Roth Conversion for Retirement: Should I do it?

Simply put, are you comfortable with the amount of your retirement savings that will be taxed at future tax rates?  

Have you considered the current demographic situation with baby boomers retiring and its effect on the entitlement programs like Medicare and Social Security and future tax rates? 

Have you considered your personal income projection and taxes over your entire retirement?

You can't waive a magic wand and turn all your taxable money into tax free money. Taxes will be owed to lower your future taxes; but had you rather pay $10,000 in taxes today or $20,000 in taxes later? 

Strategic Roth conversions could save you tens or hundreds of thousands of dollars in unnecessary taxes over your lifetime. But there is not a step in the process below that can be omitted without creating potential problems for yourself.  

A Roth IRA is an individual retirement account, like a traditional IRA, but the contributions are never tax deductible. However, the qualified distributions are tax free (unlike the deductible contributions and gains in a traditional IRA).

Many people have asked me how a Roth IRA is invested. A Roth IRA is a tax vehicle in which the assets can be invested in whatever you want based on the IRA custodian's available investments. When thinking about Roth versus traditional IRAs, don't think investments; think tax treatment.

The chart below illustrates three major account types. Since tax-deductible IRA and 401(k) assets are taxed as ordinary income when withdrawn, this can put a heavy tax burden on you in your retirement years.

Having tax-free assets can give you greater tax control in the future, which can save you thousands in taxes over time, not to mention the fortune you can parlay to future generations through stretching the Roth IRA tax-free growth for as long as possible (as long as 10 years).

Figure 1. Tax Control Triangle

There are two ways your money can get the Roth IRA tax treatment: contributions and conversions.

Basically, doing a Roth conversion is transferring assets from an IRA to a Roth IRA. While some people have nondeductible contributions in their IRA which are not taxed in the conversion (they are prorated with the all the pretax portion of all your IRAs, per backdoor Roth aggregation rule), most retirees’ 401ks and IRAs are all pretax money, and thus a conversion will be taxed entirely as ordinary income the year it is converted.

Conversions once had income restrictions, but now there are no income limits or conversion amount limits.So, conversions allow big amounts of future-taxed money to be converted to future-tax-free money. Whereas, even if your income is low enough to contribute to a Roth IRA, you are limited to small annual amounts (like $6000 per individual with an extra $1000 for individuals over age 50 in 2021). 

There is a five-year rule for Roth conversions, and it applies to your access to the principal. Before age 59½, the principal (the original amount you converted) cannot be accessed without a 10% penalty until five years has elapsed from the year the conversion was made (which could be as short as four years and a day)—unless you turn 59½ during the five-year period. As soon as you reach 59½, all converted assets are immediately penalty-free and tax-free. Each conversion has its own five-year clock until you reach age 59½. See more on the five year rules here.

Unfortunately, the recharacterization feature was repealed in the TCJA of 2017, meaning you cannot reverse a conversion later in the year. So, under the current rules, you want to be confident of your tax situation before you do a conversion. Therefore, it’s usually best to wait until later in the year to do a conversion when there are less opportunities for surprises in your tax situation.

So why would you want to do a Roth conversion and pay taxes now rather than wait until later? The simple answer is “only if you think your taxes will be higher later compared to now”. There are various factors such as liquidity, tax control, anticipated inheritance, etc. that also help you make that decision--but that is the main question to ask. See Ed Slott's 2020 article here.

Regarding contributing to an IRA or Roth IRA, remember that if the investment returns and tax rates are the same, it makes no difference mathematically whether you 1) deduct and defer taxes using a traditional IRA or 2) don’t deduct and get it tax free at the end. The key question is the comparison of tax rates at contribution time versus withdrawal time. Well, this understanding can also be applied to conversions.

Here is a good illustration. Imagine you have four bags of seed that you will plant in four separate fields. You can either give the government one of your four bags now or give the government one of your four fields later. Assuming the fields produce the same, you still have three fields at the end. 

Figure 2. IRA versus Roth IRA

This chart above shows equal outcomes if growth and tax rates are equal. But if the government takes 25% of your seeds now but would take only 20% of the produce later, it would be wise to plant all the seeds now (equivalent of the IRA). If the government would take 25% of your seeds now but take 30% of your crops later, you would let them take 25% of your seeds so you can keep all your crops (equivalent of the Roth IRA).  

While many retirees’ taxes are lower in retirement than during their working years, this is not always the case. Social Security, pensions, rental income, inheritances, and retirement account Required Minimum Distributions (RMDs) are a few income sources that can raise your taxes during retirement.

