Key Points
Roth conversions make sense when you want to enjoy tax-free retirement income and avoid RMDs.
Converting a large sum at once could push you into higher tax brackets and have other less obvious consequences.
If you have a large account to convert, give yourself as many years as possible.
Saving in a traditional IRA or 401(k) may have made sense for much of your career. If you earned a higher salary, those pre-tax contributions may have spared you from paying the IRS a boatload of money.
But if you're now nearing the end of your career, you may be bemoaning the fact that your savings are tied up in a traditional retirement account instead of a Roth. Not only will your withdrawals be taxable in retirement, but you'll eventually be forced to take them each year in the form of required minimum distributions (RMDs).
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That doesn't mean you're doomed, though. A Roth conversion allows you to move funds out of a traditional retirement account and into a Roth. And that could be a smart thing to do if you want to reduce your tax burden during retirement and avoid RMDs.
But if you're going to do a Roth conversion, it's important to do it strategically. And that means taking your time to the greatest extent possible.
Why a one-time Roth conversion can backfire
When you do a Roth conversion, the amount you convert is treated as ordinary income for that year. That means a large conversion can raise your taxable income substantially. And the IRS might get a huge chunk of it.
Let's say you have a $1 million IRA you want to convert to a Roth. If you do it all in a single year, much of that conversion is going to be taxed at the highest marginal rate possible.
But the impact doesn't stop there.
A spike in your taxable income won't necessarily just mean owing the IRS more money. It could also mean having to pay taxes on your Social Security benefits and being charged more for Medicare.
Social Security benefits are subject to taxes once your income exceeds a certain threshold. A $1 million Roth conversion in a single year guarantees you'll be losing a chunk of your benefits to taxes.
Medicare, meanwhile, has a standard monthly Part B premium it sets every year. But if you have a higher income, you may be looking at surcharges on those premiums known as IRMAAs, or income-related monthly adjustment amounts.
IRMAAs come in different tiers, depending on income. But this year's highest IRMAA tier, which applies to single tax-filers with a modified adjusted gross income (MAGI) of $500,000 or more and joint filers with a MAGI of $750,000 or more, adds $486.50 a month to the cost of Part B. And if you're doing a $1 million conversion in a single year, you can pretty much bet on being pushed into that category .
Spread your Roth conversions out over time
Doing a large Roth conversion at once could end up stinging financially. A better bet? Spead that conversion across several years.
Granted, you may only have a limited window to do conversions. But let's say you retire at age 68 and don't have to start RMDs until age 73. If you have a $1 million IRA or 401(k), you could split your conversion across five years, moving $200,000 each year during that period.
Will that result in taxed Social Security benefits and IRMAAs? Quite possibly. But you may be looking at a much lower IRMAA tier.
The lowest tier this year, for example, applies to single tax-filers with a MAGI above $109,000 but below $137,000. But the lowest tier for joint filers applies to couples with a MAGI above $218,000 but below $274,000.
With a $200,000 Roth conversion, you may fall into that latter tier if your tax status is married filing jointly. At that point, the IRMAA that applies is $81.10 a month, which is a lot less painful than $486.50.
Don't let poor timing wreck your conversion strategy
The purpose of doing Roth conversions is to avoid a large tax hit in retirement and gain more control over when you take withdrawals from your savings. But don't make the mistake of cramming your Roth conversion into a single year if you have a lot of money to move over.
Taking a measured, multi-year approach to Roth conversions could help you avoid huge financial consequences that go beyond having a large bill to pay the IRS.
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