You spent decades building your retirement savings. But how much of your 401(k), IRA, 403(b), or TSP will actually be yours to spend?
A strategic Roth conversion may allow you to reposition some of those tax-deferred retirement assets into a Roth account, pay applicable income taxes on the converted amount today, and potentially create a source of tax-free qualified withdrawals in retirement.
The question isn't simply:
At Modern Edge Capital, we help retirees and pre-retirees evaluate those questions as part of a broader retirement income and tax-efficient planning strategy.
Watch our complimentary educational video to learn how strategic Roth conversions work and what factors you should consider before making a decision.
A Roth conversion involves moving eligible assets from a tax-deferred retirement account, such as a Traditional IRA or certain employer-sponsored retirement accounts, into a Roth IRA or other eligible Roth account.
The amount converted is generally included in your taxable income for the year of conversion.
Why would someone voluntarily pay taxes today?
Because once assets are properly converted into a Roth IRA, future earnings can potentially grow tax-free, and qualified Roth IRA withdrawals can generally be taken free from federal income tax. Roth IRAs also do not require lifetime Required Minimum Distributions for the original account owner under current federal law. This can make Roth conversions an important planning tool for certain retirees, but they are not appropriate for everyone.
Traditional retirement accounts generally provide a tax deferral, not necessarily permanent tax elimination.
If you accumulated substantial assets in tax-deferred accounts, distributions from those accounts may eventually become part of your taxable income.
That creates an important retirement-planning question:
There isn't one answer for everyone.
Your current marginal tax rate, expected future tax rate, retirement income, Social Security, pensions, RMDs, investment horizon, estate goals and available funds to pay conversion taxes can all affect the outcome.
That's why we believe a Roth conversion should be evaluated as part of a comprehensive retirement strategy, rather than as a stand-alone transaction.
A properly planned Roth conversion may provide several potential advantages.
Once funds are converted to a Roth IRA, investment earnings can potentially grow free from federal income tax. Qualified withdrawals can also generally be received tax-free.
Retirement assets don't necessarily have to live entirely in one tax category.
Having a combination of taxable, tax-deferred and Roth assets may provide greater flexibility when deciding where retirement income should come from each year.
Traditional IRAs generally become subject to Required Minimum Distributions once applicable age requirements are reached.
Under current federal law, Roth IRA owners aren't required to take RMDs during their lifetime. That may allow assets to remain invested longer and can provide additional flexibility when structuring retirement income.
Converting part of a Traditional IRA before RMDs begin may reduce the balance that will later be used to calculate those required distributions. This does not mean a Roth conversion eliminates taxes. The converted amount is generally taxable in the year of conversion.
The objective is to determine whether intentionally recognizing some income today could improve your overall long-term retirement and tax picture.
Roth assets may also provide estate-planning advantages for some families because qualified distributions can generally be income-tax-free to beneficiaries.
Inherited Roth accounts remain subject to applicable beneficiary distribution rules, so estate and tax considerations should be evaluated carefully.
One of the biggest misconceptions about Roth conversions is that they are an all-or-nothing decision. They don't have to be. For many households, converting an entire retirement account in a single year could create an unnecessarily large taxable event.
Instead, a strategy may involve partial Roth conversions over multiple tax years.
For example, an analysis might evaluate whether converting a specific amount each year could take advantage of available room within a desired marginal tax bracket while avoiding unnecessary additional taxable income. This is sometimes referred to as a Roth conversion ladder or multi-year Roth conversion strategy. The appropriate amount, if any, depends on your individual circumstances.
There are certain periods when evaluating a Roth conversion may be particularly worthwhile.
You may want to explore a Roth conversion if:
> You expect your marginal tax rate to be higher in the future.
> You have accumulated significant assets in tax-deferred retirement accounts.
> You are retired but have not yet begun taking Required Minimum Distributions.
> Your taxable income has temporarily declined.
> You want greater tax diversification in retirement.
> You want to reduce the amount of retirement assets potentially subject to future RMDs.
> You have sufficient non-retirement assets available to pay the conversion tax.
> You have a long investment horizon for the converted assets.
> Leaving tax-efficient assets to your beneficiaries is an important objective.
A Roth conversion can still make sense outside these circumstances, but each situation should be evaluated individually.
For some retirees, one of the most important tax-planning periods occurs after they stop working but before Required Minimum Distributions begin.
Why?