As a result, there are often opportunities to pay taxes now at lower rates to avoid paying higher taxes later. You can sometimes take advantage of gap periods during low-income years, like after retirement, but before Social Security and before Required Minimum Distributions (RMDs) start. Another great article on Roth conversions is found here on Vanguard's website.

Note: This is what tax planning is all about: lowering your lifetime taxes.  As valuable as a good CPA is, they are usually looking through the rearview mirror rather than through the windshield at the taxes you will face in the years ahead. So, for most retirees and pre-retirees, "tax planning" just doesn’t get done at all--by their advisor or accountant. As a result, lots of opportunities are missed and valuable tax savings are forfeited year after year.  

There are many Roth conversion strategies for retirees and pre-retirees. Here is just one example.

• After retiring from work, instead of immediately taking Social Security or drawing down 401(k)/IRA assets, spend from your taxable assets for a year or two or three. During these low-income years, convert big pieces of your traditional IRA to Roth. This can do two things: 1) greatly boost your future Social Security income by delaying benefits, and 2) increase your future tax-free income.

Remember, there are no RMDs for Roth IRAs and any distributions that are taken are tax free after age 59½.

Now let’s look at ten steps to do a successful Roth conversion for retirement.

I am assuming you have clarified your goals and have saved and invested for those goals all your life and you are approaching or in retirement.

To have any idea of what your future taxes will be, you have to estimate what your future income will be.

Here are a couple of graphical examples of income projections, with inflation adjustments and long-term care expenses built in in the last two years of life.

Figure 3. Mid-60s couple in which the higher wage earner delays Social Security to age 68

 

Figure 4. Early retirement for a couple with a long gap to full Social Security age

This income must be properly characterized from a tax projection perspective since different accounts and income sources in retirement are taxed in different ways.

Use the best estimates of taxes. Below, I’ll assume the current tax laws sunset back to pre-TCJA (Tax Cuts and Jobs Act of 2017) rates in 2025.

A graph showing the tax rates would look like this.

Figure 5. Example of estimated ordinary income brackets over a couple’s retirement

Depending on where you are in retirement, you may be able to control certain things like Social Security income (you can even suspend your income and get delayed credits after you are full Security age and before age 70), pension income, capital gain/loss harvesting, and charitable giving (bunching deductions, using Qualified Charitable Distributions (QCDs), or donor advised funds).

You can also decide how much of your after-tax nest egg (beyond an emergency fund) that you can spend down for living expenses to create low tax years for doing Roth conversions. Any strategy must pay attention to liquidity for emergencies and satisfying your current cash flow needs, of course.

Before considering Roth conversions, you will want to find the withdrawal order that is the most tax efficient throughout your retirement. Most often, the order of taxable, tax-deferred, and then tax free is preferable to prorated or other sequences.

The lifetime tax savings just from this analysis can be tens or hundreds of thousands of dollars over your lifetime.

Here is an example of a client’s tax scenarios. (The spike in income at age 72 is RMDs.) These graphs are in order of tax efficiency with the pro-rata withdrawal scenario (drawing an equal portion from each tax bucket) being the baseline.

Figure 6. Tax deferred, taxable, tax free. $260,000 less than pro-rata withdrawal order (least tax-efficient)  

Figure 7. Baseline pro-rata withdrawal order

Figure 8. Taxable, tax free, tax deferred. $379,000 more than pro-rata

Figure 9. Taxable, then pro-rata.  $574,000 more than pro-rata

Figure 10. Taxable, tax deferred, then tax free.  $607,000 more than pro-rata (most tax efficient)

Notice the taxable, then tax deferred, then tax free scenario is the most tax efficient withdrawal sequence, estimating an extra $609,000 of lifetime tax savings. And that is without any Roth conversions.

While RMDs for IRAs and 401ks typically must start at age 72 (or get hammered with a huge 50% IRS penalty), Social Security, pensions, tax harvesting, and charitable giving have some timing flexibility. This flexibility may allow you to maximize the Roth conversion strategy to reduce your future RMDs and hence your future taxes.

Here are two examples of Roth conversions, combined with the most tax efficient withdrawal sequence.

Figure 11. Mini-Roth conversions over a long period for an early retiree

This proposed strategy estimates a $467,010 greater ending portfolio than a pro-rata withdrawal strategy without the Roth conversions, assuming the current tax law sunsets in 2025 as scheduled ($374,000 more if the current tax laws do not sunset). This proposed strategy will result in a $443,980 greater ending portfolio just due to the Roth conversions only.

