Post-Retirement Roth Conversion

Many people believe it doesn’t make sense to convert a traditional IRA to a Roth IRA late in life. In reality, many retirees have a longer life expectancy than you might expect. What’s more, tax savings are possible even without an extended period of post-conversion ownership. The benefits aren’t present in all cases, so careful analysis is required to determine whether a conversion makes sense, how much to convert, and when. As explained below, in most cases the conversion will make sense if all of the following are true:

• All your withdrawals from the converted IRA will be free from taxes and penalties.
• You’ll be able to pay taxes on the conversion from another source. In other words, you won’t use money from the IRA to pay taxes. (Sometimes you can benefit even if this is not true.)
• Most importantly, you won’t pay tax on the conversion at a significantly higher rate than the rate that would apply if you left the money in your traditional IRA, taking it out when you need it later in life. To avoid this problem you may need to do only a partial conversion.

Potential benefits

A post-retirement conversion may permit you to accomplish one or more of the following:

• Have a larger dollar amount invested in a tax-free vehicle by using other savings to pay tax on the conversion.
• Keep your money invested in a tax-free vehicle for a longer time by avoiding required distributions after age 72.
• Cause the money in your traditional IRA to be taxed at a lower rate than if your children inherited the IRA.
• Reduce or eliminate tax on your social security benefits.
• Reduce your estate tax by paying income tax on your IRA before you die.

We’ll take a closer look at these benefits, then turn to some important points concerning possible detriment.

Increasing the size of your IRA

Moving money from a traditional IRA to a Roth IRA has a hidden but very favorable consequence: it increases the amount of money you have in your IRA. The dollar amount is the same, but the effective amount is larger. This is because the Roth IRA contains only after-tax dollars. Part of your traditional IRA will end up going to Uncle Sam when you cash out, so it’s almost as if you don’t own the entire IRA. The better your investment performance, the more tax you end up paying. That’s not true for a Roth IRA.

Avoiding required distributions

Having more money than you need in retirement is a nice problem to have. But that doesn’t mean it isn’t a problem, if you reach age 72 and still don’t want to take money out of your IRA. If the tax rules force you to take a distribution you don’t need, you’re losing the benefit of tax-free compounding when you could otherwise be living on other savings. The Roth IRA provides a way to extend the benefits of IRA investing for as long as you can afford to leave the money in the account, and that can mean more wealth for your later years — or for your heirs.

Reducing the tax rate on distributions

If you have reason to believe there will be a substantial amount left in your IRA when you die, you may wish to consider the tax rate that will apply to the benefits. Unless the IRA will be consumed by your spouse, it may pass to children or other heirs while they’re in their prime earning years, and therefore in a higher tax bracket than you are. Converting to a Roth IRA now may avoid having that income taxed at the higher rates that apply to your beneficiaries.

Reducing tax on Social Security benefits

If you’re receiving social security benefits in the year of the conversion, you may find that the conversion causes you to include more of those benefits in income for that year. Yet many people will end up with overall savings here. The annual distributions you receive from a traditional IRA increase your income. Depending on your income level, this could cause part of your social security benefit to be taxable, year after year throughout your retirement. There’s a possible one-time hit with the conversion, but after that you may fly under the radar for the tax that might otherwise apply to your annual social security benefits.

Note. Distributions you take from a Roth IRA don’t count as “tax-exempt income” that goes into the calculation of how much of your social security benefit is taxable

Estate tax savings

Most people don’t have to worry about federal estate tax because of a credit that effectively exempts a large dollar amount from the tax. If you’ve accumulated enough wealth to be concerned with the estate tax, a conversion to a Roth IRA may provide an added advantage. The income tax you pay on the conversion reduces the size of your taxable estate (which may reduce the estate tax) without reducing the value of what you leave to your heirs. Estate tax rates are high, so this benefit can be valuable in those cases where it applies.

Check your tax bracket

Before you convert to a Roth IRA, consider how your tax bracket will affect the overall benefit of the rollover. A disadvantageous tax bracket can mean the rollover will produce costs that outweigh the benefits.

Even when you’re in a favorable tax bracket, you have to watch the size of your conversion. If you convert too large an amount, the bunching of income into one year can cause you to pay tax at a higher rate than if you withdrew money from your traditional IRA more gradually. With careful planning you may be able to avoid this consequence by controlling the amount you convert.

Example: You’re single and living on social security and pension income. After claiming the standard deduction your taxable income is $12,000, putting you in the 12% bracket. You would like to convert a $100,000 traditional IRA to a Roth IRA. But if you do this, part of the conversion will be taxed at the 22% rate. Your better choice may be to convert an amount that will leave you in the 12% bracket, and do additional conversions in later years.

Tax brackets can catch you in a different way. If your children are in a lower tax bracket than you, and you expect to be able to leave a substantial part of your IRA to them when you die, converting to a Roth IRA may cause the income to be taxed at a higher rate than if you left it in the traditional IRA to be withdrawn by your children.

For these reasons, it pays to check carefully to determine what tax bracket you’ll be hitting when you make the rollover. You may find that it’s best to convert only part of your traditional IRA — and in some cases the correct amount to convert is zero.

Determining the right amount to convert isn’t terribly difficult if your income is predictable. If you’re uncertain about this move, check with a professional who’s familiar with this type of planning. It’s worth it to avoid making a mistake.