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Legally, it’s never too late to make a Roth conversion. You can do this at any time in life, in any amount, so long as you have funds in a qualifying account.
Financially, however, the later you are in life the more likely it is that you will pay more in taxes on a Roth conversion than you will save. This still might be a sound move from an estate planning perspective, since it could save your heirs considerably in both income taxes and required minimum distribution (RMD) requirements. However, if you plan on withdrawing the money yourself, a conversion near- or in-retirement may be too late for real tax savings, depending on your circumstances and goals.
For example, say that you’re 69 years old with $1 million in a traditional IRA. Here are the pros and cons you can consider. You can also match with a vetted fiduciary financial advisor if you’re interested in reviewing your retirement strategy with a professional.
A Roth conversion is when you move money from a pre-tax retirement account, like a traditional IRA or a 401(k), to a Roth IRA. Unlike with contributions, there is no limit to how much money you can convert each year, so long as it all comes out of a qualifying pre-tax retirement account.
The advantage to a Roth conversion is that any money you move will continue to grow untaxed going forward. When you withdraw the money in retirement, you will also pay no taxes on these withdrawals and it won’t count toward your taxable income. Since this money has already been taxed, it is also exempt from RMD requirements. When you turn 73, you can leave this money in place to continue growing.
However, the disadvantage to a Roth conversion is that the entire amount you convert counts towards your taxable income for the year in which you make the conversion. For example, say that you earned $75,000 this year and converted $100,000 to a Roth IRA. So, there is the potential to be bumped into a higher tax bracket and pay higher incremental rates on some of your converted money. However, since you are above 59.5 years old in this case, you can take the money for these taxes from their retirement account. For anyone under this age, you will need to have the cash on hand from other sources.
This will also affect any other programs or eligibility related to your taxable income. For a current retiree, this means that a Roth conversion can affect your Social Security benefits taxes, Medicare premiums, Medicaid eligibility and other programs. For example, taking a Roth conversion will increase your taxable income for the year. Two years later, your Medicare premiums will be calculated on this year’s taxable income, and so those premiums will likely increase for the year.
When you make a Roth conversion, you must also consider what is called the Five Year Rule. This is a requirement that, after a conversion, you must leave the earnings in place for at least five years. There is an exception to this rule if you are over 59.5 years old, which in practice means that most households will not need to worry about this rule if they use their Roth funds for retirement income.
Conversion taxes can significantly increase the overall taxes that you pay on your retirement portfolio.
Take an extreme example. Say that you withdraw $75,000 per year from your portfolio each year as your only retirement income. Setting aside portfolio growth, this would give you income for approximately 13 years, with an effective tax rate of approximately 11.12%. You would pay about $8,341 per year, for $100,092 in total.
On the other hand, say that you convert all $1 million in a single year. This would give you an effective tax rate of about 32.28%, and you would pay $322,784 in total taxes. Despite the Roth’s long-term savings, you would still pay significantly more in up-front costs than you would have paid over the long run.
Remember, assumptions matter. A financial advisor can help you do the math based on your own circumstances.
The best way to mitigate this is usually what’s called a staggered conversion. This is when you move your money a little bit at a time to reduce your tax bracket and, as a result, your overall tax rate. Take our example above again. Say that, instead, you move your money $100,000 at a time over 10 years. Setting aside other withdrawals or returns, this would reduce your effective tax rate to approximately 13.84%. You would pay about $13,841 per year, for $138,410 in total conversion taxes.
Finally, it’s also important to remember the opportunity cost involved with conversion taxes. The money that you pay in up-front taxes today is capital that will not be available for continued long-term growth. This means that, even if you pay less in conversion taxes than you would have paid in long-term income taxes, you might still lose money overall because of the portfolio’s reduced long-term growth.
Here, you are a 69 year old with $1 million in a traditional IRA. Should you convert your money to a Roth IRA? The answer depends on what you want to achieve.
First, unfortunately in any given year a Roth conversion does not count as an RMD. You will have to begin taking required minimum withdrawals at age 73, and with a $1 million portfolio that minimum withdrawal would be about $37,735. This means that if you wanted to make a staggered conversion, you would have to take your required minimum withdrawal and then make the conversion in addition to that.
Beyond those first few years, if your goal is to avoid additional RMDs beyond the scope of your conversion timeline, or if you want to maximize the value of your estate, a Roth conversion will probably work. A Roth IRA is not subject to RMD rules, so once you have fully converted your traditional IRA to a Roth IRA, you would not have to take any additional minimum withdrawals. It can also help maximize the long-term value of your estate by letting you leave your money in place, and letting your heirs cash out the portfolio tax-free.
However, if your goal is to minimize taxes and boost the value of your portfolio for yourself, the issue gets much more complicated. Then, it becomes about balancing your current portfolio and tax status against your likely future tax status and long-term opportunity costs.
Properly structured, a Roth conversion can save you money. If you take structured conversions over a long enough period of time, you can usually reduce your conversion taxes below your lifetime income taxes. However, current or near-term demands on your portfolio significantly complicate the analysis of a Roth conversion.
At age 69, it’s likely that you will need to draw on this portfolio for income in the near future, if you haven’t begun doing so already. As a result, it’s likely that your Roth portfolio won’t have time for the untaxed growth that offsets the up-front costs of conversion taxes. A Roth IRA is also typically most advantageous when you pay lower tax rates when you make the conversion than when you will take withdrawals, which again will likely not apply.
Run the numbers with your financial advisor, because it’s worth considering your long-term rates of return against likely taxes. However, if you aren’t already paying taxes on this money, you will have to begin doing so soon. This alone will likely make it very difficult to see any real financial benefit to making this conversion.
If you don’t have a financial advisor, consider using this free tool to match with a vetted fiduciary advisor.
Should you make a Roth conversion when you have already retired? While this can have some value for issues like estate planning and mitigating RMDs, by and large current retirees will usually lose money in taxes and opportunity cost with a Roth conversion.
If you want to dive into a Roth conversion, there are a lot of strategies to help maximize the value of your untaxed portfolio. After all, with the right timing, a Roth IRA can be the most valuable retirement asset on the market by far.
Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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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