You can see in this case how it is the Roth conversions in the years prior to the start of RMDs that accounts for the lion’s share of the tax-savings. [Note: In this case, the spending shocks around age 90 (the time horizon for which we planned), reflect estimated end-of-life long term care (LTC) expenses based on national averages, assuming the retiree has no LTC insurance or other plan to cover these planned expenses.]

Let’s look at another example of the benefits of strategic Roth conversions.

Figure 12. Roth conversions over a shorter gap later in retirement

Notice in Figure 12 above the staggering $1 million tax savings of a tax efficient withdrawal sequence combined with strategic Roth conversions (filling up the 15% bracket) over just a few years before age 70 (72 is now the RMD age due to the Secure Act of 2019).

Note: If you are not likely to spend the Roth conversion money yourself and want to leave it to a charity (versus individuals), you would not likely want to do the Roth conversion since a qualified charity would receive the pretax money tax free anyway.  So, the taxes paid on the remaining balance of your portfolio through inheritance will also help you decide the amount to convert and perhaps whether it makes sense to do a Roth conversion at all.

We are looking ahead and only doing a Roth conversion now if it will save us much more in taxes later. Else, we always want to pay as little taxes as possible in the current year.

So, let’s suppose we see that a Roth conversion makes sense in the current year. Now we must figure out how we will pay the taxes due on the conversion. Having after-tax monies in the bank for example, not tied up, is the preferable way to pay the taxes. That allows every dollar of the transferred out amount to be transferred to the Roth IRA versus some of it be withheld for taxes. 

Paying the taxes from your pretax IRA may still be a smart move to shelter the remainder of the conversion in the Roth IRA from future taxes. However, you should be hesitant to ever allow your cash reserves get low in retirement. 

Also note that using extra IRA distributions to pay the taxes on your Roth conversion will trigger more taxes in the current tax year--and a 10% penalty will likely be applicable for those under age59½. All this must be weighed in your decision "whether" and/or "how much" to convert. 

The next step is to estimate what the conversion would look like this year before making the final decision. There are various limits and thresholds where your taxes increase. You want to be aware of these.

You want to watch not only for the ordinary income tax brackets, but also factors like capital gains tax brackets, tax credit phase-outs, the Medicare tax surcharge, the net investment income limit, and the Medicare premium surcharge. Your CPA or a good tax program can reveal how various conversion amounts can trigger extra taxes and/or surcharges.

Figure 13. Potential taxes and/or surcharges when doing a Roth conversion

These higher taxes and/or Medicare premiums occur at different income levels. The example above shows the tax credit phase-out and Medicare premium increases for this retiree’s income range. It shows how much you can convert before hitting the various thresholds and the tax consequences. It may be that you’d want to reduce your conversion amount just enough to be under these tax triggering income levels. It depends on the how much it offsets the conversion’s benefit.

There are other ways to reduce your future taxes, like harvesting capital gains in your taxable accounts; however, there are current tax consequences associated with this strategy too. The question is whether to accelerate ordinary income, capital gains, or a combination thereof. 

I talk more about harvesting capital gains in this article.

The goal is to choose the optimal balance between Roth conversions and harvesting capital gains. Here is a flow chart to help with that decision.

For more information, see Michael Kitces’ article, “Navigating Income Harvesting Strategies: Harvesting (0%) Capital Gains Vs Partial Roth Conversions.”

With the strategy and the amount to convert figured, you want to do the conversion. This usually involves filling out a Roth conversion form with your IRA custodian.

Without the recharacterization option, it is safer to do the conversion toward the end of year when there are less opportunities for tax surprises.

Another practical step is to sell the assets you are converting in the IRA to do a cash conversion rather than converting shares of securities. Even if you lose a little money in the bid-ask spread from selling in the IRA and rebuying the same asset in the Roth IRA, it will be easier to know the exact amount converted without having to translate the closing price of the shares to dollars at the point of conversion.

Furthermore, you’ll want to be strategic in your asset allocation in your Roth IRA versus a traditional IRA. The same investment may not be the best investment decision now that it will be taxed differently. (For example, your Roth money may be for spending shocks, so your taxes will not spike when those big expenses are needed later in retirement. Or your Roth monies may be earmarked for inheritance if you think you will likely not withdraw it for yourself and want to leave a greater tax-free inheritance to your family members.  As you can see, these two different strategies for the Roth IRA require a different investment plan. 

