Is a Roth Conversion Right for You?
THE 401(k)
Years ago, the 401(k) was created through the Revenue Act of 1978. It was pitched as an account that would a) help lower taxable income while working (contributions are tax-deductible), and b) individuals in retirement would be in a lower tax bracket when they retire compared to when they were working. This pre-tax vehicle allows employed individuals to contribute part of their paycheck to an account that is intended to be accessed in retirement. When these funds are drawn out, it is taxable income to the individual.
While this could be intrinsically true that you may be in a lower tax bracket, many individuals moving into the retirement stage of life do not wish to live a lesser lifestyle than when they were working. On the contrary, many individuals could spend more in their first decade of retirement than when they were working, as trips, home renovations, toys, and so forth, are pushed off to be enjoyed in this stage of life. Due to this increase in spending, many individuals fund these expenses with their hard-earned savings. However, because of the pre-tax nature of the 401(k), retirees may find themselves in a higher tax bracket than when they were working, as they may no longer have as many deductions, or simply may be spending more than they did when they worked. This could put many retirees between a rock and a hard place, as they wish to spend their saved-up funds in their 401(k), but are then subject to both income tax and potential Medicare premium (IRMAA bracket) increases associated with these withdrawals. This is where the Roth IRA, and subsequently Roth conversions, come into play.
ROTH CONVERSIONS: SIX THINGS TO CONSIDER
Roth IRA withdrawals avoid income taxes, grow tax-free, and are passed to heirs tax-free. You may be wondering: how do I turn my pre-tax 401(k), which is subject to income tax, into tax-free dollars? One simple answer is: Roth conversions. A Roth conversion is when an individual takes a lump sum from their pre-tax funds (457(b), 403(b), 401(k), Traditional IRA), pays the income tax on the withdrawn funds, and moves those funds into a Roth IRA.
TAX BRACKETS
There are six items to consider when performing a Roth conversion. The first is tax brackets. As previously mentioned, when funds from the pre-tax account are withdrawn, those funds are reported as taxable income. This can then affect an individual or a married couple’s tax bracket for the given year. If an individual or married couple is at the very top of the 12% tax bracket (after deductions), a Roth conversion may likely push them into the 22% tax bracket. As one can glean from the example, a 10% jump in taxability can be too much for some individuals to stomach.
MEDICARE PREMIUMS
The second item is Medicare premiums (IRMAA brackets). Similar to tax brackets, the more income a household reports on its tax return, the more likely it is that it may be pushed into a higher IRMAA bracket, resulting in a greater monthly cost for Medicare premiums. To add, Medicare premiums are a two-year look-back, meaning that a household’s taxable income in 2025 will affect its monthly Medicare premium in 2027. Keep in mind that Medicare premiums are on a MAGI basis (Modified Adjusted Gross Income), meaning that items such as Social Security, pensions, realized capital gains, pre-tax withdrawals, and interest accrued in other accounts will be totaled up to arrive at a household’s MAGI. Additionally, because Roth conversions add to a household’s taxable income, if a household is on the private market for medical insurance, this increase in income from the conversion can increase premiums due for medical coverage before Medicare age (age 65).
THE BIG PICTURE
The third is taking a holistic, big picture approach and thinking about where taxes may be in the future. For example, if an individual believes tax brackets may be higher in the future, it would be prudent to consider performing a Roth conversion sooner rather than later, as the taxability on the withdrawals from the pre-tax account may be less today than they could be in the future. Conversely, if an individual believes that taxes may be lower in the future, waiting to perform a Roth conversion may be prudent, as the individual believes that the taxability on their pre-tax dollars is higher today than it will be in the future.
LEGACIES
The fourth item is looking at pre-tax assets from a legacy perspective. When an individual passes away while possessing pre-tax funds, these funds are taxable to their heirs. Due to the SECURE Act of 2019, individuals who inherit pre-tax funds are required to pull all funds out of the inherited pre-tax accounts within a ten-year window. All withdrawals that occur from these accounts are taxable to the heir, potentially pushing the heir into a higher tax bracket. An inherited Roth account, on the other hand, is still subject to the ten-year rule, but all withdrawals from the Roth are tax-free to the heir, and the Roth will still grow tax-free for the ten years when inherited.
REQUIRED MINIMUM DISTRIBUTION (RMD)
The fifth item to consider is the Required Minimum Distribution (RMD). RMDs are imposed on an individual at age 73 or 75, depending on one’s year of birth. If an individual is born before 1959, RMDs are imposed at age 73. If an individual is born on or after 1960, they will be subject to RMDs at age 75. RMDs are the federal government's way of getting back some of its owed tax dollars after all the years of an individual putting money aside into their pre-tax account (having not paid taxes on that money when it went in). When RMDs start, the IRS forces an individual to take a certain percentage out of their pre-tax accounts as a whole and pay the tax on the forced withdrawal. This percentage increases as the owner of the pre-tax account(s) gets older. These funds cannot be converted to a Roth, but they can be reinvested into a brokerage account, in which the growth on these invested funds is subject to capital gains. In many cases, RMDs can push a household into a higher tax bracket or IRMAA bracket, with essentially no way of avoiding it. Performing a Roth conversion can help to lessen the balance of one’s pre-tax assets, and thus can reduce RMDs. RMDs can be eliminated if all pre-tax assets are either spent down or converted to a Roth.
THE FIVE-YEAR RULE
The sixth and final item to consider is the five-year rule for a Roth. One caveat with creating and funding a Roth account is that from the moment the first dollar is placed in the Roth, a five-year timer is started. During these five years, if an individual places funds into the Roth, invests the funds, the funds grow, and are then subsequently withdrawn, the growth on the funds withdrawn is subject to capital gains. After the five-year window, however, the funds and subsequent growth are tax-free forevermore. To note, this five-year timer is started once the first dollar is placed in the account; funds placed into the account during or after the five-year window are not subject to another five-year window. As an example, John converts $50,000 from his pre-tax account into his Roth IRA in 2025. John then proceeds to convert $50,000 every year for the next five years. Once the account is five years old in 2030, all funds and growth that have occurred within the account are immediately tax-free. If John continues to convert funds after the five-year window (ex., a conversion is performed in 2031), the funds and growth are immediately tax-free.
WHERE TO GO FROM HERE
Ultimately, Roth conversions are a very useful tool to help retirees pre-pay the tax on pre-tax accounts and grow their new Roth funds tax-free. Because Roth funds are tax-free, any withdrawals from the account for any reason will not affect tax brackets or Medicare premiums. Roth conversions may not have a place in every financial plan, but the tax-free nature to both the original owner and their respective heirs makes Roth conversions worthwhile to consider. If you’re thinking about making a Roth conversion or wish to understand more about them, call our office today at (775)853-9033 or click here to see how we can help.
Based in Reno, NV, Cornerstone is for individuals and families looking to grow wealth, protect and preserve their life savings, and plan for the distribution of their estate in a tax-efficient manner through a tailored strategy. Schedule a time to discuss your financial goals with us.
This information does not constitute legal or tax advice. PCIA and its associates do not provide legal or tax advice. Individuals should consult with an attorney or professional specializing in the fields of legal, tax, or accounting regarding the applicability of this information for their situations.
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