Employment income may have declined, while Social Security, pensions, investment income and RMDs may not yet have fully increased taxable income. That can potentially create a window in which strategic partial Roth conversions deserve consideration.
But this opportunity shouldn't be viewed in isolation. The conversion itself increases taxable income, so the analysis should also consider how additional income could affect other parts of your financial picture.
This is where thoughtful planning becomes especially important.
A Roth conversion creates taxable income in the year of conversion and may potentially:
> Push part of your income into a higher marginal tax bracket.
> Increase Medicare income-related premiums in future periods.
> Affect the taxation of Social Security benefits.
> Affect certain deductions or credits.
> Create state income-tax consequences.
> Require you to use other assets to pay the resulting tax bill.
And Roth conversions generally cannot simply be reversed if you later decide the tax bill was larger than expected.
That's why the goal shouldn't be to convert as much as possible.
The goal should be to determine whether a conversion makes sense and, if it does, evaluate an appropriate amount and timing based on your circumstances.
RMDs can become an important consideration for people who have accumulated substantial tax-deferred retirement savings. Once applicable RMD rules begin, you generally must withdraw a calculated amount from certain tax-deferred retirement accounts each year.s?
Those distributions are generally taxable. A Roth conversion completed before RMDs begin may reduce the amount remaining in the Traditional IRA and therefore potentially reduce future RMDs.
If you are already subject to RMDs, the rules become more complicated. An RMD itself generally cannot be converted to a Roth IRA. The applicable RMD generally must first be distributed before additional eligible assets are converted.
This is an often-overlooked part of Roth conversion planning. Medicare uses modified adjusted gross income from an earlier tax year to determine whether certain beneficiaries pay an Income-Related Monthly Adjustment Amount, commonly known as IRMAA, on Medicare Part B and Part D premiums.
Because a Roth conversion increases taxable income in the year of conversion, a sufficiently large conversion could potentially increase future Medicare premiums. That doesn't automatically mean the conversion is a bad strategy. It means the potential Medicare impact should be incorporated into the analysis rather than discovered afterward.
Depending on your overall income, a portion of your Social Security benefits may be subject to federal income tax. Because Roth conversions increase taxable income, a conversion could potentially cause more of your Social Security benefits to become taxable.
For retirees already receiving Social Security, this is another reason to evaluate the size and timing of a conversion rather than focusing solely on the amount being moved to Roth.
One of the biggest obstacles people encounter with Roth conversions is simple: They don't want to write a large check for taxes today. Depending on the strategy, products being considered, your financial circumstances, state availability and suitability requirements, certain financial products may offer bonuses or other contractual features that could help offset some of the economic impact associated with repositioning retirement assets.
These features do not eliminate the federal income tax created by a taxable Roth conversion, and they should not be interpreted as the IRS tax liability being waived or paid by the government. Bonuses and other product features are subject to the issuing financial institution's contract terms and may be accompanied by surrender periods, withdrawal restrictions, product limitations, fees, adjustments or other considerations.
A financial product should not be selected solely because it offers a bonus.
At Modern Edge Capital, any such strategy should be evaluated based on the client's broader retirement objectives, liquidity needs, time horizon, risk profile and the terms of the underlying financial product.
Learn how we evaluate Roth conversion strategies and the factors that may determine whether one could make sense for your retirement.
A Roth conversion shouldn't begin with a product. It should begin with your numbers.
We review the retirement accounts and financial information you provide, including eligible 401(k), IRA, 403(b), TSP and other retirement assets, along with relevant retirement income sources.
We consider factors such as your current income, tax-deferred assets, retirement timeline, projected income sources and potential RMD exposure. Tax projections are estimates based on assumptions and information provided and should be reviewed with your qualified tax professional.
Rather than automatically converting everything, we can evaluate different scenarios. That may include no conversion, a partial conversion, or a multi-year conversion strategy. The objective is to help you understand the potential tradeoffs before making a decision.
If a Roth conversion appears appropriate, we evaluate how it fits alongside your retirement income needs, investment strategy, liquidity requirements and legacy objectives.
You see the analysis. You ask questions. Then you decide whether moving forward makes sense for you. There is no one-size-fits-all Roth conversion strategy.
A Roth conversion may not make sense if:
> You expect to be in a significantly lower tax bracket in retirement.
> You need the converted assets in the near future.
> You don't have sufficient resources to manage the resulting tax liability.
> The conversion would create undesirable tax or Medicare consequences.
> Your time horizon is too short for the potential benefits to outweigh the conversion cost.
