Here’s a pattern I see almost every week.
A couple is nearing retirement but still working. Their income is as high as it’s ever been and so is their tax rate. They know retirement is coming but they’re looking ahead with some apprehension: When should they claim Social Security? What should they do with the large balance they’ve built in pre-tax retirement accounts? And is there anything they should be doing now to reduce the tax bill later?
What I usually show them is that retirement isn’t one tax environment. It’s three:
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- Final working years: Income is often at its peak, along with your marginal tax rate.
- Early retirement: The paycheck has stopped but Social Security may not have started and RMDs haven’t begun. Income can fall sharply.
- RMD years: Social Security is coming in, required withdrawals begin and taxable income may climb again.
That middle stretch is often where Roth conversions become especially useful.
A Roth conversion is a trade: You pay income tax today on money you move out of a pre-tax retirement account, in exchange for tax-free growth and tax-free withdrawals later. Sometimes that trade is worth making. Sometimes it isn’t. The answer depends on your tax rate today versus the tax rate you’re likely to face later, when or whether you’ll need the money and what you ultimately want those assets to accomplish for you and your family.
If you’re considering a conversion, those are the questions we can work through together.
When a Conversion Makes Sense
For many retirees, the best opportunity arrives in the years after they stop working but before Social Security and required withdrawals push taxable income higher again. That window might last five years. It might last 10. In some cases, it’s shorter.
What makes it valuable isn’t simply that income is lower. It’s that you have choices. You may be able to decide how much income to recognize, how much of a tax bracket to use and how quickly to move money from accounts that will eventually produce taxable RMDs into a Roth account that won’t.
Timing matters.
Too often, by the time someone calls me, they’re already partway through that window. We may have lost a year or two that could have been useful. Other times, someone is eager to convert while they’re still earning at their peak and paying a high marginal rate. And sometimes they don’t start thinking seriously about it until RMDs have already begun, when many of the easiest planning opportunities are behind them.
The pattern is remarkably consistent. What changes is where you are on the timeline — and how much flexibility you still have.
How RMDs Change the Math
Required Minimum Distributions, or RMDs, are the IRS’s way of making sure your pre-tax savings eventually get taxed. Once you turn 73 (or 75, if you were born in 1960 or later), you must start pulling a set percentage out of your pre-tax accounts every year, whether you need the money or not.
That can be a problem if you’ve done a good job saving. A pre-tax account worth $1 million at age 60 can grow to roughly twice that by age 73 at typical growth rates. The bigger the balance, the bigger the required taxable withdrawal. Stack Social Security and any pension on top and many retirees end up paying tax at brackets they never planned for.
Converting some of your pre-tax balance to a Roth before RMDs start does two things: It shrinks the pre-tax account that’s subject to required withdrawals and it moves future growth into an account that won’t be taxed again.
How Conversions Affect Medicare
Once you’re on Medicare, your monthly premiums for Part B and Part D are tied to your income. Earn above certain thresholds and your premiums go up. The surcharge is called IRMAA, which stands for Income-Related Monthly Adjustment Amount.
Two features of IRMAA are worth paying attention to:
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- It works in tiers: Cross an income threshold, even by one dollar, and you move into the next surcharge tier. There’s no gradual phase-in.
- It uses a two-year lookback: The IRS bases this year’s Medicare premiums on your tax return from two years ago. A conversion you do today shows up on your Medicare bill two years from now.
Careful management of your income is important when on or approaching Medicare. Filling up a tax bracket without tipping over an IRMAA threshold can save you a few thousand dollars a year. A conversion that’s even slightly too large can add Medicare premiums you didn’t plan for but only for one year. Perhaps this surcharge is a tradeoff worth accepting — the way to know is careful planning.
Where the Tax Payment Comes From
This is one of the parts of the conversation people underestimate most: It’s not just how much tax you’ll owe but where the money to pay that tax will come from. A conversion generally becomes more attractive when you have money outside your retirement accounts available to cover the tax. That allows more of the converted amount to remain in the Roth and continue growing tax-free.
When you convert money from a pre-tax account to a Roth, you owe income tax on the amount you convert. Where that tax payment comes from matters more than you’d think.
If you pay the tax from inside the IRA, by withholding it from the converted amount, you’ve shrunk your Roth before it starts growing. You want every dollar to make it into the Roth and stay there. That’s where the long-term value comes from.
Paying the tax from a regular brokerage or savings account keeps the Roth whole. There’s a catch. If you sell appreciated investments to free up the cash, you may owe capital gains tax on top of the income tax from the conversion. In some cases, the combined cost is more than the conversion is worth.
If you have charitable giving goals, it can help to integrate charitable giving with Roth conversions; giving can reduce taxes and make the math work.
What a Conversion Means for Your Heirs
Even when a conversion looks neutral for your own lifetime taxes, it can still have a tremendous impact for the next generation.
When children or other non-spouse beneficiaries inherit a pre-tax IRA, the withdrawals get taxed as ordinary income at the beneficiary’s tax rate. Under current rules, most non-spouse beneficiaries must empty an inherited retirement account by December 31 of the 10th year after the original owner’s death. Depending on the circumstances, annual distributions may also be required during that 10-year period.
If your children are in their prime earning years when they inherit, that 10-year window can fall right on top of their highest-income decade. The tax bill can be painful.
Roth accounts still follow a 10-year rule with an important difference. Since original Roth IRA owners never face RMDs, Roth IRA beneficiaries do not have to take annual RMDs in years 1-9, provided the Inherited Roth IRA is fully depleted by December 31 of the 10th year following the original owner’s death. At typical growth rates, the Inherited Roth IRA often can double in those 10 years. Since withdrawals from the inherited Roth IRA are tax-free, this important difference can be easy to overlook yet powerful.
For households that don’t expect to spend down their IRA during their lifetime, the comparison isn’t necessarily your tax rate today versus your tax rate later. It may be your tax rate versus your children’s tax rates when they inherit. If they’re in their prime earning years at the time, that 10-year withdrawal window can land directly on top of some of their highest-income years. A Roth conversion can effectively allow you to prepay some of that tax at your rate rather than leaving the bill for them at theirs.
Questions Worth Working Through
If you’re considering a conversion, these are the questions we’d talk through together:
- What does your tax rate look like today and what is it likely to look like at age 73 and beyond? If your future rate is going to be higher, that can make converting now more attractive.
- Do you have enough money outside your retirement accounts to pay the conversion tax? If not, we’d probably reconsider.
- Will the conversion push your income across a Medicare threshold? If so, can we size the conversion to stay under it or spread it across several years? What are the tradeoffs?
- If you’re going to sell investments to cover the tax, how much capital gains tax will that trigger? Sometimes the all-in cost outweighs the benefit.
- Can your charitable giving goals create better Roth conversion opportunities? Coordinating charitable giving with a conversion may help manage the overall tax impact.
None of these have one-size-fits-all answers. Our approach emphasizes starting with each client’s purpose and values and how their income, goals, timeline and desired family and community impacts interrelate.
Where to Go From Here
If you’re facing a similar situation, the best thing you can do is start the conversation early. Most of the missed opportunity we see comes from people waiting too long. Once RMDs are already in motion, your options narrow.
If you’re a current Johnson Financial Group client, reach out to your advisor and ask whether it’s worth modeling a Roth conversion for your situation. If you’re not yet a client and you’d like a second set of eyes on whether a Roth conversion fits into your broader plan, we’re glad to talk it through.
A Roth conversion is the kind of decision that’s much easier to get right when you plan it years in advance, instead of months.
