If you think retirement planning moves stop at retirement, think again. For high earners, converting an IRA to a Roth IRA while you’re still working could be the worst time of all. Although it won’t make sense in every situation, retirement can be a unique opportunity for Roth conversions for some investors. Particularly for individuals who are holding a lot of cash or have proceeds from a windfall such as the sale of a business, a multi-year Roth conversion strategy is worth considering.
Considering Roth conversions in retirement
When you convert pre-tax money from an IRA to an after-tax Roth IRA, the amount converted is included in your taxable income. This is why it’s not typically advantageous for high-earners to do Roth conversions while working. But in retirement, without a paycheck, it can be a great opportunity to control your tax situation for the year and fill up the lower tax brackets.
Whether or not a Roth conversion will make sense in retirement or at any other time will depend on facts unique to your situation. Though not an exhaustive list, in general, here are some of the key factors we look for during an analysis. As illustrated by the list below, there are a lot of factors that need to align for a Roth conversion to make sense in your wealth plan.
You have cash
It rarely makes sense to convert an IRA to a Roth if you need to take money from the account to pay tax on the conversion. Aside from the tax bill, you’ll want to have enough cash or resources to live on to minimize your taxable income in the year of conversion. If you are expecting sudden wealth from the sale of a business or other liquidity event, then it may not make sense to do a conversion in the same tax year, but could be worth considering alongside cash allocation discussions.
As you consider your cash runway and resources, remember to consult your financial and tax advisors to discuss taxes, penalties, and distribution rules. For example, for distributions from a Roth IRA to be tax-free on earnings and penalty-free, the taxpayer must be over age 59 1/2 and five tax years must have passed since the conversion.
Your taxable income is low
Again, one reason doing Roth conversions at retirement can be a great strategy is the ability to utilize the lowest tax brackets when your taxable income is low. So it’s important to consider all your income streams and whether you can control when payments begin. In retirement, this could be deferred compensation, a pension, annuity, Social Security, required minimum distributions, and so on. Even if you can defer, you’ll want to do an analysis to ensure it makes financial sense to delay any of these payments to make way for a Roth conversion.
You expect your future tax rate will be higher than it is today
Time value of money. All else equal, you’d be better off paying tax next year instead of today. But what if all else isn’t equal? If you have a large pool of pre-tax assets, when RMDs kick in you could have little protection against the highest tax brackets. Then there’s always the risk that the tax brackets themselves will increase in the future. So if you expect your tax situation today to be more favorable than it will be in the future, a Roth conversion could make sense.
If a Roth conversion is likely going to make a difference in your situation
Converting money from an IRA to a Roth might not make sense if it won’t end up making a meaningful difference in your financial situation or if it isn’t a problem that needs solving. There are typically two reasons investors convert money to a Roth IRA: to prevent being thrust into a higher tax bracket when required minimum distributions start and/or to take advantage of a more favorable tax situation today.
For example, a 73-year-old couple with pre-tax retirement account balance of $2,000,000 on December 31st 2022 would have to take RMDs of $75,472. Ignoring any other taxable income or deductions, this puts married taxpayers filing jointly in a 12% marginal tax bracket for 2023. This is quite advantageous.
If they converted $100,000 to a Roth on December 31st 2022, their RMD would be $3,774 less this year. A Roth conversion could still be worthwhile depending on other factors, but all else equal, it’s not a material change this year. Further, since the couple is already in such a low tax bracket, it’s important to consider the potential opportunity cost of using extra cash flow on a conversion versus other planning strategies.
Finally, consider your cash flow needs and sources of cash. The example above assumes the couple does not need the full distribution from the IRA to meet lifestyle expenses. If they did, the prior year conversion would have no impact on their taxable IRA distributions this year.
As part of a legacy by pre-paying tax for heirs
Given recent changes to retirement account rules eliminating the stretch IRA, in some situations retired investors opt to ‘pre-pay’ tax for heirs on a retirement account. This can be done through Roth conversions. As part of the new rules, non-spouse beneficiaries inheriting a pre-tax retirement account after 2020 must drain the account within 10 years (and potentially take RMDs within that time also, though further guidance is expected in 2024).
For adult children in their prime working years, inheriting a pre-tax retirement account could bring major changes to their tax situation. If the parent is in a much lower tax bracket and can otherwise afford to do so, inheriting a Roth IRA instead could provide meaningful tax savings to the beneficiary. As a reminder, distributions from inherited Roth IRAs are tax-free but subject to the same five-year rules discussed earlier. Though the inherited Roth IRA would still need to be taken within 10 years, there are no required distributions.
If this is your main driver for considering a Roth conversion, discuss your goals with your financial and tax advisor. Depending on your financial situation, asset mix/level, state of residency, etc., it might not be the most efficient way to accomplish your legacy goals, especially if you have a taxable estate.
Other tips when considering a Roth conversion in retirement
In retirement, it can be advantageous to have multiple buckets for tax diversification. This includes pre-tax, taxable, and after-tax Roth. If your assets are mostly pre-tax, a Roth conversion can add tax diversification while preserving tax-deferred growth and potentially tax-free withdrawals. But there are other ways to go about tax planning. Sometimes, instead of a Roth conversion, it can make sense to reinvest the funds in a taxable brokerage account for complete flexibility during life and after, plus the added benefit of a step-up in basis. Or if you’re charitably inclined, considering donating to charity right from your IRA.
If you do decide to move forward with a Roth conversion, consider doing so with shares. Instead of selling your positions to cash and converting that, you can convert the market value of the funds. This way you won’t be out of the market or incur additional transaction costs. Finally, although no one likes a down year in the financial markets, it can be a good time for Roth conversions given the reduced market value. This is just another reason why it often makes sense to consider your financial situation, cash flow needs, and tax situation annually alongside various financial planning opportunities.
Article written by Darrow Wealth Management President Kristin McKenna, CFP® and originally appeared on Forbes.
Information in this article is for informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific investment product, financial or tax strategy. This is a general communication should not be used as the basis for making any type of tax, financial, legal, or investment decision.