> Your financial or estate-planning circumstances make continued tax deferral more appropriate.
This is precisely why we believe Roth conversions should be analyzed, not automatically recommended.
Before converting retirement assets, consider asking:
Those questions can dramatically change how a Roth conversion strategy is designed.
A Roth conversion generally involves moving eligible assets from a tax-deferred retirement account into a Roth account. The taxable portion of the conversion is generally included in ordinary income for the year of conversion. Once applicable requirements are satisfied, qualified Roth IRA withdrawals may generally be received free from federal income tax.
No. You can generally convert all or part of an eligible Traditional IRA. Partial conversions can allow you to spread the taxable income associated with conversions over multiple years.
Roth conversions are different from direct Roth IRA contributions. Although income limits can restrict eligibility to make direct Roth IRA contributions, there is generally no corresponding income ceiling preventing an otherwise eligible taxpayer from completing a Roth conversion. Other rules and tax considerations still apply.
There isn't one universal "best" time. Potential opportunities can arise during lower-income years, between retirement and RMD age, during certain market declines, or during other periods when recognizing additional taxable income may fit into a broader tax strategy.
Potentially. Moving assets out of a Traditional IRA through a Roth conversion reduces the assets remaining in that IRA. This may reduce future RMDs from the Traditional IRA. Roth IRAs currently have no lifetime RMD requirement for the original owner.
Generally, no. If you are subject to an RMD for the year, the required distribution generally must be taken before additional eligible retirement assets can be converted.
Generally, pre-tax amounts converted to a Roth account are included in taxable income in the year of conversion. The exact tax consequences depend on your account composition and individual tax situation.
Potentially. A Roth conversion increases taxable income and may affect modified adjusted gross income used in determining Medicare income-related premium adjustments.
Potentially. The additional taxable income generated by a Roth conversion may affect how much of your Social Security benefits are subject to federal income tax.
Generally, Roth conversions completed under current law cannot be recharacterized back to a Traditional IRA simply because you change your mind. This makes advance planning especially important.
The answer depends on your circumstances. Using outside taxable funds to pay the conversion tax may preserve more assets inside the Roth for potential tax-free growth. Using retirement assets to pay taxes can reduce the amount converted and may create additional consequences, particularly for individuals under age 59½.
No. Roth conversions can create significant current-year tax liabilities and other financial consequences. Whether one makes sense depends on your tax situation, retirement goals, time horizon, income needs and other factors.
Accumulating retirement assets is only one part of retirement planning.
How those assets are eventually distributed can influence your taxes, retirement income, Medicare costs, RMDs and the assets ultimately left to your family.
A Roth conversion may be one tool for creating greater tax diversification and flexibility.
But the decision should start with analysis.
See how the Roth Conversion Income Shift™ works and learn what questions you should be asking before converting retirement assets.
No obligation. Educational information designed to help you better understand your options before making a decision.
Modern Edge Capital helps individuals and families navigate the transition from accumulating wealth to creating sustainable retirement income. Our planning process focuses on the interaction between retirement income, investments, taxes, risk management and legacy planning.
Rather than looking at any one account in isolation, we help clients evaluate how the different pieces of their financial lives work together.
Serving clients nationwide.
Important Disclosures
This material is provided for general educational and informational purposes only and is not intended as individualized investment, tax, accounting, or legal advice. The information presented should not be relied upon as a substitute for consultation with qualified investment, tax, accounting, or legal professionals regarding your individual circumstances. Roth conversions may not be appropriate for every investor. A Roth conversion generally creates taxable income in the year of conversion and may affect tax brackets, Medicare premiums, taxation of Social Security benefits, deductions, credits, and other tax-related items. Tax laws and regulations are subject to change. References to tax-free Roth distributions assume applicable requirements for qualified distributions are satisfied. Nonqualified distributions may be subject to taxes and penalties. Any projections, comparisons, or hypothetical analyses are based on assumptions and information provided and are not guarantees of future results. If insurance or annuity products are discussed, product guarantees are subject to the claims-paying ability of the issuing insurance company. Bonuses, crediting strategies, income features, surrender periods, fees, withdrawal limitations, and other contract provisions vary by product and carrier and should be carefully reviewed before making a decision. Modern Edge Capital does not provide legal or tax advice. Clients and prospective clients should consult their own qualified tax and legal professionals regarding their individual circumstances. Investment involves risk, including possible loss of principal. Past performance does not guarantee future results.
