Should You Process Roth Conversions Before You Retire?

By Michael Ruger, CFP®
Partner and Chief Investment Officer at Greenbush Financial Group

As you approach retirement, one of the biggest tax-planning questions you may encounter is whether you should begin converting some of your pre-tax retirement accounts to a Roth IRA.

Roth conversions can be a powerful retirement tax strategy when used correctly. They can allow you to take advantage of temporarily lower tax brackets, reduce the amount of money accumulating in pre-tax retirement accounts, potentially reduce future required minimum distributions, and create a larger pool of tax-free assets for later in retirement. 

But a Roth conversion isn't automatically a good strategy simply because you are approaching retirement.  In fact, processing a large Roth conversion during the wrong year can result in paying substantially more in taxes than necessary.

When we evaluate Roth conversions as part of a financial plan, some of the most important considerations include:

• Your current federal and state income tax brackets

• Your expected tax brackets after retirement

• Whether you are experiencing an unusually low-income year

• The amount you have accumulated in pre-tax retirement accounts

• Your expected future required minimum distributions

• Where you live now and where you plan to live in retirement

• Potential future inheritances

• Medicare premiums once you reach Medicare age

• How you plan to pay the taxes generated by the conversion

The real question isn't simply, “Should I do a Roth conversion?”  A better question is, “At what tax rate does it make sense for me to convert pre-tax retirement assets to Roth assets?”

What Is a Roth Conversion?

A Roth conversion involves moving money from a pre-tax retirement account, such as a traditional IRA, into a Roth IRA.  Some 401K plan even allow “in plan Roth conversions” from pre-tax to a Roth source within the plan.

The important part is what happens for tax purposes.

Generally, the taxable portion of the amount converted from a traditional IRA to a Roth IRA is included in your taxable income for that year. You are essentially choosing to pay the income tax today in exchange for moving those assets into the Roth environment.

Why would you voluntarily accelerate a tax bill?  Because qualified Roth IRA distributions can eventually be tax-free, and Roth IRAs are not subject to lifetime required minimum distributions for the original owner. By paying tax today, you may be able to create greater tax flexibility later in retirement.  The strategy can be particularly attractive if you can pay tax on the conversion at  the same or lower tax rate today, compared to the one you would pay in the future during the retirement years.

Be Careful With Roth Conversions During Your Peak Earning Years

One of the biggest mistakes we see in Roth conversion planning is focusing only on the benefits of the Roth IRA without considering the tax cost of getting the money there.  Imagine that you are 60 years old, still working, and earning one of the highest salaries of your career.  You decide to convert $200,000 from your traditional IRA into a Roth IRA.

That $200,000 doesn't replace your salary for tax purposes. Generally, the taxable conversion amount is added on top of your other taxable income.  If you are already in a high federal income tax bracket—and potentially paying state income tax as well—the conversion could result in a very large tax bill.  This is why Roth conversions immediately before retirement aren't always advantageous.

If you're going to retire in two years and your taxable income is expected to fall dramatically, why voluntarily recognize a large amount of additional income while you are still in one of your highest tax brackets?  In some situations, waiting until retirement may provide a much better opportunity.

The Ideal Roth Conversion Opportunity: An Abnormally Low-Income Year

Some of the best Roth conversion opportunities occur when someone's income temporarily drops.  This can happen before or after retirement.  Consider a self-employed consultant who normally generates approximately $700,000 of annual income.  For whatever reason, the business has a difficult year and the consultant only generates $100,000.  If the consultant expects income to return to $700,000 the following year, that temporary decline may create an opportunity.

Instead of allowing lower tax brackets to go unused, the business owner could evaluate converting some traditional IRA assets to a Roth IRA and intentionally recognizing additional taxable income during the lower-income year.

The key word here is intentionally.

Rather than picking an arbitrary conversion amount, the taxpayer and their advisors can estimate taxable income for the year and determine how much could potentially be converted at acceptable marginal tax rates.  This concept is often referred to as filling up the tax brackets.

