By Katia Stern
A Roth IRA is a type of retirement account that allows you to contribute “after-tax” dollars that then grow tax-free and remain untaxed when you withdraw the assets. This differs from a traditional IRA to which you contribute “pre-tax” dollars. While those assets also grow tax-free, the money is taxed at your ordinary income tax rate upon withdrawal.
People often contribute to an IRA expecting to be in a lower tax bracket during retirement than they are while they are working. However, if their taxable income is lower than usual during a specific year, it can be prudent to pay taxes on some of the money contributed to the IRA while you are in a lower tax bracket than you will be in the future. This is known as a Roth Conversion.
Consider this example. John and Jane are a married couple who have contributed to their 401(k) retirement accounts throughout their working careers. They will be required to begin drawing money from their respective accounts when they are each age 72, per IRS requirements. John and Jane have also qualified for Social Security benefits and have decided to delay claiming these until age 70. Assuming they retire from their jobs at age 65, they will have less taxable income between ages 65 and 72.
Let’s assume their annual taxable income is $30,000 soon after retirement. That would put them in the 12% marginal tax bracket and their estimated CA state and federal taxes for the year would be around $3,626.
At age 72, we will assume Social Security benefits and RMDs (Required Minimum Distributions from their 401(k) accounts) bring their taxable income up to $100,000, placing them in the 22% marginal tax bracket.
In a situation like this, when they can take advantage of their current lower tax bracket, John and Jane would likely benefit from making Roth conversions between ages 65 - 72.
The 12% federal marginal tax bracket they are currently in maxes out at $81,050 of taxable income (in 2021). This means they could declare an additional $51,050 of taxable income before entering the 22% tax bracket. Doing a Roth conversion of this amount while they are in the 12% federal income tax bracket would require paying additional estimated state and federal taxes of around $8,235.
However, if they wait until they are in a higher tax bracket after age 72, the marginal tax on this $51,050 would require paying additional estimated taxes of around $10,745.
This means that by doing a Roth conversion, their tax savings would be $2,5091. If they were to continue doing Roth conversions for five years, their total tax savings would equal $12,546.
This question will have a different answer for everyone, each tax year. A rule of thumb is to convert the amount that gets you as close as possible to maxing out your current tax bracket.
It is best to make this calculation near year-end, so you would know what your taxable income would be, so as not to push part of the conversion into the next (higher) tax bracket.
Anyone who has money invested in a traditional IRA or a qualified retirement plan such as a 401(k) can convert to a Roth IRA; there are no income limitations. It is important to note that if you are older than 72 and have an RMD, you must meet your annual distribution requirements prior to a conversion.2
Breakdown of Example Calculation:
“Roth Conversion: Converting IRAs.” Fidelity, www.fidelity.com/building-savings/learn-about-iras/convert-to-roth
Federal & State Tax Brackets for Reference: