Roth IRA: How a well-timed conversion could yield sweet tax savings for retirees

If you are a retiree with a traditional 401(k) or IRA, there may be a window of opportunity for you to convert a significant portion to a Roth IRA tax-free. You can take advantage of this Roth IRA conversion if you’re not working, not yet living off your retirement savings, and not yet drawing Social Security.

Baby boomers are now retiring at an unprecedented rate. As a retiree, there may be a window of opportunity for you to convert a significant portion of your IRA or 401(k) to a Roth IRA tax-free.

First, let’s revisit the advantages of a Roth IRA conversion:

1. Tax-free compounding: Once converted, investment returns will continue to grow tax-free.
2. No required minimum distributions at age 70 ½: This is ideal if you don’t need to spend the money and want to pass it on to your beneficiaries.
3. Tax-free withdrawals for beneficiaries: Beneficiaries inherit the IRA proceeds tax-free.
4. Withdrawals are not included when determining the taxable portion of Social Security benefits, whereas withdrawals from IRAs and 401(k)s are included.

The amount of pre-tax money converted to a Roth IRA is normally included in taxable income. If your tax rate in the year of conversion will be higher than your tax rate when you withdraw the Roth money, it doesn’t make sense to do the conversion, especially if you need to use IRA funds to pay the conversion tax. So how you can convert a portion of an IRA or 401(k) tax-free to a Roth IRA each year in the early years of retirement?

In early retirement it’s generally advantageous to let your retirement accounts continue to grow tax-deferred and live off of other savings. It’s also advantageous to wait as long as possible to start your Social Security retirement benefits. So there may be a period of time when you’re not working, you’re not living off your retirement savings, and you’re not yet drawing Social Security. If you plan ahead or are fortunate enough to fall into this trifecta for one or more years, it’s a perfect opportunity to convert part or all of your IRA into a Roth. This is often the case with early retirees.

As an individual, if you have no other income, you can convert up to $10,000 each year and not pay any federal taxes. You can convert an additional $9,000 at the 10% federal tax rate. If you itemize your expenses, you may be able to convert even more.

A couple filing jointly with no other income can convert up to $20,000 each year and not pay any federal taxes. Joint filers can convert an additional $18,000 at the 10% rate. So with no other income or deductions a joint filer can convert $38,000 into their Roth account for only $1,800 in federal taxes. That’s only a 4.7% tax rate, and you’ll never pay tax on that money again.

There may be other consequences for Roth conversions, state taxes and subsequent withdrawals. If you’re in the sweet spot, be sure to consult with an experienced tax professional before you commit to the process.

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