Converting a traditional IRA to a Roth can shield your retirement savings from future tax increases, but there are pitfalls and trapdoors too.
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You’ll owe taxes on a conversion, and the upfront tax bill could be higher than you expected — particularly if the conversion pushes you into a higher tax bracket. If your income tax rate drops significantly after you retire, the tax advantages could be modest or nonexistent. And you must comply with multiple rules and regulations to avoid running afoul of the IRS.
When you convert money in a traditional IRA to a Roth, you must pay taxes on the amount you convert (although part of the conversion will be tax-free if you’ve made nondeductible contributions to your IRA).
Once you’ve converted, all withdrawals are tax-free as long as you are 59 1/2 or older and have owned a Roth for at least five years. Unlike traditional IRAs and other tax-deferred accounts, Roths aren’t subject to required minimum distributions at age 72. So if you don’t need the money, you can let it continue to grow, tax-free.
Many planners believe the period between the time you retire and the time you turn 72 is the sweet spot for Roth conversions. There’s a good chance your income will drop after you stop working, and until you are required to start taking distributions, you have some control over the amount of income you receive each year. That will help you lower the tax bill on your Roth conversion.
But even within that time period, there are potentially negative consequences to a conversion, particularly for retirees. What to watch out for:
Medicare high-income surcharge. The Medicare Part B premium is tied to income. While the standard premium that most people pay is $148.50 per month in 2021, higher-income enrollees may pay $208 to $505 per month. A Roth conversion will inflate your income, triggering an increase in premiums for Part B as well as Medicare Part D, which covers prescription drugs.
Keep in mind, though, that a Roth conversion could offset the costs of Medicare premiums in the future, says Ed Slott, founder of IRAHelp.com. Withdrawals from a Roth won’t affect the formula used to calculate surcharges.
Social Security benefits. The additional income from a Roth conversion could increase the portion of Social Security benefits that are subject to federal income taxes. Up to 85% of your Social Security benefits are taxable, depending on income from other sources, such as a job, a pension, withdrawals from an IRA or a Roth conversion.
Taxes on investment income. Most taxpayers pay a 15% capital gains rate on income from long-term capital gains and qualified dividends. If your income is low enough — up to $40,400 in 2021, or $80,800 for married couples who file jointly — you qualify for a 0% rate on capital gains, which can be a sweet deal for retirees. But because a Roth conversion will increase your taxable income, taxes on your investment income could go up too.
Sandra Block is a senior editor at Kiplinger’s Personal Finance magazine. For more on this and similar money topics, visit Kiplinger.com.
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