Key Takeaways
|
No one jumps at the chance to send the IRS money before it’s due. For decades, the common wisdom has been simple: defer, defer, defer. Put as much as possible into 401(k)s, IRAs, and business deductions with the promise that retirement will bring lower tax bills.
But “later” doesn’t always mean “less.” Required minimum distributions, Social Security income, and heirs inheriting large IRAs in their own high brackets can all transform deferred taxes into a bigger burden.
That’s where Roth conversions come in. In our conversations with clients, we’ve found that paying some taxes earlier often gives them greater flexibility later, both in retirement and in legacy planning. In certain situations, strategic conversions can help create flexibility in retirement, smooth tax brackets, and preserve more wealth for your family and causes.
Quick Recap: What’s a Roth Conversion?A Roth conversion is the process of moving funds from a traditional IRA or 401(k) into a Roth IRA. You’ll pay income taxes on the amount you convert today, but from then on, the growth and withdrawals are tax-free. Unlike RMDs, you also decide when and how much to convert, making timing an essential part of the strategy. |
When Does a Roth Conversion Make Sense?
Roth conversions aren’t a blanket recommendation. They tend to be most effective in specific windows of time, often created by changes in your income, filing status, or tax law.
Between peak career income and required distributions (RMDs)
For many families, this “gap period” can be an ideal time to convert. You may no longer be earning at your highest levels, but you haven’t yet started Social Security or RMDs, which can push you into higher brackets. Converting during these years can often mean locking in lower rates and smoothing out your future income stream.
While married and filing jointly
Joint filers benefit from wider tax brackets than single filers, and that difference matters.
One family we worked with illustrates this well: The wife is 70, her husband 85, and together they’ve built more than $1.5 million in retirement assets. With his health declining, she knows that once she’s a widow, higher tax brackets will apply.
To help them prepare for the future, we began a series of conversions: $100,000 last year, $150,000 this year, and similar amounts planned in future years. By shifting assets now, more of her retirement income will be sheltered in a Roth by the time she’s a single tax-filer.
Related: Retirement Planning for High Achievers
Considering State Tax Rules
Federal brackets usually take center stage in conversion decisions, but state taxes can also tip the scales. Some states, like Illinois, don’t tax retirement account distributions at all, including Roth conversions.
One strategy of contributing to a Roth account is to fund a 401(k) and to then convert an equal amount to a Roth IRA. This approach is a means of funding a Roth IRA with money that has only been taxed at the federal level and not the state level. It’s effectively using a conversion strategy to make a large contribution to a Roth IRA.
When Roth Conversions Don’t Make Sense
Just because you can convert doesn’t always mean you should. The right timing usually depends on both your tax situation today and what you expect in the years ahead.
During high-income years
We recently worked with a couple earning well over $1 million annually who were interested in converting $100,000 right away.
After running the numbers, we suggested waiting. With federal, state, and Medicare taxes combined, they were already facing an effective rate close to 45%. Converting in that environment would have meant paying about $45,000 in taxes. By waiting until retirement or during a year with less taxable income and lower tax rates, the opportunity to convert becomes much more compelling.
If you need to use IRA funds to pay conversion taxes
Roth conversions are most powerful when they fit naturally within your financial picture and the full amount can be converted.
That’s why we typically caution clients against using IRA funds to cover the tax bill, since doing so reduces the amount converted and the long-term benefit. We encourage clients to use cash savings or brokerage assets instead, so the full conversion amount can grow tax-free.
Estate Planning: Multi-Generational Roth Conversion Strategies
Roth conversions aren’t only about smoothing your own retirement income; they can also play a meaningful role in your family’s legacy planning.
The SECURE Act and the 10-year rule
Before 2020, children who inherited an IRA could “stretch” withdrawals across their lifetimes. The SECURE Act changed that. Now, most non-spouse heirs must fully deplete the account within 10 years. For children in their prime earning years who inherit IRAs, this often means taking large distributions on top of already high salaries, pushing them into even higher tax brackets.
Here’s how this might play out: Imagine you’re comfortably retired in the 22% bracket, with a goal of leaving your children a $1 million IRA. At your tax rate, that looks like a $780,000 gift after taxes.
But if your children inherit that account and withdraw it in the 32% bracket, the after-tax value is closer to $680,000. That’s $100,000 less than what you were envisioning for them, simply because of the comparative tax rates.
Many people in their 70s and 80s make Roth conversions less for their own benefit and more as a thoughtful gift to the next generation. By pre-paying taxes at their own lower rates, they reduce the tax bill on their IRA and help ensure more of their hard-earned wealth passes as intended.
When viewed this way, Roth conversions can become not just a tax strategy, but a legacy strategy to care for the people and causes that matter most.
How Much Should You Convert?
When we sit down with clients to explore Roth conversions, the first question is often “How much should we convert?”
In our experience, there’s no one-size-fits-all answer. The right amount usually depends on a mix of factors: your current tax bracket, future income expectations, cash available to cover the tax bill, and your long-term goals. We’ve found it most helpful to look at these pieces together and revisit the decision regularly, since life, tax laws, and income rarely stay the same for long.
Here’s how we can help you approach this decision:
- Filling the bracket: Often, we recommend converting just enough to “fill up” your existing tax bracket. The idea is that this allows you to take advantage of today’s rate without pushing additional dollars into a higher bracket. In years when income is unusually low, it might make sense to be more aggressive.
- Covering taxes wisely: Conversions are most effective when you can pay the taxes from non-IRA funds, such as a savings account or taxable investments. This ensures the full converted amount goes into the Roth, maximizing the long-term benefit of tax-free growth.
- Timing the tax bill: If you decide to convert later in the year, say in October, we would want to plan for estimated tax payments earlier (typically starting in March). Spreading out payments can help avoid unwelcome surprises the following April.
Above all, Roth conversions often work best as part of your larger, flexible strategy. Rather than locking into a rigid multi-year plan, we evaluate opportunities annually to make sure the decision reflects your current circumstances and the broader tax environment.
Bringing Strategy into Focus
When we sit down with accomplished professionals and business owners, these conversations often center around something really important: having choices and control over your financial future.
This goes well beyond just tax planning. It’s about maintaining flexibility while potentially preserving significantly more wealth for the people and causes closest to your heart.
If this raised new questions about your own plan, let’s keep the conversation going. We can revisit your conversion strategy during our next review or set aside time to look specifically at how today’s tax environment may create opportunities for you.
____________________________________________________________________________________
If you’re not currently working with us but this way of thinking about wealth feels aligned with your own values, we’d love to connect. A Financial SWOT Session will give us the chance to sit down together, talk through your current tax picture, and uncover opportunities that may help your investments and legacy work more in sync with what matters most to you.
Learn more about how Roth conversions might complement your financial planning.