You'll also want to reassess your IRA investment allocation, as well as your entire portfolio, after the conversion to align with your new tax allocation.  

Lastly, consider your state taxes on Roth conversions. For example in Georgia, taxpayers 65 and older can exclude up to $65,000 of retirement income (up to $35,000 for taxpayers ages 62 to 64). Eligible retirement income includes taxable pensions and annuities (including military pensions), taxable IRA distributions, interest, dividends, net income from rental property, capital gains, royalties, and the first $4,000 of earned income (such as wages).

To show the relevance here, suppose an early-retired couple in Georgia was delaying Social Security to do some strategic Roth conversions. They want to keep their Affordable Care Act (ACA) Premium Assistance Tax Credit (PATC) and minimize their state taxes on the conversion.

Keeping their ACA Modified Adjusted Gross Income (MAGI) to $73,000 would still allow a $68,000 Roth conversion in their case and keep their PATC health insurance premium subsidy. But instead of the 64-year-old husband doing the $68,000 Roth conversion from his IRA, since the wife has also turned age 62, they could do $34,000 from each of their IRAs and take advantage of the $35,000 Georgia tax exclusion for all individual taxpayers age 62 to 64. After age 65, the state exclusion goes to $65,000 per individual and they would be on Medicare. The PATC and $35,000 limit would no longer apply.

(Note: ​​Georgia accounts for individual income in this regard even though they file "married filing jointly").

This decision has to be coordinated with factors like the ages of the IRA owners and the size of the IRAs. You would prioritize the conversion of the older, the larger IRAs, and the least state taxes owed. Tradeoffs can then be analyzed for the best decision.
​​
For Roth conversions done when both individuals are older than age 65, Georgia's tax exclusion of $65,000 per person could also guide you on how much to convert from each IRA if conversion amounts exceed $65,000 for a married couple. For example, not considering other income sources, a $100,000 Roth conversion might be split $35,000/$65,000 or $50,000/$50,000 so as not to exceed a total income of $65,000 per person.

If the amount is less than $65,000 (with all other qualified income added together) and it receives the state tax exclusion, other factors might then be considered. For example, the oldest person's IRA might be prioritized for conversions since their RMD percentage will always be higher after RMDs start due to their age and the increasing RMD rates with age based on the IRS life tables.  

Even though you will likely implement your Roth conversion toward the end of the tax year, if you didn’t withhold taxes or make an extra tax payment, your tax preparer will likely have some bad news for you. And it’s easy to get irritated when you must pay more taxes due to the conversion. At this point you must remember why you did the conversion: to avoid higher taxes later. Consider it an investment in your lower tax future. Your future self will thank you.

In many cases, you may have strategically lowered other income tax sources in conjunction with the Roth conversion. In such a case your tax liability may not be higher.       

Planning is important. But life happens. Things change. Tax laws change. A Roth conversion that may not have made sense from last year’s analysis could make sense now, and vice versa. So the verdict is never conclusively determined ahead of time. Every year, you should run through the steps above to reassess your tax picture.

As I’ve said before, financial planning is not a one-time event; it is a process. Always staying on top of it is how you stay on track with your goals, avoid mistakes, and take advantage of opportunities.    

Simply put, are you comfortable with the amount of your retirement savings that will be taxed at future tax rates?  Have you considered the current demographic situation with baby boomers retiring and its effect on the entitlement programs like Medicare and Social Security and future tax rates? Have you considered your personal income projection over your entire retirement?

You can't waive a magic wand and turn all your taxable money into tax free money. Taxes will be owed to lower your future taxes;  but had you rather pay $10,000 in taxes today or $20,000 in taxes later? 

Strategic Roth conversions could save you tens or hundreds of thousands of dollars in unnecessary taxes over your lifetime. But there is not a step in this process that can be omitted without creating potential problems for yourself.  

I realize this is more than most retirees are willing to tackle--which is one reason that this powerful strategy is so neglected or done poorly. So, it seems to me your choices are to

1. Wing it without these steps and do Roth conversions blindly--but that could very possibly do more harm than good,
2. Throw your hands up and dismiss Roth conversion strategies—but know you may be leaving the IRS a big tip that you and your family could have used to fund your dreams and goals,
3. Do the steps yourself—but this takes lots of time and effort, or
4. Work with a professional financial advisor who specializes in tax planning for retirement. This is where many retirees find themselves and this is where I can help. A good advisor and accountant can work together to get you the best results. 

Travis Echols, CRPC®, CSA