Retirement planning involves many decisions, including how and when to pay taxes on your savings. One increasingly popular strategy is the Roth conversion, especially following the changes introduced by SECURE Act 2.0. But what exactly does it mean, and how does it impact retirees?
Below, we break down Roth conversions in simple terms to help retirees and pre-retirees make informed decisions.
What is a Roth Conversion?
A Roth conversion involves transferring money from a traditional retirement account (such as a traditional IRA or 401(k)) into a Roth IRA.
- Traditional retirement accounts are funded with pre-tax dollars. You pay taxes when you withdraw money in retirement.
- Roth IRAs are funded with after-tax dollars, meaning you pay taxes upfront. Withdrawals, including earnings, are tax-free in retirement.
When you convert funds to a Roth IRA, you pay taxes now on the amount converted but benefit from tax-free withdrawals later.
Who Might Benefit from a Roth Conversion?
Roth conversions are helpful for retirees who:
- Expect to be in a higher tax bracket in the future.
- Want to reduce required minimum distributions (RMDs) from traditional accounts.
- Aim for tax diversification, balancing taxable and tax-free retirement income.
- Plan to leave tax-free money to heirs.
Potential Drawbacks of Roth Conversions
- Immediate tax burden: Taxes on converted amounts must be paid in the year of conversion.
- Could push you into a higher tax bracket: Larger conversions might raise your taxable income significantly in a single year.
- Medicare premiums and Social Security: Increased income from conversions can lead to higher Medicare premiums and greater taxation of Social Security benefits.
- Funds unavailable for short-term use: Ideal when the money can grow tax-free for several years.
How the SECURE Act 2.0 Impacts Roth Conversions
The SECURE Act 2.0, signed in late 2022, introduces important changes:
- Increased RMD Age: The RMD age has increased from 72 to 73 starting in 2023, and it will move to 75 in 2033. This gives retirees more time for strategic Roth conversions.
- No RMD for Roth 401(k): Beginning in 2024, Roth 401(k) accounts no longer require RMDs during your lifetime, aligning them with Roth IRAs and providing more flexibility in retirement planning.
- Catch-up contributions in Roth: Starting in 2026, high-income individuals aged 50+ must make catch-up contributions to Roth accounts, emphasizing the Roth option even further.
How to Perform a Roth Conversion
Evaluate your tax situation:
- Calculate potential taxes on the conversion amount.
- Consider partial conversions over multiple years to manage taxes.
Choose the amount to convert:
- Convert amounts that won’t push you significantly higher in tax brackets.
- Coordinate with your financial institution:
- Your custodian can help initiate the transfer directly into your Roth IRA.
Pay taxes:
- Taxes are due in the year of conversion. Ideally, use outside cash (not IRA funds) to cover taxes.
Is a Roth Conversion Right for You?
Consider these key questions:
- Will your tax rate be higher or lower in retirement?
- Can you comfortably pay the upfront taxes from non-retirement funds?
- Will the long-term benefits outweigh the immediate costs in your situation?
Moving Forward
Roth conversions can be an effective retirement strategy, providing potential long-term tax savings and flexibility. However, careful planning is essential. Considering your unique financial situation and potential future tax environment is key.
To understand if a Roth conversion fits your retirement plan, consider scheduling a complimentary meeting to help you evaluate your situation and provide tailored insights.
Source
(1) Mengle, Rocky. “New RMD Rules: Starting Age, Penalties, Roth 401(k)s, and More.” Kiplinger, May 2024, www.kiplinger.com/retirement/new-rmd-rules
For more complete information about your 401(k) investment options, call your company’s plan administrator or your financial professional for a prospectus. The prospectuses contain details on investment objectives, risks, fees, and expenses, as well as other information about your plan’s investment options, which you should carefully consider. Please read the prospectuses thoroughly before sending money. Roth accounts require the owner to be 59.5 years old and have had the account open for 5 years to take penalty-free withdrawals. We do not provide tax or legal advice or services. Always consult with qualified tax and legal advisors concerning your own circumstances.
