Introduction
Let’s cut to the chase: Roth conversions can be a game-changer for your retirement planning. They offer a way to move money from tax-deferred accounts to tax-free ones, setting you up for a more flexible financial future.
The trick is, however, knowing when it makes to use them (because it doesn’t, always).
Read on to learn more about Roth Conversions, why they matter and how they can help you plan for your retirement.
Why Roth Conversions Matter
Roth conversions are not just a buzzword; they’re a strategic move. Here’s why:
- Tax Diversification: Having both Roth and traditional accounts allows you to optimize your tax situation in retirement. How? You’ll have to make withdrawals in retirement. Nice to be able to give yourself more control over your future tax situation.
- No RMDs: Roth IRAs don’t have Required Minimum Distributions, giving you more control over your money. What are Required Minimum Distributions? Click here to find out.
Problems you should aim to avoid
Tax Rates
Historically, tax rates have fluctuated. According to the Tax Policy Center, the top marginal tax rate in 1980 was 70%. Today, it’s around 37%. Who knows what it’ll be when you retire?
RMD Costs
Fidelity reports that failing to take RMDs can result in a 50% tax penalty on the amount not withdrawn. That’s a costly mistake you can avoid with a Roth IRA.
Why? Roth IRAs have no RMDs. That can make planning your retirement much easier because of the added control you have over your finances.
The Conversion Process
Converting is straightforward but needs to be done carefully:
- Choose the Account: Decide which traditional IRA or 401(k) to convert.
- Calculate the Tax: Know the tax implications before making the move.
- Execute the Conversion: Contact your financial institution to initiate the process.
Meet Sarah
Sarah was a marketing executive and was heavily invested in her 401(k). She worked hard for years, building her 401k and pretax savings, and budgeting thoughtfully.
By the time she retired at 55, she was worth over 4 million in her pretax retirement accounts when she realized that she lacked any tax diversification.
She then heard about required minimum distributions starting at 73 and being about 4-5% of her account balance by that point. If her accounts grew by 10%, she’d have over 12 million by 73 meaning she’d be forced to spend $500,000 per year, not even including social security.
She decided to convert some of her assets every year from 55 – 73 into Roth to take advantage of lower tax rates given the fact she’s not working anymore. This way she’s capturing the benefit of lower income years. Every year, she targeted staying in the 32% tax bracket. She’s married and her spouse retired at the same time but had no assets saved as she had.
They targeted their taxable income falling at $364,200 every year (pretax income – the greater of the standard deduction or itemized deductions = taxable income for most retirees) so their tax rate was 32% federal. Therefore, they were able to convert a large portion of their retirement before turning 73.
| Marginal Tax Rates for 2023 | |||
| Tax Rate | Single Filers | Married Filing Jointly | Heads of Households |
| 10% | ≤ $11,000 | ≤ $22,000 | ≤ $15,700 |
| 12% | > $11,000 | > $22,000 | > $15,700 |
| 22% | > $44,725 | > $89,450 | > $59,850 |
| 24% | > $95,375 | > $190,750 | > $95,350 |
| 32% | > $182,100 | > $364,200 | > $182,100 |
| 35% | > $231,250 | > $462,500 | > $231,250 |
| 37% | > $578,125 | > $693,750 | > $578,100 |
Now, she enjoys more tax flexibility and has diversified her retirement income sources.
The Downsides
Nothing is perfect. Roth conversions can be costly upfront and may not be ideal if you expect to be in a lower tax bracket in retirement. The taxes themselves are expensive. Whether they make sense depends on how much you have saved, your longevity (longer = better argument), and your confidence in the stock market.
Your Financial Future, Upgraded
So, there it is. A Roth conversion isn’t just a financial move; it’s a lifestyle decision. It’s about gaining control, diversifying your tax situation, and setting yourself up for a more comfortable and flexible retirement. Make the move. Your future self will thank you.
