For seniors heading toward retirement, one of the most important conversations they can have with their advisor is about whether it makes sense to convert their traditional IRA into a Roth IRA. The strategy can result in tremendous tax savings, but it depends on the client’s financial goals, tax situation and legacy plans.
On the surface it seems like a no-brainer. All the income generated in a Roth IRA is tax-free. Additionally, there are no required minimum distributions and no 10-year cashout rule under the SECURE Act of 2019.
But before pulling the trigger on a client’s Roth conversion, please review these important considerations:
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Taxes. Converting an IRA to a Roth requires the IRA holder to pay taxes on the amounts converted today. Money to pay the tax can come out of the IRA itself or it can come from outside capital. Some math is needed to determine which method is better and whether the strategy is worth it (more on that in a minute).
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RMDs. Traditional IRAs require the account holder to take RMDs starting at age 73. This forces them to start liquidating their IRA when they might start to need the money. If the Roth is not an acceptable solution, consider pre-distribution charitable gifts, buying life insurance on grandchildren or funding long-term care plans for children. There are numerous options if this money is truly surplus.
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Timing. Roth IRAs do not require RMDs during the owner’s lifetime. So, converting to a Roth may cost taxes today, but it eliminates taxes in the future. As a result, the owner has more control of the amount of income subject to tax.
Remember, if your client converts their IRA to a Roth, all future appreciation is tax-exempt under current laws. All distributions of capital are tax-free from the Roth, and all income is tax-free as well—five years after the conversion (assuming the owner is over age 59 1/2). Even better, Roth IRAs can be passed to heirs income-tax-free, although current IRA rules force recipients of an inherited IRA to liquidate the IRA fully within 10 years of their death—i.e., no more stretch.
Additionally, RMDs are included in the IRMAA (Income-Related Monthly Adjustment Amount) surcharges applied to higher-income earners. IRMAA is how Medicare increases the premiums paid by adding a surcharge to the Medicare Part B and Part D premiums if a person’s total income exceeds certain thresholds.
If your client decides to convert a percentage of their IRA to a Roth (instead of the full account value), it is important to determine whether the distribution will push them into a higher tax bracket. IRMAA complicates this calculation.
How does an IRA owner convert to a Roth
Step 1: Consider your client’s conversion window
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The ideal window is between age 60 and 73 (before the RMD begins).
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This gives the owner 13 years to manage the tax liability and stay below the IRMAA limits and avoid higher tax brackets.
Step 2: Analyze your client’s tax bracket
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Determine your client’s current tax bracket, considering all sources of income (Social Security, pensions, W-2 income, dividends and interest, etc.).
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Identify where your client’s next highest bracket begins. What is the gap between their adjusted gross income and the next bracket? This is how much the owner can take from their IRA without pushing themselves into a higher bracket.
Step 3: Create a schedule for conversions
Here’s a sample five-year plan:
Depending upon how long the Roth has to grow, it’s probably better to pay the tax with outside funds than to reduce the value of the Roth to pay the tax. This also allows your client to optimize the bracket gap.
Step 4: Calibrate income needs with social security benefits
Social Security benefits grow 8% annually from age 62 to 71. If your client’s budget can postpone taking Social Security based on Roth income distribution, there may be a significant long-term, inflation-adjusted benefit. This analysis may reduce taxes considerably while increasing the stability and amount of retirement benefits in later years.
Step 5: Consider Medicare Premiums
IRMAA surcharges can be very costly. Knowing the cap before the surcharges are added can save significant costs. Using the Roth supplement can help solve this problem.
Let’s work through an example:
Assume your client is in the 22% federal tax bracket and uses outside funds to pay the Roth conversion tax.
If you expect your client’s tax rate to rise in the future (due to RMDs, Social Security or policy changes) converting now can save you more in the long run. Rather than converting all $200,000 at once, consider converting $40,000 to $50,000 a year over four to five years. This spreads out your client’s tax bill, keeps them in a lower bracket, and helps manage their Medicare and Social Security taxation.
Let’s take an example of a 65-year-old whose income is $50,000 a year. If her IRA is $200,000 and she is in the 12% tax bracket, what are the benefits?
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Lock in Low Tax Rates Now. Your client is in the 12% tax bracket, which is historically low. Converting now means she pays taxes at this lower rate rather than potentially higher rates later (especially if tax laws revert in 2026 or her income increases due to RMDs).
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Avoid Future RMDs. Traditional IRAs require RMD starting at age 73 which will increase your client’s taxable income. Roth IRAs have no RMD’s, giving your client more control over their income and taxes and retirement.
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Tax-Free Growth and Withdrawals. Once converted, your client’s Roth IRA grows tax-free. All qualified ithdrawals (after 5 years and age 59½) are completely tax-free, which is ideal for long term planning
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Reduce Future Medicare and Social Security Taxation. RMDs from traditional IRAs can push your clients income above thresholds that trigger IRMAA surcharges on Medicare premiums as well as taxation of up to 85% of their Social Security benefits. NOTE: Roth withdrawals do not count toward these income thresholds.
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Legacy Planning Advantage. Heirs who inherit a Roth IRA can withdraw funds tax-free (within 10 years under SECURE Act rules). This can significantly reduce their tax burden compared to inheriting a Traditional IRA.
Conclusion
A Roth conversion decision should not be taken lightly, and there is no one-size-fits-all solution. But when done correctly with a skilled advisor, this strategy can provide significant tax advantages for retirees, particularly for clients in lower tax brackets who can manage the immediate tax burden while avoiding future RMDs and creating tax-free legacy wealth.
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