Retirement accounts come in two types: those that give a tax benefit when money is initially contributed and those that give a tax benefit when money is withdrawn. Most often, during a person’s working years, contributions go into the first type, such as a 401(k) or Traditional IRA, rather than the second type, known as a Roth. 401(k)s and Traditional IRAs lower current taxes as money comes directly from their paycheck pre-tax and grows tax deferred. As a result, many of our clients enter retirement with 401(k)s and IRAs as their most significant assets.
Retirees will eventually pay taxes on these accounts, whether they need income or not. To plan for these eventual taxes, it may make sense to take money out today to make future tax liability a current one through a process known as a Roth Conversion. To determine if Roth conversions make financial sense, there are five things to consider:
Required Minimum Distributions (RMD)
In retirement, income is often lower, and the tax rate a person pays is consequently lower. Taxes are paid when money is withdrawn from retirement accounts to meet expenses. The result is taxes are deferred from high tax rate working years to low tax retirement ones. However, it doesn’t always play out this way. Social Security income, pension income, and required minimum distributions (RMD), which start at age 73, may mean more taxes paid in retirement. One strategy is to convert a portion of a Traditional IRA into a Roth in the period between when retirement starts and when RMDs begin.
Medicare premiums and healthcare subsidies
In addition to income tax, conversions can directly impact Medicare premiums and subsidies received through the Affordable Care Act. As of 2024, a married couple with an income under $206,000 will pay $349.40 monthly for Medicare Part B. As income increases, Part B premiums also increase. The premium can go as high as $1,118 monthly for couples making over $750,000. Converting to a Roth will increase current income, which could result in higher Medicare premiums during the conversion years but may reduce premiums over time.
For any individual obtaining health coverage through the Affordable Care Act, the number of government subsidies received is based on income. Greater income received means less subsidies provided and vice versa. According to healthinsurance.org, a 62-year-old with $50,000 of income would receive $1,068 per month in government assistance. That number is reduced to $654 monthly when income doubles to $100,000.
Where you live
Where retirees will call home in retirement is also an important factor. For example, if a retiree plans to move to an income tax-free state like Florida, a conversion may become less attractive if there is no state income tax. In Connecticut, retirees are afforded tax breaks on retirement account distributions, but these breaks do not apply to everyone. A married couple filing jointly with less than $100,000 will have 50% of their IRA income exempt from Connecticut taxes in 2024. The exemption will increase to 100% by the 2026 tax year. The tax break begins to phase out when income is over $100,000 and is eliminated when income is greater than $150,000.
Legacy planning for loved ones
There are alternate strategies to consider in addition to what taxes will look like in retirement and where one lives. One of those strategies is around legacy planning for loved ones. In 2020, the government made changes to IRA accounts inherited by non-spouse beneficiaries. These changes require the full distribution of inherited IRAs within ten years of the original owner’s death. Recent IRS revisions now also require yearly distributions during the 10-year period. For loved ones who are working and in their peak earning years, these additional distributions can create large tax bills. While a conversion into a Roth does not eliminate the requirement to withdraw within ten years, it does leave beneficiaries with no tax burden.
Future tax rates
It is true that today’s top tax rates are historically low, as are tax rates on investment gains. While a reasonable assumption would be for tax rates to increase, this should not be the main reason for doinga conversion.
In 2026, the Trump Administration tax cuts are scheduled to sunset, with tax rates reverting to 2017 levels. This means the highest marginal rate of 37% would increase to 39.6%. Questions are often posed about the viability of doing Roth conversions today based on these potential tax code changes. When it comes to financial planning, however, it is important to only utilize the information that is known at the time a decision is being made. As New York Yankee great Yogi Berra once said, “It is difficult to make predictions, especially about the future.”
Converting to a Roth is a balance of long-term goals and shorter-term current tax payments. Please consult your advisor to determine if Roth conversions are right for you.