What to Know About Roth Conversions in Retirement

A Roth conversion is a financial strategy that involves transferring funds from a pre-tax retirement account, such as a Traditional IRA or 401(k), into a post-tax Roth IRA. The main trade-off is paying income tax on the converted amount in the current year. In exchange, the funds can grow and be withdrawn in retirement completely tax-free, provided certain conditions are met. This process is a permanent decision, as a conversion cannot be reversed once completed.

Key Factors for Retirees to Consider

A primary consideration for retirees is how a Roth conversion affects Medicare premiums. The income from a conversion increases a retiree’s Modified Adjusted Gross Income (MAGI). This can push them into a higher bracket for the Income-Related Monthly Adjustment Amount (IRMAA), resulting in higher monthly premiums for Medicare Part B and Part D. IRMAA is determined based on the MAGI from two years prior, so a large conversion in one year could lead to higher Medicare costs two years later.

The income from a conversion can also change the taxation of Social Security benefits. A Roth conversion adds to a retiree’s “combined income,” which can cause a greater percentage of their Social Security benefits to become taxable. This can shift the taxable portion from 50% to as high as 85%, creating an indirect tax cost on top of the direct tax on the conversion.

Retirees must also understand the pro-rata rule if they hold both pre-tax and after-tax (non-deductible) funds in any of their Traditional IRAs. This IRS rule prevents individuals from converting only the after-tax contributions to avoid taxes. Instead, any conversion is treated as a proportional distribution of both pre-tax and after-tax dollars from the combined total of all Traditional IRAs. For example, if a retiree has $100,000 total in Traditional IRAs, with $80,000 being pre-tax and $20,000 after-tax, any conversion is considered 80% taxable and 20% tax-free.

An individual who has reached their Required Minimum Distribution (RMD) age must take their RMD for the year before converting funds from that same account. The RMD age is 73 for those born from 1951 through 1959, and 75 for those born in 1960 or later. The RMD amount itself is ineligible for conversion and must be withdrawn and taxed as ordinary income. Failing to take the RMD first can result in significant penalties.

Calculating the Tax Impact

To calculate the tax impact of a Roth conversion, first determine the amount that will be subject to income tax. For most retirees, this is the total value of the pre-tax funds being moved. If the pro-rata rule applies, the taxable portion is found by dividing the total pre-tax amount across all Traditional IRAs by the total balance of all Traditional IRAs, then multiplying that percentage by the amount being converted.

Next, estimate the resulting tax bill. Add the taxable conversion amount to your other projected income for the year, which includes pensions, investment gains, and the taxable portion of Social Security benefits. This new total provides an estimate of your Adjusted Gross Income. With this estimated income, consult the federal income tax brackets for your filing status to see how the additional income will be taxed. The conversion income will “fill up” the tax brackets, so a large conversion could push some income into higher brackets.

Remember to account for potential state and local income taxes. For example, a retired couple with $75,000 in other taxable income decides to convert $50,000 from a Traditional IRA. Their total taxable income becomes $125,000. They would use the “married filing jointly” tax brackets to calculate the tax on this new total and subtract the tax they would have owed on their original $75,000. The difference is the estimated federal tax cost of the conversion.

The Conversion Process

First, you must have an open Roth IRA to receive the funds. If you do not have one, you must establish one with a financial institution, which can often be done online. Next, contact the institution holding the source funds to inform them you want to perform a Roth conversion. They will provide the necessary paperwork or online portal to initiate the request.

The conversion forms will require the account numbers for the source and destination accounts and the exact dollar amount to be converted. The most common method is a direct trustee-to-trustee transfer, where funds move directly between institutions. An alternative is an indirect rollover, where you receive a check and have 60 days to deposit it into the Roth IRA. The direct transfer is preferred as it avoids the 60-day deadline and mandatory tax withholding.

Finally, arrange to pay the income tax liability. It is advisable to pay the taxes using funds from a separate, non-retirement account. If taxes are withheld from the converted amount, that withheld portion is considered a distribution and could be subject to a 10% early withdrawal penalty if you are under age 59½. You can cover the tax bill by making quarterly estimated tax payments or by increasing tax withholding from other income sources.

Post-Conversion Rules and Management

After a conversion, the principal (the amount that was taxed) can be withdrawn from the Roth IRA tax-free at any time. However, each conversion has its own five-year holding period, which begins on January 1 of the conversion year. If you are under age 59½ and withdraw the converted principal within this five-year window, the withdrawal will be subject to a 10% penalty, unless an exception applies.

The rule for withdrawing earnings is different. For earnings to be withdrawn tax-free, you must be at least 59½ years old, and it must be at least five years since you first contributed to any Roth IRA.

A major benefit of a Roth IRA is that it does not have RMDs for the original owner. This allows the funds to continue growing tax-free for the owner’s entire lifetime without forced withdrawals, providing greater flexibility in managing retirement assets.

Upon the owner’s death, the Roth IRA can be passed to beneficiaries, who can make tax-free withdrawals. However, under current rules, most non-spouse beneficiaries must withdraw all assets from the inherited Roth IRA within 10 years of the original owner’s death.