Roth Conversions Could Save Your Retirement: Here’s What You Need To Know

In the decades when you’re planning for retirement, the focus of many savers is to build up a substantial nest egg. But after you hit retirement, the focus shifts to efficiently using the funds by minimizing your tax obligations.

If you invested money in a Roth IRA when you were working, good for you. You’ve paid those taxes, and withdrawals are all yours.

For those who don’t have a Roth IRA, you can still move funds into one. While Roth conversions offer an opportunity for savvy retirees to lower their tax burden in retirement, it’s important to understand the advantages and pitfalls before diving in.

Let’s explore what you need to know about Roth conversions.

A Roth IRA conversion involves transferring retirement assets from another type of retirement account into a Roth IRA. These retirement accounts include traditional IRAs, SIMPLE IRAs, and 401(k)s.

During a Roth IRA conversion, the investor must pay income taxes on the funds converted. But after this initial tax hit, Roth IRAs are designed for tax-free withdrawals in the future.

It is important to note that there is a five-year holding period, which means you cannot withdraw the funds from a Roth conversion for at least five years without paying taxes.

The goal of a Roth IRA conversion is to enjoy tax-free withdrawals later. But the upfront tax levied on the converted amounts could be a deal-breaker for some investors. With that, it’s important to weigh the benefits against the tax to determine if a Roth conversion makes sense for your situation.

In general, a Roth IRA conversion makes sense if you think that your tax bracket will be higher in retirement. If you expect to face higher taxes in the future, converting your funds and paying the tax now could be the right move.

For retirees who experience a drop in income in their first years of retirement, that window could present a golden opportunity for Roth IRA conversions. With a lower income, you could avoid paying too much in taxes to pursue the conversion.

Finally, retirees seeking to maximize the funds left behind for their heirs might consider a Roth conversion. Although you’ll pay taxes on the converted amount, the funds in your Roth IRA can grow without the need to take a required minimum distribution (RMD). Ultimately, this could help you leave the most funds to your heirs.

A Roth IRA conversion doesn’t make sense for everyone. If you're planning to use the funds within five years or less, a Roth IRA conversion won’t suit your needs due to the five-year holding requirement.

Another reason to skip the conversion is if you don’t have enough funds on hand to cover the conversion tax. If you have to sell assets to cover the taxes, that could lead to additional tax obligations.

Finally, retirees relying on Social Security or Medicare benefits might opt to skip the conversion. If you pursue a Roth IRA conversion, the action will increase your taxable income, which could mean more of your Social Security benefits would be taxed, and your Medicare costs could increase. Make sure to understand the impacts before moving forward.

If you decide to pursue a Roth IRA conversion, it’s important to determine how much you’ll pay in taxes before moving forward. The amount you’ll owe in taxes varies based on your income tax rate, which ranges from 10% to 37%.

For example, let’s say you are in the 24% tax bracket and convert $30,000. Your income will increase by $30,000 for the year, which could push you into another tax bracket. But if you remain in the 24% tax bracket, you’ll owe $7,200 in taxes on the conversion.

The main benefit of a Roth IRA conversion is that your funds will be subject to the rules of a Roth IRA going forward. With that, you can make tax-free withdrawals if you're at least 59 1/2 years old and have left the funds in the account for at least five years.

Additionally, Roth IRAs don’t come with required minimum distributions for your entire life. This gives you more control over when you want to withdraw funds from your Roth IRA.

If you want to pursue a Roth conversion, the best time is usually in your early retirement years. That’s especially true if your income drops for a few years after leaving paid work behind.

For retirees who can lean on their savings without selling any other assets to create a taxable event, the window of early retirement can be the perfect time for a Roth IRA conversion.

A Roth IRA conversion presents an opportunity for retirees to potentially maximize their retirement savings by enjoying tax-free withdrawals later on. The catch to this potential bank account boost is that you’ll pay income tax on the converted funds upfront.

But if you have a period of lower income, pursuing a Roth IRA conversion during that window could make sense in your retirement plans.