Saving for retirement in a traditional IRA or 401(k) may have seemed like the right choice each year you made those contributions. But if you have all of your savings in a traditional retirement account, you could have a tax headache on your hands once required minimum distributions, or RMDs, begin. RMDs force you to take withdrawals from a traditional IRA or 401(k) annually starting at either 73 or 75, depending on your year of birth. And they could be a problem if they create a massive tax obligation which, depending on your savings balance, they might.
Understand Required Minimum Distributions (RMDs)
If you don’t like the idea of taking RMDs, you may want to consider a Roth conversion. With a Roth conversion, you move money from a traditional retirement account into a Roth IRA, which lets you off the hook. While the transfer itself is relatively simple, the tax implications of Roth conversions can make the decision more complicated. The reason? When you convert funds to a Roth IRA, the amount you move over is treated as taxable income for that year.
The good news is that with proper planning, a Roth conversion can be extremely beneficial to your overall financial situation. Here’s how to pull off a pain-free Roth conversion.
Related: Divorce can devastate retirement savings; can a QDRO help?
Understand your current tax situation
Before starting a Roth conversion, it’s important to review your current income and tax bracket. Since converted amounts are added to your taxable income for the year, you should estimate how much room you have before moving into a higher tax bracket.
For example, if your taxable income places you comfortably within the 22% federal tax bracket, you may decide to convert only enough funds to fill up that bracket without spilling into the 24% bracket. This approach allows you to control the tax impact while gradually moving money into a Roth IRA over several years.
Also consider state income taxes, capital gains, Social Security taxation, and Medicare premium thresholds when moving funds over. Even a moderate conversion could have less obvious implications, such as increasing your income to the point where your Social Security benefits are taxed or you’re assessed surcharges on Medicare Parts B and D.
Figure out optimal conversion years
It pays to do Roth conversions when your income is lower than usual. Some common lower-income windows include:
- The first few years of retirement before you start getting Social Security
- A pre-retirement “coast” job that comes with less stress and lower wages
- A transition to part-time work before full-fledged retirement kicks off
Keep in mind that the more years you have to do conversions, the less the tax impact might be in any given year. And that could spare you other unwanted consequences, like Medicare surcharges.
For example, if you have $800,000 to convert in total, doing it over 10 years means raising your taxable income by $80,000 per year. Converting it over five years means you’re looking at an increase of $160,000 per year in income, which is apt to have bigger tax implications.
Decide how much to convert
A lot of people think it’s in their best interest to convert their entire traditional IRA or 401(k) to a Roth IRA. But having some taxable income in retirement could actually work to your benefit.
If you’re looking to be charitable in retirement, keeping funds in a traditional IRA makes sense, as these accounts allow you to do qualified charitable distributions, which are basically an easy way to satisfy an RMD without incurring taxes. Plus, certain tax credits currently require you to have an income, and that requirement may hold true for new credits introduced in the future.
Before you move all of your money into a Roth IRA, think about the benefits of having multiple tax buckets.
Careful planning is key
A Roth conversion can be one of the most powerful tools in retirement planning. By paying taxes strategically today, you can pave the way to greater flexibility by minimizing or avoiding RMDs. Plus, don’t forget that once your money is in a Roth IRA, it gets to grow tax-free.
It’s important to pull off a Roth conversion correctly so you get the maximum benefit. Following the steps above could help you make the most of this strategy without painful tax bills or hidden consequences along the way.
