As the astute and money-wise Benjamin Franklin famously said,
“In this world, nothing is certain, except death and taxes.”
If he were alive today, I suspect he might add a third observation: Sometimes paying taxes can feel a little too much like the first item on that list. While there isn’t much we can do about the former, a well-timed and well-planned Roth conversion can help us take a more strategic approach to taxes.
First and foremost, what is a Roth conversion? It is the act of voluntarily moving money from a pre-tax retirement savings account to an after-tax account, choosing to pay income taxes on those dollars today rather than in the future. At first glance, intentionally creating a larger tax bill may seem counterintuitive. After all, most of us spend our lives looking for ways to reduce our taxes, not increase them. However, a well-timed Roth conversion can be one of the most powerful tax-planning strategies available. By paying taxes at the right time and at the right rate, you may be able to reduce your lifetime tax burden, increase tax-free income in retirement, and potentially save thousands of dollars in taxes over the long run.
To demonstrate just how powerful this tax-planning tool can be, I’ve outlined five cases in which a Roth conversion could meaningfully save thousands of dollars in taxes.
Case #1 – Getting Ahead of Required Minimum Distributions
One of the most beneficial ways a Roth conversion can be used is to reduce the amount of future Required Minimum Distributions. RMDs are annual withdrawals that the IRS requires individuals to take from most pre-tax retirement accounts once they reach a certain age. Failure to do so can result in significant penalties, and while the underlying calculation for RMDs can be slightly complex, the concept is simple: The larger the pre-tax account balance, the more money the IRS will require you to take out of your account and, subsequently, recognize as taxable income.
During the period known as the “gap years,” many retirees find themselves in temporarily lower tax brackets because their employment income has ceased and RMDs have not yet begun. By strategically converting pre-tax dollars to Roth dollars during this period, they can pay taxes at potentially lower rates while reducing the balance of their pre-tax accounts. The result is often smaller future RMDs, greater tax flexibility in retirement, and potentially a lower lifetime tax bill. In other words, by voluntarily paying some taxes today, you may be able to avoid paying significantly more taxes tomorrow.
Case #2 – Making the Most of Lower-Income Years
It may make sense to do a Roth conversion in a year when you have higher tax deductions or lower taxable income than in “typical” years. A few examples where this can be common:
- Career changes that temporarily reduce income
- Large tax-deductible items, such as charitable giving, that lower taxable income
- Business owners, sales professionals, or others with variable income who experience an unusually low-income year
In all these examples, lower taxable income can result in reduced tax rates and more room within your current tax bracket. A Roth conversion during these periods can be especially valuable because it allows you to take advantage of a temporary tax opportunity to meaningfully reduce future taxes, giving you more flexibility and control over your income later. When the IRS gives you a lower tax bill than usual, it may be worth considering whether that year’s “discount” should be used to move some money into the tax-free bucket.
Case #3 – Planning for Taxes Before Moving to Another State
Another less obvious situation where a Roth conversion may be beneficial is relocation to a state with higher income taxes. It is not uncommon for individuals, especially in retirement, to move from one state to another to avoid the cold winter, be closer to family, or simply enjoy a change of scenery. In these situations, state tax laws can have a meaningful impact on retirement income. For example, Iowa currently does not tax qualifying retirement income distributions for individuals age 55 and older. However, if an Iowa retiree moves to a state such as Wisconsin, those same distributions may be subject to state income tax. Completing a Roth conversion before the move may help reduce future state taxes. By paying taxes under Iowa’s favorable rules, retirees may avoid some of the state taxes that would otherwise apply after relocating.
Case #4 – Planning Ahead for a Surviving Spouse: The Widow’s Tax
A Roth conversion also can help mitigate what is often referred to as the “widow’s tax.” When one spouse passes away, the surviving spouse typically transitions from filing a joint tax return to filing as a single taxpayer. Because single tax brackets are more compressed than married filing jointly brackets, the same amount of income can result in a significantly higher tax rate.
