As the year winds down, it’s time to think about your financial “housekeeping” tasks—especially tax planning. A popular, strategic approach is the Roth conversion, which allows you to convert some or all of your traditional IRA funds into a Roth IRA. A Roth conversion can offer significant tax benefits for retirees and those nearing retirement, but timing is key. Below, we’ll dive into why year-end is ideal for tax planning and how a Roth conversion can help you create a more tax-efficient retirement.
What is a Roth Conversion?
A Roth conversion allows you to transfer money from a pre-tax retirement account (like a traditional IRA) into a Roth IRA, where future growth and withdrawals can be tax-free. However, because traditional IRAs are funded with pre-tax dollars, converting this money into a Roth IRA means paying taxes on the amount converted at your current income tax rate.
While paying taxes now may seem counterintuitive, the benefits can be significant for your retirement future—especially if you expect tax rates to rise or if you’ll be in a higher tax bracket.
The Benefits of a Roth Conversion in Retirement
- Tax-Free Withdrawals in the Future: Since Roth IRAs grow tax-free, all qualified withdrawals in retirement are also tax-free. This is especially beneficial if you expect higher income later in life or anticipate higher tax rates. Roth IRA distributions aren’t counted as taxable income, which can help you keep your tax liability low in retirement.
- No Required Minimum Distributions (RMDs): Traditional IRAs require you to start taking withdrawals at age 73, but Roth IRAs don’t have RMDs during your lifetime. This flexibility lets your Roth account grow tax-free as long as you wish, providing you with a “tax-free” cushion for unexpected expenses or healthcare costs later in life.
- Estate Planning Benefits: If your heirs inherit a Roth IRA, they can continue to take distributions tax-free. This can make Roth IRAs useful in an estate planning strategy, allowing you to pass on wealth more efficiently.
- Lower Your Medicare Premiums and Adjusted Gross Income (AGI): Traditional IRA withdrawals increase your taxable income, potentially raising your Medicare premiums. Since Roth conversions can lower future RMDs, they help manage your AGI and Medicare costs.
Why Now? Timing Your Roth Conversion for Maximum Benefit
The end of the year is the ideal time to consider a Roth conversion for several reasons:
- Clarity on Your Current Tax Situation: By December, you will have a reasonable estimate of your annual income and deductions, allowing you to calculate the impact of a Roth conversion accurately. Converting too much could push you into a higher tax bracket, so choosing an amount that won’t dramatically increase your tax bill is essential.
- Leverage Lower Tax Brackets: You may be in a lower tax bracket if your taxable income is lower this year due to a job change, retirement, or market losses. Converting part of your IRA at this lower rate can save you money on taxes now.
- Aligning with Other Year-End Tax Strategies: Roth conversions can complement year-end tax moves, such as maximizing charitable deductions, harvesting tax losses, or contributing to tax-advantaged accounts.
Calculating the Right Amount to Convert
To determine how much to convert, you must assess your current tax bracket and how much room you have before reaching the next one. Here’s a basic process:
- Estimate Your Taxable Income for the Year: Include any additional income sources, Social Security benefits, and other retirement distributions.
- Determine Your Tax Bracket Threshold: Check the IRS’s current tax brackets and calculate how much room you have before reaching the next bracket.
- Convert Enough to Avoid a Higher Bracket: Aim to stay within your current bracket. For instance, if you’re near the top of the 12% bracket, limit your Roth conversion so you don’t spill over into the 22% bracket.
- Consult a Financial Advisor: Roth conversions can be complex and impact other parts of your financial plan, including Medicare premiums, Social Security taxation, and estate planning. Professional guidance ensures you’re making an informed decision.
Roth Conversions and Required Minimum Distributions (RMDs)
If you’re already taking RMDs, it’s important to understand that these must be satisfied first from your traditional IRA before converting additional funds to a Roth. For retirees looking to reduce future RMDs, Roth conversions can be especially valuable. By converting a portion of your IRA now, you can lower the balance on which future RMDs will be calculated, resulting in smaller distributions and lower taxable income in the future.
Roth Conversions as a Legacy Strategy
If you’re considering leaving assets to your heirs, a Roth conversion could be a powerful estate planning tool. Heirs who inherit a Roth IRA must withdraw the funds within ten years under the SECURE Act, but those withdrawals remain tax-free. This could be an attractive benefit for your beneficiaries, especially if they are in a higher tax bracket.
Common Questions About Year-End Roth Conversions
- Is There a Deadline for Roth Conversions? The conversion must be completed by December 31 to count for the current tax year. Unlike contributions, which can be made until the tax filing deadline, Roth conversions have a year-end deadline.
- How Will a Roth Conversion Affect My Medicare Premiums? Medicare premiums are determined by your Modified Adjusted Gross Income (MAGI) from two years prior, so a Roth conversion could increase premiums if it significantly boosts your MAGI. It’s important to consider this impact before converting a large amount.
- Can I Reverse a Roth Conversion? No. The IRS removed the “recharacterization” option in 2018, so it’s permanent once you complete a conversion. Be sure to evaluate your tax situation carefully before proceeding.
Final Thoughts: Taking Action Before Year-End
With tax season approaching, now is the time to think about strategies like Roth conversions that can give you greater control over your tax bill, retirement income, and estate planning. Although paying taxes upfront might feel counterintuitive, the future tax-free income, flexibility in retirement, and benefits for your heirs can make a Roth conversion a valuable addition to your year-end financial planning.
If you’re considering a Roth conversion or want help optimizing your year-end tax strategies, contact SFA Wealth. Our team can provide insights tailored to your financial situation, helping you maximize your retirement savings and minimize your tax burden now and in the years to come.