Roth Conversions When One Spouse Retires Before the Other

Another common opportunity occurs when spouses retire at different times.  Suppose both spouses have historically earned $150,000 per year. Their combined employment income is approximately $300,000.

Now assume one spouse retires at age 60 while the other continues working.

Their employment income suddenly falls from $300,000 to approximately $150,000.

Depending on their deductions and other income, this reduction could create room in lower tax brackets that wasn't available while both spouses were working.  Instead of waiting until both spouses are retired, the couple could evaluate whether the period between the first and second retirement provides an attractive Roth conversion window.  This is why Roth conversion planning often works best when it is mapped out over multiple years, rather than making the decision one year at a time.

What If Your Retirement Tax Rate Won't Be Lower?

A common assumption is that everyone moves into a lower tax bracket after retirement.  That isn't always true.  Some retirees accumulate very large balances in traditional IRAs, 401(k)s, 403(b)s, and other pre-tax retirement accounts.  Eventually, distributions from those accounts can create substantial taxable income.

Required minimum distributions can also force money out of certain retirement accounts later in life, whether you need the income or not. Under current federal rules, traditional IRA owners generally begin RMDs at age 73, although applicable starting ages depend on birth year under current law.

For someone with significant pre-tax retirement assets, future taxable income may not decline nearly as much as expected.  That can strengthen the case for evaluating Roth conversions earlier.

The $1 Million Traditional IRA Example

Assume you have $1 million in a traditional IRA.

You don't expect to need most of that money during the next decade.  Over time, assume hypothetically that the account grows from $1 million to $2 million.

If the money remains in the traditional IRA, you have another $1 million of investment growth inside an account whose future taxable distributions will generally be subject to ordinary income tax.  Now consider converting some of the traditional IRA to a Roth IRA today.  You pay tax on the taxable conversion amount now, but future growth on the converted assets occurs inside the Roth IRA. If the applicable requirements are satisfied, qualified Roth distributions can eventually be received tax-free.

This can make Roth conversions particularly attractive when you expect your future marginal tax rate to be similar to or higher than your current rate.  But there is an important caveat.

Don't Ignore the Tax Dollars You Give Up Today

It is easy to compare $1 million in a traditional IRA with $1 million in a Roth IRA and conclude that the Roth is obviously better.  But those aren't economically equivalent balances.  The traditional IRA contains money on which taxes generally haven't been paid yet. Converting it to Roth requires paying that tax. 

Suppose a conversion would result in a combined federal and state marginal tax cost of 40%.  That is a substantial upfront tax expense.  If you pay the conversion tax from other assets, those dollars are no longer available to remain invested elsewhere. If you pay the tax from the IRA itself, less money makes it into the Roth account.  That tax cost has to be included in the analysis.

In some situations, particularly when the current marginal tax rate is very high and the expected future tax rate is lower, not converting can produce a better financial result.  This is why Roth conversion planning should involve an actual tax analysis rather than simply assuming that Roth accounts are always better than traditional retirement accounts.

New York Residents Have an Additional Roth Conversion Consideration

State income taxes can have a significant impact on Roth conversion decisions.  New York provides a useful example.

Under current New York rules, taxpayers who meet the age requirements may exclude up to $20,000 of qualifying pension and annuity income from New York adjusted gross income. Married taxpayers who both have qualifying income can each potentially qualify for their own exclusion. New York's published guidance also recognizes qualifying IRA distributions, and state guidance specifically addresses Roth conversion income within the pension and annuity exclusion rules.

For a married couple in which both spouses qualify, this can potentially create an opportunity to convert qualifying amounts from traditional IRAs while reducing or eliminating New York income tax on a portion of the conversion. 

Consider a hypothetical married couple who are both over age 59½ and each has a traditional IRA.  If each spouse qualifies to use the full $20,000 exclusion against conversion income, they could potentially convert a combined $40,000 per year while excluding that qualifying amount for New York income-tax purposes.

If they did that for five years, they could potentially move $200,000 from traditional IRAs to Roth IRAs while using the available New York exclusions each year, assuming they continue to meet all applicable requirements.  Federal income tax can still apply to those conversions.

