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Roth conversions are often described as a smart move for retirees who want tax-free income later in life. But the same strategy that creates long-term savings for one household could trigger higher taxes, Medicare premiums or lost deductions for another.
Christina Wiebelt-Smith, a CPA and wealth advisor Gertsema Wealth Advisorssaid, “With Roth conversions, the name of the game is to take Uncle Sam out of the equation and keep as much of your hard-earned money as possible.” Here are the situations when it works best.
When can you get a lower tax rate now
Wiebelt-Smith said Roth conversions work best when retirees can withdraw money from pretax accounts at a lower tax rate today than they will face in the future. This may include times when there is a possibility of future tax increases due to required minimum distributions, portfolio growth or the surviving spouse filing as single. “By making the change, retirees prepay taxes and make all future growth tax-free,” he said.
However, Matt Hyland, a financial planner Arnold & Mote Wealth Management, That said, tax rates are only one part of the equation. “While income tax rates are the primary driver, other taxes such as the net investment income tax, Medicare IRMA, taxes on capital gains and qualified dividends and taxes on Social Security may also be considered.”
When you can stay under the income limit
Where Roth conversions often backfire is at the income threshold, leading to a sharp jump in taxes. These “cliffs” may trigger a disproportionate increase in taxes or Medicare premiums with little increase in income.
For one thing, Hyland said, the taxable income for married households is just over $100,000, where income above that threshold starts being taxed at 22% instead of 12%. Another big jump occurs above $403,000, when the marginal rate rises from 24% to 32%. “That 10% difference is a huge jump,” he said.
Medicare IRMAA changes Roth conversion math
In addition to income taxes, retirees also need to consider the Medicare IRMAA limits when making a Roth conversion. “Going just one dollar over those income thresholds will trigger the entire IRMAA surcharge,” Hyland said. “In a worst-case scenario, one dollar of income could cost a married couple more than $2,000 per year in extra Medicare premiums.”
However, there is also potentially a trade-off, Hyland said, that “could result in savings for years or decades.”
The key, said Wiebelt-Smith, is to weigh the short-term pain against the long-term benefits. “Tax planning can no longer be done in a vacuum. Every decision creates a ripple effect,” he said.
Partial and multi-year conversion
Consultants agreed that full conversions are rarely optimal. Partial conversions spread over several years give retirees more control over tax brackets, Medicare premiums and deductions.
Wiebelt-Smith insisted on timing. “Most retirees have enough money in traditional IRAs that converting the entire account in one year would be extremely expensive,” he said. “By spreading Roth conversions over several years during a low-income window, retirees can manage tax brackets, preserve deductions, limit Medicare premiums and reduce future RMDs.”
When market timing and RMD planning tip the scales
Market conditions and future required minimum distributions (RMDs) can also determine whether a Roth conversion is a good idea, said Jennifer Kohlbacher, CPA and director of wealth strategy. Mariner Wealth Advisors. “When markets decline, we often take advantage of the opportunity to convert IRA assets at temporarily lower values.”
He described a recent case where timing during a market decline helped a client convert a large portion of their IRA and saved them over $300,000 in income taxes.
Future RMDs are often the underlying driver. “RMDs are like a faucet you can’t turn off,” Wiebelt-Smith said. “The Roth conversion helps reduce the pressure so it can be managed.”
Finally, Roth conversions do not save money by avoiding taxes altogether, but rather by deciding what taxes retirees are willing to pay in order to avoid larger taxes later.