Deciding When to Do a Roth Conversion: Timing Factors & Tax Planning
One of the first steps in preparing for retirement is evaluating your net worth and determining what percentage of your assets reside inside traditional pre-tax retirement accounts. Upon reviewing the types of accounts they have accumulated, we often see retirement savers with 80% or more of their net worth (excluding their home) in traditional IRAs or 401(k)s, meaning they still owe taxes on the bulk of their savings.
A major risk retirees face, especially those with substantial pre-tax savings, is the potential for tax rates to rise unexpectedly over the next 20-30 years.
At Toberman Becker Wealth, we often recommend Roth conversions and other proactive drawdowns of pre-tax retirement accounts to safeguard retirement portfolios against tax vulnerabilities and allow retirees to settle up with Uncle Sam on their own terms. Explore this section of the Retirement Decision Dashboard to understand timing factors and tax planning considerations involved in Roth conversions.
What is a Roth Conversion?
A Roth conversion moves funds from a traditional pre-tax retirement account into a Roth IRA (Individual Retirement Account), triggering a taxable event where the transferred amount is subject to federal income tax at ordinary income tax rates. Unlike Illinois, state income tax may also apply, such as in Missouri, which imposes taxes on IRA withdrawals and Roth conversions.
Operationally, Roth conversions function similarly to a standard account transfer. Apart from the income tax which should generally be paid from a separate cash account if possible, the transfer remains exempt from additional fees or penalties. Income tax may also be withheld from the pre-tax account during the conversion process, though be mindful that this withholding amount would itself be considered a taxable distribution at that time.
How is a Roth IRA Different From a Traditional IRA?
Roth IRAs contain post-tax funds, whereas traditional IRAs accumulate funds on a pre-tax basis. With taxes already paid on Roth assets, the account is positioned to grow and compound income, tax-free going forward – regardless of any future tax regime changes that investors may face. Alternatively, investors in traditional IRAs have no way of knowing exactly what tax rate might be assessed on their pre-tax accounts in the future. All else being equal, any future increase in income taxes would lower the net amount of a pre-tax account that could be used to fund retirement.
Said another way, Traditional account holders still owe taxes so the government effectively retains a stake in Traditional IRAs and other pre-tax retirement accounts. As a result:
- The government can increase its “stake” at any time by increasing the income tax rate.
- Traditional IRAs are subject to Required Minimum Distributions (RMDs) once an account holder reaches their early-to-mid 70s – inevitably guaranteeing that taxes will begin by this time.
| Traditional | Roth | |
|---|---|---|
| Contributions | Pre-Tax | After-Tax |
| Distribution Taxes | Yes | No |
| Exposed to Future Tax Income Rate Increases | Yes | N/A |
| Required Minimum Distributions | Yes | No |
| Taxable Income for Beneficiary | Yes | No |
Roth IRAs can offer more favorable long-term tax implications than traditional pretax retirement accounts.
What Are the Benefits of a Roth Conversion?
Transferring funds into a Roth IRA has several benefits, including:
- Tax-free growth.
- After a one-time income tax payment at the year of conversion, Roth IRA assets are no longer taxable. Roth IRA funds grow in a permanent income tax-free wrapper insulated from future changes to federal income tax policies.
- Removing uncertainties around future tax hikes.
- Deciding to convert retirement funds at a known tax rate mitigates the risk associated with tax rate fluctuations. As shown in the chart below, tax rates are constantly in flux, rising and falling over time. Roth conversions shield retirees from worry about future tax trends, ensuring that Roth IRA funds remain unaffected by potential tax increases, regardless of the income bracket.
Income tax rates are prone to frequent and unpredictable fluctuations.
- Reducing the Required Minimum Distributions (RMD).
- To ensure tax revenue from traditional retirement accounts, the government requires mandatory withdrawals when an account holder reaches her mid-to-late 70s. Known as Required Minimum Distributions (RMDs), the withdrawal amounts depend upon the account balance at the beginning of each tax year. Since Roth Conversions draw funds from a traditional account and reduces the balance, subsequent RMDs will also be reduced.
- Preventing tax liability for the next generation.
- The income tax-free status of a Roth IRA passes on to your beneficiaries. Adult children who inherit assets are often in their prime earning years and at a high-income phase in their careers. Roth conversions safeguard generational wealth transfers and shield beneficiaries from significant income tax burdens.
At Toberman Becker Wealth, we recommend proactive tax planning and Roth conversions to give clients the peace of mind that their money is secure and that the net amount is 100% theirs. While we lack control over government spending and tax policies, we minimize the risk inherent in this financial planning assumption by taking advantage of the Roth IRA’s known 0% tax rate and decades of tax-free compounded growth.
Once converted, we encourage clients to preserve Roth IRA assets as long as possible. In our financial modeling work, these accounts are frequently the last accounts we would recommend spending from to fund retirement.
When Is the Best Time to Do a Roth Conversion?
