Is It Wise to Convert 10% of My IRA into a Roth Each Year to Avoid Taxes and RMDs?

Roth IRAs are not subject to rules on required minimum distributions (RMDs), and qualifying withdrawals from Roth accounts in retirement are also free of federal income taxes. You can get those advantages for funds in your traditional IRA by transferring them into a Roth account. You'll have to pay income taxes now on funds you convert, but spreading conversions over multiple years may help you manage and potentially reduce your overall tax liability. Still, there's no way to completely avoid taxes and conversion isn't always the best strategy. Also, converting a set percentage each year isn't the only way to go about it.

A financial advisor can help you figure out whether and how to do a Roth conversion. Get matched with a fiduciary advisor today.

RMD Rules

If you save for retirement in a pre-tax account such as a traditional IRA, you'll have to start pulling money out of the account after you reach age 73 (or 75 in 2033 or later). Those RMDs are taxable as ordinary income, which can cause problems for some retirees if they are having to receive taxable income when they don't need the funds to maintain their lifestyle.

For example, say you are 73 and receiving $45,000 in taxable income from Social Security, pensions and other sources. If you are a single filer, this will put you in the 12% marginal bracket using the 2024 income tax brackets and your federal tax bill would be approximately $3,500. If you also have to take $20,000 in RMDs, your new taxable income of $65,000 will put you in the 22% bracket and your federal tax bill will rise to approximately $6,500.

Gradual Conversion Strategy

If you convert your IRA to a Roth IRA before turning 73, you won't have to take any RMDs. This will not only help you manage your taxes in retirement, it will also allow your Roth funds to keep growing tax-free. And you can pass them onto your heirs un-taxed as well, making Roth conversion a useful estate planning tool.

These benefits come at a cost, however. If your traditional IRA has $500,000 in it, for example, the tax bill for converting the entire amount in a single year could be about $145,000, using 2024 tax brackets for a single filer. Because of this, people doing Roth conversions sometimes spread the process over several years by converting a portion each year.

If you convert 10% of a $500,000 IRA annually, for instance, it would raise your income the first year by $50,000. Assuming your taxable income from other sources is $50,000, your taxable income increases to $100,000. Using 2024 brackets for a single filer, you would stay in the 22% bracket. Over 10 years, you may have an opportunity to save money on taxes versus the lump-sum conversion.

A financial advisor can help you calculate the tradeoffs for your own Roth conversion strategy and find a suitable approach for your goals. Talk to a financial advisor today.

RMD Conversion Caveats

Despite the appeal, Roth conversion has a number of drawbacks and limitations and is not for everyone. One of the major considerations is whether you will be in a lower tax bracket after retirement. If you are, you may be better off paying taxes then on IRA withdrawals rather than paying taxes now to convert to a Roth.

Also, you can't withdraw earnings on converted funds without owing a 10% penalty until five years after you do the conversion. This is known as the five-year rule. So conversion may not make financial sense if you are near retirement or may need the funds for another purpose, such as paying for a child's college, within five years.

If conversion does seem to make sense, doing a set percentage each year is only one approach. The idea is to convert only enough to bring your taxable income up to the top of your current tax bracket. With this in mind, the dollar figure is more important than the percentage.

Also bear in mind that a decision to do or not do a Roth conversion rests on a number of assumptions about the future, any of which may not turn out as expected. For instance, you may elect not to convert because it appears you'll be in a lower tax bracket after retirement. However, the tax cut in 2017 is set to expire in 2026, after which taxes may be higher. Generally, tax rates have been falling for decades and are low compared to historical averages, suggesting that they may go up before they go down.

Consider matching with a financial advisor to discuss your options for a Roth conversion.

Bottom Line

Converting funds from your IRA to a Roth IRA can be a good move if you think you'll be in a lower tax bracket after retirement. Conversion also gives you more control over withdrawals from your retirement account because Roth accounts aren't subject to RMD rules. You'll have to pay income taxes on any funds you transfer to a Roth, but gradually converting your IRA over a period of years may help you reduce your overall tax burden.

Tips

• Ask a financial advisor for insight into how taxes could impact your retirement plan. SmartAsset's free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

• Find out how much your RMDs will be using SmartAsset's Required Minimum Distribution Calculator.

• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.

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