Is There a Sweet Spot For Doing a Roth Conversion?

Roth IRAs (Individual Retirement Accounts) are helpful tools for creating tax-free income in retirement. The total contribution amount for this account is $7,000 (or $8,000 for those over 50) for the 2024 tax year.

 

But because the IRS limits eligibility, high-earners aren’t always able to take advantage of these popular savings vehicles.

 

However, a Roth conversion is a fantastic strategy high-earners use to gain access to the benefits of Roth IRAs and build up their tax-free income bucket. While you may be tempted to jump right in, timing is everything when taking full advantage of the potential long-term tax benefits a Roth conversion offers.

 

We’ll let you in on the “sweet spot” for doing Roth conversions: oftentimes beginning with the tax years immediately following retirement, but before the commencement of Social Security and traditional IRA Required Minimum Distributions (RMDs).

What is a Roth Conversion?

A Roth conversion is a strategy used to convert pre-tax funds from a traditional account (like an IRA, 401(k), 403(b), etc.) into a Roth IRA.

 

This is an excellent option for those who wish to take advantage of tax-free growth and withdrawals in retirement but aren’t eligible to directly contribute to a Roth IRA due to the IRS’s income thresholds. Moreover, this strategy is popular among those who may have accumulated significant pre-tax retirement account balances throughout their career and also those who wish to pass on tax-free assets to their heirs as part of their overall estate planning strategy.

 

Here are the 2024 income threshold and phaseout limits for contributing to a Roth IRA:1  

 

Single filers or married filing separately:

 

• $146,000 to $161,000: May contribute a reduced amount

• More than $161,000: Cannot contribute to a Roth IRA

 

Married filing jointly and qualifying widow(er)s:

 

 

• $230,000 to $240,000: May contribute a reduced amount

• More than $240,000: Cannot contribute to a Roth IRA

 

Roth conversions allow you to convert all or a portion of the funds from your pre-tax retirement account to a Roth account. Unlike the typical income-based Roth IRA contribution limit, there’s no limit to how much you can convert. This technique creates a great opportunity for retirees to transfer funds from a pre-tax status to a tax-free status while they are in a low tax bracket in early retirement. 

Is There a Catch?

Of course, Roth conversions aren’t a get-out-of-tax-free card. The IRS must get their cut either way, whether it’s the year you make the contributions (like Roth account contributions or conversions) or when you withdraw the money in retirement (like a traditional IRA). So you’re responsible for paying taxes on anything you convert from a pre-tax account into a Roth IRA in the tax year of the conversion.

 

Be sure to check with your state’s rules on the taxation of retirement account distributions (and, by extension, Roth conversions). Illinois, for example, does not tax IRA distributions or Roth conversions for state income tax purposes, but Missouri (and federal) laws do.

 

The amount of taxes you pay depends on several factors like your tax bracket, how much money you convert, and if you have multiple IRAs. If the latter is true for you, the taxation rules get much more complex, and the pro-rata rule comes into play. The IRS uses the pro-rata rule to determine how much of the money you’re converting will actually be subject to income tax.

 

You may also encounter the pro-rata rule when you have a traditional IRA with both deductible and nondeductible contributions. If that’s the case, the pro-rata rule says that funds you convert to a Roth IRA will be taxed proportionately based on the percentage of deductible versus nondeductible contributions.

 

This is a complex but important rule to remember when completing a Roth conversion. Be sure to speak with your financial advisor and tax professional before moving forward, especially if your traditional IRA includes pre and post-tax contributions.

 

When Is The “Sweet Spot” For Roth Conversions?

As you’re planning for retirement, you might wonder when the best time is to pursue this strategy. Most people find the ideal time to do a Roth conversion is within the first three to five years of retirement.

 

Why is it optimal during the early years of retirement? Because at this time, you’re likely to be in a much lower tax bracket. In addition, you may not be tapping into income sources like your pension, Social Security, annuity payouts, required minimum distributions (RMDs), or other forms of retirement income. Since you’re in a lower tax bracket now, you’ll ultimately pay taxes at a lower rate.

 

For this reason, market downturns can also be a good time for a Roth conversion, as long as you have the cash flow to cover the tax bill. 

Keep the Five-Year Rule In Mind

Don’t forget about the five-year holding period for Roth IRAs. 

 

What’s the five-year rule?

 

Every time you do a conversion, the contributions plus any growth must sit for at least five years in the account. If you withdraw before the five years are up, you may be on the hook for additional taxes and penalties.

Why Is A Roth Conversion Strategy Relevant For Pre-Retirees To Understand?

 

Roth IRAs offer immense flexibility and benefits for those heading into retirement. Any qualified distributions you make are tax-free, which gives you more freedom to withdraw when you need or want to—unlike traditional accounts with RMDs. 

 

Tax-free income opens more strategic options to better manage your tax bracket throughout retirement; something retirees must be particularly cognizant of.

 

The funds in your Roth IRA can grow tax-free for as long as you like – even beyond your lifetime. As discussed, some retirees find this helpful for estate planning, as you can use it to leave a tax-free inheritance for loved ones. 

 

Roth IRAs provide plenty of great benefits for long-term investors, and you should consider them carefully as a part of your retirement income strategy. If you have questions about making a Roth conversion or would like to discuss your retirement planning as a whole, please feel free to reach out anytime. 

 

Sources:

 

1Amount of Roth IRA Contributions That You Can Make for 2024