This Could Be Your Most Powerful Tool When Doing a Roth Conversion
Key Points
When you do a Roth conversion, the money you move into a Roth IRA counts as taxable income that year.
Moving too much money over at once could trigger a large tax bill.
The more time you give yourself to complete a Roth conversion, the less painful the taxes might be.
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If you don't like the idea of being taxed on your retirement plan withdrawals or having to take required minimum distributions (RMDs), then you may want to consider doing a Roth conversion rather than leave your money in a traditional IRA or 401(k). A Roth conversion lets you move funds from a taxable retirement account to a Roth IRA.
Once your money lands in a Roth IRA, you get to enjoy tax-free gains and withdrawals. And you won't have to worry about taking RMDs, either.
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But the process of doing a Roth conversion is not so easy for one big reason -- taxes. The amount of money you convert to a Roth account is considered taxable income each year. That's why one of the best things you can do is give yourself as many years as possible to pull a Roth conversion off.
Time can reduce the tax hit
If you only have a small traditional IRA or 401(k) balance, you may be able to complete a Roth conversion in a single year with minimal taxes. But if you have a few million dollars, converting that sum in just one calendar year could be disastrous from a tax perspective. If you do that, you'll be converting a lot of that money at the highest marginal tax bracket.
That's why the best thing you can do is give yourself more time to move your money over. Doing so could make it possible to convert more of your money at lower tax rates, thereby sparing yourself a bigger IRS bill.
One window of time you might especially want to take advantage of is early retirement before RMDs kick in. Let's say you decide to retire at 65, which is when Medicare eligibility starts. If you were born in 1960 or later and don't have to take RMDs until age 75, you have a 10-year window to do a Roth conversion.
Now, let's say you have $2 million to convert. At $200,000 a year, you're not bumping yourself into the highest tax bracket -- not even close -- provided you don't have a huge amount of income outside of that conversion. But if you were to convert a $2 million 401(k) over just two or three years, you'd be looking at very high taxes.
A strategic move that requires careful planning
A Roth conversion could be a great solution when you're staring at a large balance in a taxable retirement account and are already starting to dread the RMDs that might ensue. But before you rush into a Roth conversion, plan it out thoroughly. Just as importantly, aim to give yourself as many years as possible to pull it off.
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