The Hidden Cost of Roth Conversions No One Talks About Until It's Too Late

There's a reason Roth IRAs are a popular retirement savings tool. With a Roth IRA, you don't get a tax break on your contributions. But gains in that account are tax-free, as are withdrawals.

Plus, Roth IRAs don't force you to take required minimum distributions (RMDs) in retirement. That gives you a lot more flexibility with your money.

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The problem with Roth IRAs is that higher earners are barred from making direct contributions. And even if that weren't the case, saving in a Roth may not make sense if you're a higher earner who falls into a higher tax bracket.

If you're nearing the end of your career with most or all of your nest egg in a traditional retirement account, you may be worried about the taxes you'll have to pay on that money once you start taking withdrawals. You may also be concerned that RMDs will mess with your plans.

The good news is that it's not necessarily too late to benefit from a Roth IRA. A Roth conversion allows you to move funds in a traditional retirement account into a Roth IRA. But if you're going to do that, it's important to be strategic so you don't suffer a huge financial hit in the near term.

The problem with Roth conversions

When convert funds to a Roth IRA, the amount you move into that account is treated as taxable income for that year. This means that if you do a huge conversion at once, you risk a very large bill from the IRS.

But that's not the only danger. You may not realize it, but a Roth conversion could impact other areas of your financial life.

For one thing, if you're on Medicare or are planning to enroll soon, doing a large Roth conversion at once could push your income high enough that you're subject to an income-related monthly adjustment amount, or IRMAA, two years later. IRMAAs are surcharges that can apply to both Medicare Part B and D premiums. And in some cases, they can add hundreds of dollars a month to the cost of Medicare.

Another overlooked consequence of doing a large Roth conversion is being taxed on Social Security. Let's say you're retiring this year and plan to claim benefits right away. If you do a giant Roth conversion, you may have too much income to get out of paying taxes on your Social Security. And you may not qualify for the new $6,000 senior tax deduction either.

Time your Roth conversion carefully

None of this is meant to discourage you from doing a Roth conversion. The key, however, is to be strategic with your timing, especially if you have a large sum of money you're looking to move into a Roth IRA.

Let's say you retire at age 65, during which time your income decreases substantially. If you're not on the hook for RMDs until age 73, you have an eight-year window to do your Roth conversion. And depending on the amount of money you have saved, it could make sense to split that conversion up into multiple years.

For example, say you have $1.2 million. If you move that entire sum into a Roth IRA in a single year, you may be looking at an enormous tax bill. And if you're on Medicare, you're pretty much guaranteed to be hit with the highest IRMAA tier, driving your premium costs up substantially.

Now, let's say you split that $1.2 million conversion across eight years. At $150,000 a year, the tax consequences may be less extreme. And you may, depending on your tax-filing status, be able to avoid IRMAAs completely.

Roth conversions can be a very smart thing, provided they're done efficiently. Be mindful of not just regular taxes, but Medicare surcharges and taxes on Social Security when making plans for one. The last thing you want is to solve the problem of taxed withdrawals and RMDs in retirement only to create new problems along the way.

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