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Converting a traditional IRA to a Roth IRA can help you minimize taxes in retirement. But executing the conversion strategically is key to maximizing the benefits. A recent Schwab retirement planning report recommends three tactics to reduce your Roth conversion tax bill: max out your current bracket, spread conversions over multiple years and start planning early for tax changes. Any or all can be effective retirement planning tools, but a Roth conversion comes with costs, limits and risks and may not be optimal for everyone.
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With a Roth conversion, you can move funds from a traditional IRA to a Roth IRA and pay income taxes on the amount converted. This can benefit you in retirement by letting your savings then grow and be withdrawn tax-free. It’s a savvy strategy if you expect to be in a higher tax bracket later in retirement or want to avoid required minimum distributions (RMDs) on traditional IRAs.
The mechanics of Roth conversion aren’t particularly difficult and the institution that holds your Roth account can help. But it’s up to you to make sure that you don’t pay too much in taxes. The Schwab Center for Financial Research recently offered three potential ways to reduce the tax hit of your Roth conversion:
1) Max out your current tax bracket with a partial conversion. This seeks to avoid being bumped up to the next bracket by adding smaller amounts to your taxable income each year. For example, if you’re in the 24% bracket, convert just enough funds to bring your current taxable income up to the next bracket’s threshold.
2) Spread out conversions and break them up over several years to control the tax impact. As with the previous strategy, this seeks to avoid being bumped up to the next bracket by adding smaller amounts to your taxable income each year. Stay strategic to maximize each year’s bracket.
3) Think about tax changes nice and early. If you think tax hikes are coming, you can convert more now to avoid higher rates later. Convert before year-end to account for income fluctuations.
To see how this might work, consider a hypothetical example of a single retirement saver who has $200,000 in a traditional IRA. They think their tax rates will be higher in retirement, so they’d like to convert that to a Roth. They make $150,000 annually, putting them in the 24% bracket. For example, in the 2023 tax year, the next bracket starts at $182,101, with a rate of 32%, and the bracket above that is 35% and applies starting at $231,251.