The best time to process a Roth conversion is commonly in your mid-to-late 60s, the year after you stop working, and before you turn on Social Security retirement benefits or your pension if you have one. A major goal is to keep other income sources as low as you can in the year you plan to execute a Roth conversion.
While account holders can initiate a Roth conversion at any time, the decision warrants thoughtful exploration of these timing considerations:
- Are we in a bull or bear stock market?
- Clients pay less tax on a Roth conversion when the stock market is down because of the compressed value of stock shares. Then, any subsequent rebound in the stock market would accumulate in the tax-free setting of the Roth IRA.
- What is your Social Security strategy?
- Generally speaking, if you have a solid financial portfolio and a healthy life expectancy, waiting until age 70 to collect Social Security benefits can maximize your fixed income. Delaying benefits also allows you more time to access additional IRA funds while in potentially low tax brackets.
- While Social Security faces well-known solvency challenges, and recent forecasts have raised concerns about the future reliability of benefits, we believe future politicians will have an easier time increasing future income tax rates to fund the retirement system rather than cutting promised benefits to retirees. While no one can predict the future with absolute certainty, the potential for the government to increase taxes to maintain solvency makes transferring funds into a Roth account a strategic risk management maneuver for many retirees.
- Do you also file taxes as a business owner?
- A year in which a business owner incurs a Net Operating Loss (NOL) can present a great opportunity for a Roth conversion. The income tax increase that usually accompanies a Roth conversion can be offset by a business owner’s net operating loss. Therefore, a business owner may be able to use a down year in the business to avoid taxes on a Roth conversion.
At Toberman Becker Wealth, we create custom strategies for every client. Through single-year tax planning models, we demonstrate how a Roth conversion will impact their taxes in that specific year.
Then, we develop long-term models that forecast lifetime total tax savings, RMDs, and compounded growth potential over many decades. Using these models and many possible scenarios, we personalize each Roth conversion strategy to support the client’s retirement goals.
What Are the Risks and Drawbacks of Doing a Roth Conversion?
Roth conversions assume a risk that future tax rates could in fact dip below current tax rates. Similarly, the government could soften RMD requirements to the advantage of retirees. Based on current trends and the economic state of affairs, these scenarios are technically possible, but not highly probable in our view. Here are a few additional risks:
- Roth conversion taxes must be paid in cash.
- Any funds converted into a Roth IRA are considered by the IRS as ordinary income for the year of the conversion. For some, voluntarily parting ways with a large sum of cash creates a psychological barrier to embracing a Roth conversion strategy.
- Additional income from a Roth conversion impacts Medicare and other healthcare premiums.
- Creating an income spike through a Roth conversion requires a careful analysis of tradeoffs to prevent or consider increased healthcare premiums. As Medicare and open marketplace insurance plans are based on income, changes to the household income bracket can alter plan eligibility or negatively impact your monthly premiums.
- Roth conversion funds are subject to the “five-year rule”.
- The IRS imposes a “five-year rule” on Roth IRAs requiring converted funds to remain in the Roth account for at least a 5-year minimum. Early withdrawal results in a 10% penalty fee– and therefore near-term liquidity should be considered.
At Toberman Becker Wealth, we believe future tax rates and RMD requirements will trend in a way that creates an opportunity for many early retirees who opt for Roth conversions. The chart below illustrates how the fiscal gap between government income and spending levels has steadily increased since the early 2010s. Reducing taxes or easing RMD rules would only worsen this gap and increase pressure on federal finances.
How Do I Know if a Roth Conversion Is Right for Me and My Family?
An experienced financial advisor specializing in retirement planning will create a customized approach tailored to your needs. Avoid generic advice, as retirement planning requires personalized strategies on a case-by-case basis.
At Toberman Becker Wealth, we rely on advanced modeling software and comprehensive data to help clients develop a retirement plan. Based on a projected life expectancy well into the 90s, we generate projections to support every decision. These projections consider national economic trends, individual asset mixes, and lifestyle requirements.
In Conclusion
The decision to move forward with a Roth conversion boils down to whether you prefer to settle up with the IRS today, at a known tax rate, or in the future at an unknown rate.
With the right timing strategy, Roth conversions strengthen portfolios and enable retirees to manage assets on their terms, rather than the government’s.
Toberman Becker Wealth is a fee-only, independent fiduciary firm based in St. Louis. Whether starting to invest for retirement in your 50s or actively planning for retirement in your 60s, we help people nearing a transition build a resilient retirement plan. We operate in the best interests of our clients, always, and our top priority is to help you live comfortably now, without sacrificing your financial future later.
If you’re looking for an investment advisor to help you build a diversified strategy that hedges against risk, feel free to book a meeting or give us a call.
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Craig Toberman is a Partner at Toberman Becker Wealth – a fee-only, fiduciary financial advisor based in St. Louis. He assists families and businesses with strategic financial planning and long-term wealth management. He has over a decade of experience in financial services and has crafted custom financial plans for hundreds of families and businesses.