Also, the $20,000 New York exclusion is not an additional $20,000 exclusively reserved for Roth conversions. Other qualifying pension or annuity income can use some or all of the same annual exclusion.  This is why the taxpayer's entire income picture needs to be reviewed each year.

Your Future State of Residence Can Completely Change the Analysis

Now let's look at the state-tax question from the opposite direction.  Assume you currently live and work in a state that imposes an income tax.  However, you know that immediately after retirement you plan to establish residency in a state with no individual state income tax.  Processing a large Roth conversion immediately before moving could potentially mean voluntarily paying state income tax that might have been avoided by waiting.

For example, imagine converting $500,000 while still domiciled in a state that taxes the conversion.  If you instead retire, legitimately establish residency in a state without an individual income tax, and then process the conversion, the state-tax result could be materially different.  Of course, residency and domicile involve specific rules, and moving to another state should not be treated as simply changing your mailing address.

But the larger planning point is important:

Where you live when the Roth conversion occurs can matter.

When someone is already planning a move in retirement, we want to coordinate the timing of Roth conversions with that move rather than viewing those decisions separately.

A Future Inheritance Can Affect Today's Roth Conversion Strategy

Potential inheritances can also influence Roth conversion planning.  Suppose you are 60 years old and your parents are in their mid-80s.  Your parents have accumulated substantial balances in traditional retirement accounts, and based on their current financial position, you expect that you may eventually inherit some of those assets.

Under current federal rules, many non-spouse designated beneficiaries who are not eligible designated beneficiaries generally must empty an inherited retirement account by the end of the tenth year following the original owner's death. Depending on when the owner died relative to their required beginning date and the beneficiary's status, annual distribution requirements can also apply during that period.

Taxable distributions from an inherited traditional IRA generally become income to the beneficiary.  Now imagine inheriting a $1 million or $2 million traditional IRA while you already have significant pre-tax retirement assets of your own.  That inheritance could materially increase taxable income during your retirement years.

In that situation, the assumption that “I'll be in a lower tax bracket after I retire” may turn out to be incorrect.  If a significant inheritance is reasonably anticipated, it may be worth modeling whether converting some of your own traditional IRA assets earlier could reduce future tax concentration.

However, inheritances are inherently uncertain. Timing, asset values, healthcare expenses, estate-plan changes, and other circumstances can all change. For that reason, we generally would not want an entire Roth conversion strategy to depend on receiving a particular inheritance at a particular time.

Roth Conversions Can Affect Medicare Premiums

Medicare adds another important consideration.

Higher income can result in income-related monthly adjustment amounts, commonly called IRMAA, being added to Medicare Part B and Part D premiums.  Roth conversions increase taxable income in the year of conversion and can therefore potentially result in higher Medicare premiums later, because Medicare generally uses income information from two years earlier when determining IRMAA. 

This is particularly important for someone processing large Roth conversions at or after Medicare age.

However, there can also be a longer-term planning benefit.  Reducing traditional IRA balances through Roth conversions may reduce future required minimum distributions. Lower future taxable income could potentially help reduce exposure to higher Medicare premiums in later years.  In other words, Roth conversions don't automatically lower Medicare premiums.

A conversion could increase Medicare premiums in the short term while potentially helping control taxable income and Medicare costs later.  That tradeoff needs to be included in the analysis.

Be Careful With Tax Withholding on Roth Conversions

Another important consideration is how you pay the tax generated by a Roth conversion.  Suppose a 53-year-old wants to convert $100,000 from a traditional IRA to a Roth IRA.  Assume the conversion creates an estimated $30,000 federal and state tax liability.  Ideally, if appropriate and sufficient funds are available, the individual may consider paying that tax from cash or another non-retirement source so the entire $100,000 can reach the Roth IRA.

Why?

If $30,000 is withheld from the traditional IRA and only $70,000 actually reaches the Roth IRA, the withheld $30,000 is not part of the conversion. For someone under age 59½, amounts distributed and not rolled over may also be subject to the 10% additional tax on early distributions unless an exception applies. The IRS specifically illustrates this principle for rollover withholding.

