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Converting a traditional IRA to a Roth IRA can help you minimize taxes in retirement. But executing the conversion strategically is key to maximizing the benefits. A recent Schwab retirement planning report recommends three tactics to reduce your Roth conversion tax bill: max out your current bracket, spread conversions over multiple years and start planning early for tax changes. Any or all can be effective retirement planning tools, but a Roth conversion comes with costs, limits and risks and may not be optimal for everyone.
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With a Roth conversion, you can move funds from a traditional IRA to a Roth IRA and pay income taxes on the amount converted. This can benefit you in retirement by letting your savings then grow and be withdrawn tax-free. It’s a savvy strategy if you expect to be in a higher tax bracket later in retirement or want to avoid required minimum distributions (RMDs) on traditional IRAs.
The mechanics of Roth conversion aren’t particularly difficult and the institution that holds your Roth account can help. But it’s up to you to make sure that you don’t pay too much in taxes. The Schwab Center for Financial Research recently offered three potential ways to reduce the tax hit of your Roth conversion:
1) Max out your current tax bracket with a partial conversion. This seeks to avoid being bumped up to the next bracket by adding smaller amounts to your taxable income each year. For example, if you’re in the 24% bracket, convert just enough funds to bring your current taxable income up to the next bracket’s threshold.
2) Spread out conversions and break them up over several years to control the tax impact. As with the previous strategy, this seeks to avoid being bumped up to the next bracket by adding smaller amounts to your taxable income each year. Stay strategic to maximize each year’s bracket.
3) Think about tax changes nice and early. If you think tax hikes are coming, you can convert more now to avoid higher rates later. Convert before year-end to account for income fluctuations.
To see how this might work, consider a hypothetical example of a single retirement saver who has $200,000 in a traditional IRA. They think their tax rates will be higher in retirement, so they’d like to convert that to a Roth. They make $150,000 annually, putting them in the 24% bracket. For example, in the 2023 tax year, the next bracket starts at $182,101, with a rate of 32%, and the bracket above that is 35% and applies starting at $231,251.
If they converted the full $200,000 to a Roth IRA in one year, here is how their tax liability would break down on that money specifically:
On the first $32,100, they would owe 24%, or $7,704
On the next $49,150 they would owe 32%, or $15,728
On the remaining $118,750, they would owe 35%, or $41,562
In total, they would owe $64,994 in income taxes on the full one-time $200,000 conversion.
If they used a gradual conversion strategy, they could convert $32,100 this year to increase their income to $182,100. This fills her 24% bracket without moving up to the higher rates. At the 24% marginal rate, she’ll pay approximately $7,704 on the converted funds.
Assuming their income and the tax brackets don’t change, they can repeat this over the next several years to gradually move the entire $200,000 in their IRA to a Roth.
Without brackets changing, in each of the first six years, they could convert $32,100 and pay $7,704 in taxes for a total six-year tax bill of $46,224. In the seventh year, they could convert the remaining $7,400, paying $1,776 in tax.
Their total seven-year tax bill for the gradual conversion would come to $48,000. That represents a hypothetical tax savings of $16,994, although in reality the tax brackets as well as their annual earnings would likely shift to produce a somewhat different schedule of withdrawals and outcome.
A financial advisor can help you determine the tax implications in your own Roth conversion.
While a Roth conversion can be a smart move, it’s not without potential drawbacks. For instance, although Roth conversions can optimize your retirement taxes, they incur extra tax costs now.
Also bear in mind that Roth conversions are irreversible. You can’t undo it and move funds back to a traditional IRA or other pre-tax retirement account.
Finally, if you’re under 59.5, pulling money from an IRA is considered an early withdrawal. That means the funds you plan to convert must pay a 10% penalty in addition to taxes owed before you can put them into a Roth account.
Roth conversion can make sense, but it’s not always the right move for every retirement saver. Before deciding to do a conversion, consider your individual circumstances carefully.
Look especially at your current tax bracket versus your expected retirement income and tax rates. Weigh the benefits of tax-free retirement withdrawals against paying conversion taxes now. Align conversion years with lower income. For larger IRAs, discuss partial conversions with a pro. You can get matched with a financial advisor with SmartAsset’s free tool.
Strategic partial Roth IRA conversions can optimize your retirement taxes. But work through the analysis to see if conversions align with your overall savings and tax picture. Enlist help from a financial advisor to run the numbers. With the right plan, you can make the most of this IRA planning tool.
You may want to consider working with a financial advisor to project your retirement income and tax rates and see if a Roth conversion can work. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Kaitlin Rogers is a writer, editor, and news junkie. She has been working in the media industry for over five years, and her work has appeared in dozens of publications.
Kaitlin graduated from Michigan State University with a bachelor's degree in journalism and political science.
