Just as diversification is important in investing, it’s equally important in retirement planning. By diversifying your assets across different types of accounts—taxable, tax-deferred, and tax-free—you can potentially lower your tax burden in retirement to try and maximize your income. One diversification tool is the Roth IRA conversion strategy that can potentially provide tax advantages and greater financial flexibility.

What is a Roth Conversion?

A Roth conversion involves transferring funds from a Traditional IRA or 401(k) into a Roth IRA. The primary difference between these accounts is their tax treatment.

Contributions to a Traditional IRA are pre-tax, but withdrawals are taxed as ordinary income. Conversely, Roth IRA contributions are made with after-tax dollars, but qualified withdrawals are tax-free.

A conversion is the process of converting tax deferred assets to tax-free assets. By paying taxes now on the converted assets, there are potential tax savings in the future.

Who Should Consider a Roth Conversion?

Deciding whether to convert to a Roth IRA involves several factors and you should always consider speaking to a qualified professional. Roth conversions may be beneficial for individuals who:

1. Expect Higher Taxes in the Future: If you anticipate being in a higher tax bracket during retirement, converting to a Roth IRA now, while in a lower tax bracket, could result in tax savings.
2. Have Significant Non-Retirement Assets: If you possess substantial assets or income sources outside of your retirement accounts, you can use these to cover the taxes incurred during the conversion process.
3. Seek Greater Tax Diversification: Having both Traditional and Roth accounts can provide more flexibility in managing taxable income during retirement.
4. Reduced Required Minimum Distributions (RMDs): Unlike Traditional IRAs, Roth IRAs do not require RMDs. Doing Roth conversions prior to RMD age, can reduce or eliminate future RMDs.
5. Want Tax-Free Assets Passed to Beneficiaries: Roth IRAs can be inherited tax-free by beneficiaries. This allows heirs to benefit from the growth of the assets without the burden of additional taxes.

When Does It Make Sense to Do a Roth Conversion?

Roth conversions can be particularly advantageous in the following scenarios:

• Low-Income Years: If you anticipate a period of lower-than-normal income, it may be an opportune time for a conversion. Examples of this would be periods right after retirement, and before starting Social Security or RMDs.
• Market Downturns: Converting during a market dip can result in a lower tax bill because the value of the converted assets are reduced.
• Before Tax Law Changes: Anticipating future tax law changes that could increase taxes on retirement accounts can make early conversions more appealing.
• Long Time Horizon: The benefits of a Roth Conversion are typically maximized over a longer time horizon. The trade-off of paying higher taxes now, for future tax savings, increases with a longer time horizon.

Important Considerations for Roth Conversions

1. Current and Future Tax Rates: Estimate your current tax rate versus your expected tax rate in retirement. This can help determine if a conversion makes financial sense. If your expected tax rate in retirement is low, a conversion may not be beneficial.
2. Tax Withholding: Plan for how you will pay the taxes due on the conversion. Using non-retirement funds to pay for the taxes is the most advantageous, while using retirement funds to pay for the taxes is not.
3. Impacts on Benefits: The extra income from conversions can impact Medicare Premiums and Social Security benefits.

Real-Life Benefits of a Roth Conversion

We recently worked with a retired client on a financial plan. The client had the opportunity to execute Roth conversions over a period of years during a time when income was relatively low and before RMDs kicked in. By converting portions of the Traditional IRA to a Roth IRA each year to fill up the client’s desired tax bracket, we were able to spread out the tax liability. This kept the client in a lower tax bracket while moving tax-deferred assets into tax-free assets.

In the graphic above, the green area shows the adjusted taxable income with the proposed conversion strategy, while the purple area shows it without. During conversion years, taxable income is higher, but once the conversions are complete, taxable income is reduced compared to the scenario with no conversions. This allows more of portfolio to grow tax-free and reduces taxable income from the RMDs. Over the lifetime of the portfolio, this strategy is estimated to reduce taxes and increase the total value of the portfolio.

Roth conversions can be a powerful tool in retirement planning, offering tax advantages and financial flexibility. However, they are not a one-size-fits-all solution and require careful consideration of various factors, including current and future tax rates, timing, and individual financial circumstances. Be sure to consult with a qualified professional.

If you’re considering a Roth conversion or have questions about your retirement plan, let us know! We’re here to help you navigate these questions and walk you through these decisions.