That can make using retirement assets to pay conversion taxes particularly costly for someone younger than 59½.  Once someone is over age 59½, the 10% early-distribution tax generally no longer applies based solely on age. However, withholding taxes from the retirement account still means fewer dollars ultimately reach the Roth IRA.  For that reason, even after age 59½, paying the conversion tax from outside assets may be preferable when the overall financial plan supports it.

Why We Often Wait Until Later in the Year to Process Roth Conversions

Timing during the calendar year is another important part of Roth conversion planning.  When possible, we often prefer to make final Roth conversion decisions later in the year.

Why?

Because income has a way of surprising people.  This is especially true for business owners, executives, sales professionals, and anyone whose compensation includes bonuses, commissions, stock compensation, or other variable income.  Consider an employee earning a $200,000 base salary who plans to process a $50,000 Roth conversion.

In March, everything looks straightforward.

The employee processes the $50,000 conversion.

Then the company has an exceptional year and, in November, the employee receives an unexpected $100,000 bonus.

That bonus may push some or all of the Roth conversion income into a higher marginal tax bracket than originally anticipated.  Had the employee known about the bonus before converting, they might have reduced the conversion or skipped it entirely for that year.

November and Early December Can Be Good Planning Windows

By November or early December, you may have a much clearer picture of your annual income.

W-2 employees generally have a good idea of their salary, bonuses, and other compensation.  Business owners have most of the year's financial results available.  Investment income, capital gains, pension payments, and other income sources are also easier to estimate.  At that point, you and your tax and financial professionals can prepare an income projection and determine how much Roth conversion room may be available within your desired tax brackets.

However, there is another side to this strategy:

Don't wait until December 31.

Financial institutions can have year-end processing deadlines, and conversion requests may require time to complete. Waiting until the final days of December creates the risk that the transaction will not be completed during the intended tax year.  If you are considering a year-end Roth conversion, contact your custodian well in advance and determine its processing deadlines.

Roth Conversion Planning Should Be a Multi-Year Strategy

Perhaps the biggest mistake is viewing a Roth conversion as a one-time, all-or-nothing decision.  Imagine that you have $800,000 in a traditional IRA.

The question isn't necessarily:

“Should I convert the entire $800,000?”

Doing so in one year could create an enormous tax bill and push a significant amount of the conversion into higher tax brackets.  Instead, perhaps the better strategy is converting $50,000 this year, $80,000 next year, $100,000 during the first year of retirement, and additional amounts during subsequent lower-income years.  The appropriate numbers will be different for everyone.

This approach allows you to potentially fill lower tax brackets over multiple years rather than creating one enormous taxable event.

The years immediately following retirement can sometimes provide an especially valuable Roth conversion window. Employment income may have stopped, Social Security may not have started, and required minimum distributions may still be years away.

That gap can provide opportunities to recognize income intentionally at tax rates you find acceptable.

So, Should You Process Roth Conversions Before Retiring?

Sometimes.

Roth conversions before retirement can make a lot of sense when you encounter an unusually low-income year, when one spouse retires before the other, when current and expected future tax rates are similar, when you have substantial pre-tax retirement balances, or when future income—including potential inherited retirement assets—could push you into higher tax brackets.

They can also make sense when state-specific tax provisions create an opportunity.  But there are equally valid reasons to wait.  If you are currently in your peak earning years and expect your income to fall substantially after retirement, converting today could mean voluntarily paying tax at a much higher rate.

If you plan to move from a state with an income tax to a state without one, waiting could potentially produce state-tax savings.  And if you are approaching Medicare or already enrolled, the impact of conversion income on IRMAA should also be considered.

The goal isn't simply to get as much money into a Roth IRA as possible.

The goal is to determine when and how much to convert so that you can potentially reduce the amount of tax you pay over your lifetime while maintaining flexibility throughout retirement.

