When it comes to retirement planning, timing can be everything. Yet many people completely overlook a specific window of opportunity where a Roth conversion can save them thousands in future taxes.
In this short video, we review the Roth conversion window many people miss, and how you can figure out if it’s the right move for your financial strategy.
Watch now!
Transcript
There’s often a stretch of time after that final paycheck stops and before Social Security and required minimum distributions begin when taxable income may drop lower than it’s been since your first job. For some households, that stretch may look like only a couple of years. For others, it could run more than a decade, depending on when someone retires and when their other income sources begin.
However long this window lasts, it can be a chance for you to move money out of a pre-tax account deliberately rather than waiting until the rules set the timing.
Hi, I’m Sean Gallagher with Thrive Wealth Management. Over the next few minutes, I’ll walk you through what this window of opportunity is and why it’s so easy to miss. Then I’ll cover what our team and myself typically look at when weighing whether a Roth conversion fits.
What Creates a Roth Conversion Opportunity in Early Retirement?
Let’s start with what that stretch looks like. When someone retires in their early 60s, their paychecks obviously stop. And if they hold off on claiming Social Security benefits, there may be very little income coming in for quite some time. Required minimum distributions are the other piece. Those don’t start until your mid-70s, so there can be a really long stretch of years here where nothing is forcing money out of your retirement accounts.
Put those together, and taxable income may be lower than it’s been in the last few decades. That’s what can create this opportunity. Tax rates climb in steps. So in a low-income tax year, money coming out of a retirement account may be taxed at one of those lower rates. The catch is that low-rate space resets every year. Whatever goes unused generally can’t be carried into the next one.
How Does a Roth IRA Conversion Work?
A Roth conversion is one way to use that space. Under this strategy, you move money from a traditional IRA or old 401(k) into a Roth IRA account and pay the tax this year at this year’s tax rate. From there, the balance will continue to grow tax-free and qualified withdrawals later on come out tax-free as well.
Why Do Retirees Miss the Roth Conversion Window?
So this opportunity is sitting right there. Why does it pass so many households by? Two things often keep this stretch from getting noticed, and the first one is pretty simple.
Nobody tells you it’s happening, right? You’re not going to receive a notice in the mail. You’re not going to have a 401(k) statement flagging that this year’s tax bracket happens to be unusually low. So the window can open and close without even being noticed.
How Can RMDs and Changes in Filing Status Affect Retirement Taxes?
The second reason is an assumption that a lot of people carry into retirement, which is that taxes only go down from here. That can hold true for a while, but once required minimum distributions begin, income can climb back up pretty quickly, and that tax bill will climb with it. Something similar can also happen when one spouse passes. The survivor may be living on close to the same income, but now has to file as a single taxpayer, and single filers reach the higher brackets at lower income levels.
Either way, waiting has a potential cost. Each year that goes by without a look at the numbers may be a low-bracket space that generally doesn’t come back. Here’s what our team and myself typically look at when we work through these types of scenarios.
How to Plan Roth Conversions Before Required Minimum Distributions Begin
When we see someone retire with almost everything sitting in pre-tax accounts, one of the first things our team does is map out the years ahead. That projection often looks at income year by year, when Social Security benefits are going to begin, and what required minimum distributions may look like down the road. Another thing is what changes for the household if one spouse outlives the other.
How Much Should You Convert to a Roth IRA Each Year?
What comes out of this is a picture of the expected tax bracket someone’s heading toward, and that’s the number we’re comparing against. From there, we can seek to identify a sensible amount to convert each year, usually stopping short of that next tax bracket. We may also look at where the tax payment comes from, covering it with cash from outside of the retirement account rather than using the converted dollars themselves to pay the tax bill. This will allow you to keep more of the balance growing in that Roth tax-free bucket.
What Is the Roth Conversion Five-Year Rule?
A conversion doesn’t fit every situation, and timing is a really big part of that. Converted money generally needs to stay put for five years. If you withdraw it sooner, there may be an additional tax for anyone under the age of 59½, and earnings may not come out tax-free. So, if the money’s going to be needed in the near term, that’s a very big factor early on in our projection, and that’s one of the reasons why the projection comes first before any conversions take place.
Coordinating Roth Conversion Strategies With Your Retirement Tax Plan
This window is real, and it doesn’t stay open forever. Making good use of it generally starts with a projection that connects your taxes, your income, and timing. As an independent fiduciary firm, our team can coordinate a retirement plan alongside your CPA or other professionals, so you’re not stuck playing go-between.
Is that stretch between your last paycheck and your first RMD coming up? We’d be glad to talk about it with you. Reach out by calling us at 215-376-5530 or email me directly at sgallagher@thrivewealth.com.
When is the best time to do a Roth Conversion?
The answer is different for everyone, but for many retirees, the window opens when earned income falls, often after the last paycheck and before Social Security begins. It typically narrows as pensions, capital gains, and other income start filling the lower tax brackets, and it can narrow further once required minimum distributions (RMDs) begin. Conversions remain available after that point, though the tax cost is often higher. Because the timing depends on the household, a year-by-year tax projection generally comes first.
How does a Roth conversion work?
A Roth conversion moves money from a traditional IRA or 401(k) into a Roth account. The converted amount is taxed as ordinary income in the year of the conversion, and qualified withdrawals later can be tax-free with no RMDs required. Thrive Wealth Management can help determine whether a conversion makes sense for you, and an appropriate amount to convert each year, based on an evaluation of a household’s tax bracket and overall circumstances.
How do I know if a Roth conversion is right for me?
A Roth conversion can be a powerful lever in your broader retirement income planning, particularly when three things line up: taxable income is temporarily low, a large pre-tax balance could push future RMDs into a higher bracket, and cash is available outside the account to cover the tax.
This material is provided for informational and educational purposes only, should not be viewed as an exhaustive discussion of the topics presented, and should not be construed as individualized advice for any reader’s personal circumstances. For guidance on how these matters may impact your financial plan or investment portfolio, please contact your Thrive Wealth Management, LLC representative. While the information presented is believed to be factual and up to date, Thrive Wealth Management, LLC does not guarantee its accuracy and, due to various factors, including but not limited to changing laws and regulations, this information is subject to change. All expressions of opinion reflect the judgment of the authors as of the date of publication. Thrive Wealth Management, LLC is not a law firm or an accounting firm, and no content contained herein should be construed as legal or accounting advice. Please consult with the qualified professional(s) of your choosing for legal and accounting advice. Please visit https://thrivewealth.com/disclosure for additional information regarding the professional designations and credentials discussed. Professional designations and credentials do not guarantee success or any particular investment or financial outcome. Past performance does not guarantee future results. All investing comes with risk, including risk of loss.
