If you’re like most people, you’re probably looking for ways to reduce your tax burden in retirement. Using Roth Conversions is one strategy that can help is to convert your traditional IRA or 401(k) to a Roth IRA. By doing so, you can potentially save thousands of dollars in taxes over the long term.
There are two key benefits to converting a traditional IRA to a Roth IRA. First, Roth IRA withdrawals are tax-free, which can be a significant advantage later in retirement. Second, Roth IRAs do not have required minimum distributions (RMDs), giving you more flexibility in managing your withdrawals.
However, it’s important to handle the conversion carefully to avoid penalties. Early withdrawals from a traditional IRA (before age 59.5) are subject to a 10% penalty, so you’ll want to ensure the conversion is executed correctly. You generally have 60 days to complete the conversion, and it’s often safer to have your brokerage handle the process to avoid missing this deadline.
Remember, money in a traditional IRA has not been taxed yet. Converting to a Roth IRA means you’ll need to pay ordinary income taxes on the amount you convert in the year of the conversion. This taxable amount will be added to your income for that year and taxed at your current rate. The goal of the conversion is to shift to tax-free growth and withdrawals, but it’s crucial to plan for the tax implications in the year you make the conversion.
The key point is to convert just enough each year to keep you from being bumped up into a higher tax bracket.
For example, in 2024 a married couple filing jointly earning up to $201,050 would top out at the 22% tax bracket. But this couple’s top rate would then jump to 24% if their total taxable income was instead between $201,050 and $383,900. If they have a taxable income of $125,000, their income tax would be calculated across the different federal tax brackets: 10%, 12%, and 22%. This would then result in a total income tax of $17,606.
If they convert a traditional IRA with a $115,000 balance to a Roth, that would result in their taxable income rising from $125,000 to $240,000. This then puts their top rate in the 24% marginal tax bracket, raising their total income tax to $43,685.
Partial conversions if done correctly can avoid unnecessary federal taxes but can also pose some challenges. It’s crucial to consider state taxes in addition to federal taxes. Moving to a state with a higher tax rate could impact the overall tax cost of your conversion. Remember to think about commissions, bonuses, or incentive stock options in your annual salary as well, this can affect your total taxable income for the year and, impact your conversion. Another important factor to consider is how extra income from the Roth conversion might affect subsidies you receive under the Affordable Care Act (ACA). An increase in income could potentially reduce or eliminate these subsidies.
In conclusion, the primary reason to consider a Roth conversion is to control future tax liability. You do this by maxing out your current tax bracket before jumping into the over into the next one, is it worth it to pay taxes in a higher tax bracket? Probably not, but in your current tax bracket, it might make sense to complete a full or partial conversion. Paying taxes now at a lower rate may be beneficial than otherwise you would have to at a future date.