That requires looking beyond this year's tax return.  A good Roth conversion analysis considers your current tax brackets, projected retirement income, Social Security, pensions, required minimum distributions, Medicare premiums, state taxes, investment growth, estate planning, and potentially even inherited retirement assets.  When all of those variables are considered together, Roth conversions can become a powerful component of a comprehensive retirement tax strategy.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Frequently Asked Questions About Roth Conversions Before Retirement

1. Should I do a Roth conversion before I retire?
   A Roth conversion before retirement may make sense if your current marginal tax rate is lower than or similar to the rate you expect to pay later. It can be particularly attractive during an unusually low-income year or when one spouse retires before the other. However, individuals in their peak earning years may benefit from waiting until retirement if their taxable income is expected to decline substantially.
2. What is the best age to do a Roth conversion?
   There is no single best age for a Roth conversion. The best opportunities are often determined by your tax bracket rather than your age. Low-income years between retirement and the beginning of Social Security or required minimum distributions can be particularly valuable conversion windows. Your state taxes and Medicare situation should also be considered.
3. How much should I convert from my traditional IRA to a Roth IRA?
   The appropriate Roth conversion amount depends on your taxable income, deductions, federal and state tax brackets, Medicare considerations, and expected future income. Rather than choosing an arbitrary amount, many taxpayers evaluate how much they can convert while remaining within a targeted marginal tax bracket. A multi-year conversion strategy can sometimes be more tax-efficient than converting a large balance all at once.
4. Do I pay taxes when I convert a traditional IRA to a Roth IRA?
   Generally, yes. The taxable portion of a traditional IRA converted to a Roth IRA is included in income for the year of conversion. If the traditional IRA contains nondeductible contributions, the tax calculation can be more complicated. The conversion itself should therefore be coordinated with your overall tax situation.
5. Should I do Roth conversions before or after retirement?
   It depends primarily on your tax rates during each period. If you are in a high tax bracket while working and expect a substantially lower bracket immediately after retirement, waiting may be advantageous. If your income temporarily falls before retirement or future retirement income is expected to keep you in the same or a higher bracket, converting before retirement may deserve consideration.
6. Can a Roth conversion increase my Medicare premiums?
   Yes. A Roth conversion can increase modified adjusted gross income and may cause higher Medicare Part B and Part D premiums through IRMAA. Medicare generally uses tax-return information from two years earlier when determining these income-related adjustments. However, reducing pre-tax retirement balances through conversions could potentially reduce future required minimum distributions and taxable income, so both the short- and long-term Medicare effects should be considered.
7. Are Roth conversions taxable in New York State?
   Roth conversion income can be subject to New York income tax, but qualifying taxpayers age 59 1/2 or older may be eligible for New York's pension and annuity income exclusion of up to $20,000 per taxpayer. Married taxpayers can potentially each qualify for their own exclusion if each has qualifying income. Other pension income can also use the exclusion, so the full $20,000 may not always be available for a Roth conversion.
8. Should I pay Roth conversion taxes from my IRA or from cash?
   When possible and appropriate, paying the conversion tax from cash or other non-retirement assets can allow more of the retirement money to reach the Roth IRA. This can be especially important before age 59 1/2 because money distributed from an IRA for taxes rather than converted may be subject to the additional 10% early-distribution tax unless an exception applies. Even after age 59 1/2, withholding from the IRA reduces the amount transferred to the Roth.
9. Can an expected inheritance affect whether I should do Roth conversions?
   Yes. If you reasonably expect to inherit substantial traditional retirement accounts, future taxable distributions from those inherited accounts could increase your retirement income and potentially your marginal tax rate. Many non-spouse beneficiaries are subject to a 10-year distribution period under current federal rules. However, because the timing and amount of an inheritance are uncertain, it generally makes sense to model multiple scenarios rather than basing your entire Roth conversion strategy on an expected inheritance.
10. What time of year is best for a Roth conversion?
    Later in the year can be useful because you generally have a clearer picture of your salary, bonuses, business income, capital gains, and other taxable income. November or early December may provide enough information to estimate an appropriate conversion amount while still allowing time for the financial institution to process the transaction. Avoid waiting until the final days of December because custodians may have earlier year-end processing deadlines.