Transferring funds from a pre-tax retirement account such as an IRA to an after-tax Roth IRA is a move many retirement savers might want to consider. A Roth conversion, as the move is called, has many benefits. It can help you avoid required minimum distributions, or RMDs, in retirement, as well as taxes on your retirement withdrawals. There are even some estate planning benefits. Gradually converting IRA funds to Roth funds is a popular refinement of the technique, because it can save on taxes now while providing for tax-free withdrawals later on. However, converting 20% of your IRA to a Roth account every year may or may not represent an optimal approach. And in some cases, it may be more efficient not to convert at all. A financial advisor can help you identify a promising strategy for funding your retirement, but here are some things to consider.
Roth conversions offer a lot of appeal to retirement planners. Roth accounts are not subject to Required Minimum Distribution (RMD) rules, so retirees won’t have to make mandatory withdrawals that could increase their tax liability after they stop working. Also, Roth withdrawals incur no income taxes past age 59 1/2, so they don’t affect Social Security benefit taxation, among other benefits. Roth accounts also can provide for tax-deferred transfers of wealth to heirs, making them popular in estate planning.
For many savers, the chief concern is whether the retirement saver will be in a higher income tax bracket after retiring. If they will be in a lower tax bracket, the Roth may not make sense. That’s because any funds converted from a pre-tax retirement account such as an IRA are taxed as ordinary income when the conversion occurs. With that in mind, if a saver expects to be in a lower income tax bracket post-retirement, as is often the case, it won’t save money to pay taxes now at a higher rate. A financial advisor can help you devise an appropriate tax strategy for your Roth conversion.
Because funds transferred from an IRA into a Roth are treated as taxable income when the conversion occurs, it can get very expensive to convert a large IRA all at once. Gradual conversion is one popular approach. Spreading the conversion out over multiple years can avoid bumping the taxpayer into a higher bracket, reducing the current and overall tax burden.
When designing a Roth conversion plan, aiming to convert a percentage each year also may not be the best approach. That’s because the dollar amount of the conversion, not the percentage, is what affects current taxes. The usual approach is to convert only enough IRA funds every year to move the taxpayer’s income up to the top of the current bracket.
