes on the converted amount.
However, choosing the right timing – conducting a Roth conversion in lower tax years – could potentially help reduce your tax burden and bring additional benefits.
This is why many financial advisors recommend considering a Roth conversion during what is known as the “golden period” or “gap period.”
According to financial professionals, the “golden period” for a Roth conversion typically occurs after early retirement, before starting to collect Social Security benefits, and before beginning Required Minimum Distributions (RMDs).
Data from financial services firm Empower indicates that the average retirement age for men is 65 and for women is 63. Americans can start collecting Social Security benefits as early as 62, while RMDs usually begin at 73.
Therefore, everyone’s “gap period” varies. The most crucial consideration here is your individual tax situation.
In theory, after early retirement, before starting to collect Social Security benefits, and before RMDs kick in, you may be in a lower income tax bracket. Hence, conducting a Roth conversion during this gap period could potentially mitigate the tax impact of the conversion.
Additionally, before proceeding with a Roth conversion, the amount to be converted should be carefully considered. You don’t have to convert the entire balance of your traditional IRA all at once. You can stagger conversions over several years, known as “staggering conversions.”
Many financial advisors suggest converting a sufficient amount to fill the lower tax brackets, such as the 12% and 22% brackets, without pushing your income into a higher 24% or above tax bracket.
The primary goal is to ensure that the tax rate you pay for the Roth conversion now is lower than the potential tax rate when withdrawing these funds in retirement. In other words, if you anticipate being in a higher tax bracket when withdrawing in the future, a Roth conversion may be beneficial.
Furthermore, conducting Roth conversions in increments can gradually decrease the balance of your traditional IRA account, potentially reducing future RMDs. This is because the calculation of RMDs partly depends on your IRA account balance.
For many retirees, an unexpected consequence of RMDs is that the withdrawal amount may push them into a higher tax bracket. In some cases, this could lead to increased taxes on their Social Security benefits or additional taxable portions. Additionally, it may trigger or elevate Medicare premium surcharges through Income-Related Monthly Adjustment Amounts (IRMAA).
However, strategically implementing Roth conversions may help you avoid these so-called “tax torpedoes.” Yet, improper handling of Roth conversions could also negatively impact your retirement savings.
To prevent encountering unexpected tax issues, let’s explore some potential risks and how to avoid them.
When conducting a Roth conversion, you must pay income taxes on the converted amount in the year of conversion.
Make sure you have enough cash on hand to cover this tax payment. It is advisable not to use funds from your traditional IRA to pay the taxes generated from the Roth conversion, for the following reasons:
Firstly, money withdrawn from a traditional IRA is considered a taxable distribution. Therefore, you might face a higher tax burden in the year of conversion.
Secondly, if you are under 59.5 years old, this withdrawal may also incur a 10% additional tax penalty.
Moreover, using traditional IRA funds to settle conversion taxes means those funds lose the benefit of continued tax-deferred growth.
Therefore, before proceeding with a Roth conversion, ensure you have funds available in savings or checking accounts to cover the taxes.
Before conducting a Roth conversion, familiarize yourself with the “Five-Year Rule.” Typically, to make tax-free withdrawals on earnings generated post-conversion, you must wait five years. This holding period starts from January 1 of the conversion year.
Additionally, each Roth conversion has its independent five-year holding period.
To avoid penalties on withdrawals, you must also be at least 59.5 years old.
If you are on Medicare or approaching the age of 65 for Medicare eligibility, it is crucial to understand Income-Related Monthly Adjustment Amounts (IRMAA). This is an additional premium charged for high-income individuals on Medicare Part B and Part D.
However, there is a complexity to consider.
The government determines if you need to pay IRMAA based on your Modified Adjusted Gross Income (MAGI) from two years ago.
Hence, if you file taxes individually and your MAGI exceeds $109,000 in 2024, you may be subject to IRMAA in 2026. If filing jointly, surpassing $218,000 in 2024 could trigger IRMAA.
Therefore, if your Roth conversion amount in 2026 pushes your income to IRMAA threshold levels, it may lead to IRMAA payments in 2028.
This highlights the importance of conducting Roth conversions during lower-income “golden periods.” Simultaneously, consider maximizing Roth conversions to fill the 12% and 22% lower tax brackets without entering higher tax brackets.
Engaging in Roth conversions during favorable-income “golden periods” can yield significant benefits – provided the process is executed correctly.
Otherwise, it could backfire, becoming an unexpected “tax bomb.” Hence, seeking advice from financial advisors is crucial before proceeding with Roth conversions.