A Roth IRA (Individual Retirement Account) conversion involves moving funds from a traditional IRA or other eligible retirement account into a Roth IRA. Income taxes must be paid at the time of conversion, but once the funds are in the Roth IRA they may grow and be withdrawn tax free after age 59 ½. The best time to do a Roth IRA conversion is when annual taxable income is lower than usual. Conversions can be done all at once or with a portion of the traditional retirement account.
There are several long-term benefits to Roth IRAs versus Traditional IRAs:
- Tax Free growth and withdrawals after age 59 ½ as long as you meet the 5-year aging rule
- No Required Minimum Distribution (RMD)
- Direct contributions may be withdrawn without penalty at any time
- Heirs inherit the tax-free nature of the account withdrawals.
- In 2024, the 10-year rule went into effect for IRAs inherited by anyone other than a spouse, applying to both traditional and Roth IRAs. The heir has 10 years to withdraw all funds from IRAs. For Roth IRAs these funds are not taxable. However, these withdrawals are taxable for traditional IRAs which can create quite a headache if inherited during peak earning years.
The primary difference between a traditional IRA or other eligible retirement accounts versus a Roth IRA is when funds are taxed. Roth IRA funds are taxed prior to investment and not taxed again as long as qualifications are met, while traditional IRAs or other eligible retirement accounts have funds taxed when withdrawn, versus prior to contribution. Ideally, funds are deposited into Roth IRA accounts at a lower relative tax rate.
The two columns on the left show a net withdrawal amount of $10,560 for both the Traditional and Roth IRA because the investor’s tax rate is the same when the funds are invested as it is when they are withdrawn. The two columns on the right show that this investor could withdraw a net amount larger in the Roth IRA versus the Traditional IRA ($10,560 versus $9,360) because taxes were paid at a lower rate with the Roth IRA versus the Traditional.
Have you heard any retirees complain about paying higher taxes in retirement than when they were working? Logic might say that an investor benefits from saving a large amount in the 401(k) and/or IRA during working years and withdrawing funds when retired. However, what we are seeing is that many retirees find themselves in the same, or higher, tax bracket than when working. Saving is always important, however planning with an advisor as to the best ways to save can be very effective in the long run.How does this happen? Required Minimum Distributions. A retired couple where both spouses worked could collect $50,000 to $70,000, or more, in social security income during retirement. If both spouses also saved diligently in their employer plans they could have $1 million or more subject to required minimum distribution(RMD). To calculate RMD the IRS has a table with distribution factors that decrease each year, meaning each year the percentage amount to be withdrawn increases. The 2025 factor for someone who turned 73 in 2025 (the first year they need to take RMD) is 26.5. So, if they have $1 million subject to RMD they would have $37,735.85 in additional taxable income potentially boosting their total annual income in retirement above $100,000:
$1,000,000/26.5 = $37,735.85
RMDs are required for individuals who reach age 73. This age is scheduled to increase to 75 in 2033 for those born on or after 1960. The time between retirement and the age that RMDs are required can be critical years for planning with an advisor.
2025 offers retirees an additional opportunity with the “senior” bonus deduction. An extra $6,000 per individual over age 65 can be deducted from income ($12,000 when both spouses are over age 65). This is subject to income limits of $75,000 for individual filers and $150,000 for married. This bonus might provide an additional opportunity for Roth Conversion, especially for individuals between age 65 and 73. Tax brackets for 2025 are as follows with the income listed being adjusted gross income after deductions:
Roth Conversions done prior to RMDs can maximize the 12% tax bracket while also lowering the balance in traditional IRAs or other eligible retirement accounts. By lowering the balance in these accounts there will be less funds subject to RMD. i.e. less likelihood of being forced to take income that may be subject to a higher tax rate. This can be beneficial for the retiree and heir alike.
As you know from these newsletters I’m always a big proponent of “free” money. This is potentially another way many investors can save 10% over the long term.
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