The challenge can be even greater when large pre-tax retirement accounts are involved. In most cases, the surviving spouse rolls the deceased spouse’s IRA into their own account. While this simplifies account management, it also creates a larger IRA balance and, over time, potentially larger Required Minimum Distributions (RMDs). As a result, a surviving spouse may find themselves paying taxes as a single filer on income levels that were previously taxed much more favorably when filing jointly.
Strategic Roth conversions during the years when both spouses are alive can help address this risk. By converting pre-tax assets to Roth assets while still benefiting from the wider joint-filing tax brackets, a couple may reduce future RMDs and lower the amount of taxable income the surviving spouse must recognize later in life. As an added bonus, the surviving spouse will have an account with tax-free income that they can withdraw from, adding more flexibility to their financial plan.
Case #5 – Making the Most of a Net Operating Loss
The final case for a Roth conversion would be in years when a business owner has a Net Operating Loss (NOL). In those years, a business’s tax-deductible expenses exceed business income, creating a loss that can be used to offset taxable income. In years when a NOL is available, a Roth conversion can become particularly valuable because the loss may offset some of income generated by the conversion. This can allow you to move money from a taxable retirement account into a Roth account while paying little or no additional tax. In the right circumstances, a NOL can create a rare opportunity to make a Roth conversion at a steep tax discount, or even potentially tax-free.
Tax Considerations Before Making a Roth Conversion
Of course, with any planning tool, the question of whether to do a Roth conversion is not as straightforward as it seems. There are always a few complexities that you will have to keep in mind anytime you are trying to utilize tax-saving strategies.
The first is that the conversion amount is taxable at ordinary income rates. As I stated previously, Roth conversions take money that has never been taxed and deposit it into an account that, in most cases, will never be taxed. While this may end up being a great deal for you, the IRS is not going to simply let you make this transaction for free (though we can all dream!). The amount being converted is subject to ordinary income tax rates, essentially adding the conversion amount on top of your taxable income. This can result in a hefty tax bill in April of the following year. Making sure you have enough money saved to foot the bill come tax time is of paramount importance in these situations.
This brings me to my second point: Roth conversions can bump you into the next tax bracket. Due to the conversion amount being added to your taxable income, if you are near the edge of a tax bracket, converting income may bump you into the next bracket, which could negate the effectiveness of a conversion.
In some cases, such as moving from the 22% bracket to the 24% bracket, the benefits of doing a conversion may outweigh the additional tax cost. However, when a conversion moves you from the 12% bracket to the 22%, or the 24% to the 32% bracket, it may be worth considering whether a conversion would still be effective.
Roth conversions can sometimes have hidden additional costs that show up elsewhere and if you aren’t accounting for them, they can reduce the effectiveness of a conversion. For example, if you are in retirement and are currently on Medicare, Roth conversions can sometimes result in increased Medicare premiums due to IRMAA increases (IRMAA stands for Income-Related Monthly Adjustment Amount). If your taxable income reaches certain thresholds, the Social Security Administration will increase your Medicare premiums to cover a larger share of medical and prescription drug costs, which can result in thousands of dollars in otherwise avoidable Medicare premiums.
Another example is the Net Investment Income Tax (NIIT for short). NIIT is a 3.8% surtax that is added on top of regular income taxes when your income exceeds certain amounts. It applies to interest, dividends, capital gains, and other forms of investment income. While the Roth conversion amount, itself, would not be subject to this surtax, it may increase your taxable income to the point where you cross that threshold and other forms of income become subject to it.
Finally, tax credits or deductions that you may have otherwise qualified for may be phased out or eliminated entirely if your taxable income is too high. The enhanced senior deduction is a good example of this: Once you exceed the applicable threshold, the deduction is reduced by 6% for every dollar of income above that line.
There are many reasons why a Roth conversion may fit into a financial plan but in essence, it boils down to this: By taxing yourself now with a Roth conversion, you could be saving yourself future taxes down the road. How can you determine whether a Roth conversion could help reduce your future tax burden? As with many financial decisions, the best approach may be consulting your financial advisor and tax professional. They can help you navigate the complexities associated with Roth conversions. At Foster Group, truly caring for our clients means taking the time to learn what’s in their hearts and helping them pursue their goals.
