Retirement

Roth Conversion Rules

By Chris Duderstadt

May 1, 2023

Roth Conversion Rules

Key Points – Roth Conversion Rules

  • What Are the Roth Conversion Rules in Retirement?
  • Why Are They Important?
  • Is a Roth Conversion Right for Me?
  • Why Is It Important to Tackle Roth Conversions Before 2026?
  • 11 Minutes to Read | 23 Minutes to Listen

What Are the Roth Conversion Rules in Retirement?

Dean Barber and Bud Kasper have made it clear on several occasions that the Roth IRA is their favorite part of the tax code. The tax-free component of the Roth is something to strongly consider, especially as we close in on 2026. What’s so special about 2026, you ask? On January 1, 2026, we’ll revert back to the higher tax rates of 2017 when the Tax Cuts and Jobs Act sunsets.

So, if you have most your retirement savings in a traditional IRA or 401(k), maybe it’s time for you to think about Roth conversions. The thing is that deciding to contribute to Roth vs. traditional isn’t cut and dry. For some people, Roth conversions can be a tax planning strategy that results in hundreds of thousands of dollars in tax savings. But for others, doing Roth conversions could cause unintended tax consequences, such as a significant amount more of their Social Security to become taxable or higher Medicare premiums. Dean and Bud will discuss all that and more as they break down the Roth conversion rules in retirement.

What’s So Good About the Roth IRA?

Before Dean and Bud take a deeper dive into Roth conversion rules in retirement, let’s take a closer look at Roth vs. traditional. With traditional investing, pre-tax money goes into the 401(k). While that seems very attractive at the time when you’re putting money in, just remember that at some point you’ll need to take it out and you’ll get taxed on that money.

“With not knowing specifically what the tax brackets might be in 10, 20 years depending on your timeline, if I can control that tax situation up front rather than after the fact, I feel like I’m controlling the amount of money that I’m calculating that I’ll need in retirement.” – Bud Kasper

Learning About Benefits of the Roth from America’s IRA Expert

One of the ways that Dean and Bud stay up to date on the tax code is by studying with America’s IRA Expert Ed Slott. They did exactly that with several other members of Ed Slott Elite IRA Advisor GroupSM for a spring workshop last week in Baltimore.

One of Ed’s books is titled, The Retirement Savings Time Bomb … and How to Diffuse It. That time bomb that Ed was talking about is what happens when you get money out of traditional IRAs.

“That’s exactly what it is. It’s a time bomb because you take the money out and pay taxes at that time as if it were ordinary income. But the Roth IRA goes in on an after-tax basis. In other words, you’re paying the tax on the contribution before the money goes in. Then, all the earnings are tax-free when the money comes out.” – Dean Barber

Roth Conversion Rules — The Five-Year Rule

Now, let’s cover a couple of the key Roth conversion rules. After converting to a Roth IRA, you must keep the money in the Roth IRA for at least five years before taking it out to get the earnings tax-free. You also must also attain the age of 59½.

“A lot of people get confused when we talk about Roth conversions and the five-year rule. For example, if you did a Roth conversion for $100,000 and then took the money out of the Roth IRA within two or three years, you can take the $100,000 out without penalty or taxes because it was already taxed. It’s just the earnings that have the five-year and 59½ rule.” – Dean Barber

Why Roth Conversions Are Going to Be Popular the Next Three Years

In the 40 years that Bud has been in the financial services industry, he’s never done more Roth conversions than he did last year. And he expects that trend to continue this year. That’s because of that January 1, 2026 date of the Tax Cuts and Jobs Act sunsetting that we mentioned earlier.

This doesn’t mean that you won’t be able to do Roth conversions after January 1, 2026. It’s just more appealing to do them prior to tax rates going back up to the higher rates of 2017.

Do Roth Conversions Make Sense for You?

No matter how appealing Roth conversions might be to you, you shouldn’t just do them blindly. You need to do more than just simple math to see if they truly make sense for you. A lot of people will do that simple math with thinking that if they do a Roth conversion today, they’ll need to pay X-amount in taxes to move their money from the traditional to the Roth. It will grow tax-free and they’ll get income tax-free, but how long will it take them to make up the difference in what they paid in taxes up front?

Don’t Forget About Required Minimum Distributions

When you’re considering Roth conversions, you need to step forward into the future and to the age of 73. That’s when you must start taking Required Minimum Distributions.

“That’s when the IRS is telling you, ‘We’re tired of waiting on you to die to get our share of your IRA. You need to start taking your money out. That’s the Required Minimum Distribution. So, when you complete your financial plan and see what your RMDs are going to look like at 73, what does that does that do to your tax situation at that time?” – Dean Barber

Avoiding a Potential Tidal Wave of Taxes

As we’re working with people that are heading into retirement or already retired, those RMDs can oftentimes put people into a higher tax bracket. They can cause their Medicare premiums to become elevated for the rest of their lives, 85% of their Social Security to become taxable, and capital gains and dividends to become taxable when they otherwise wouldn’t have been. It just creates a tidal wave of taxes.

Are you starting to see that retirement savings time bomb that Ed Slott was talking about? Well, let’s get to the part about how to diffuse it. There’s a different method of doing it for everyone. Why’s that? Because everyone has different resources and goals for retirement. That’s why you need to be methodical and do Roth conversions one at a time to see if they make sense for you.

“When we meet with our clients, we look at the possibility of having Roth conversions in their future. We bring in our CPAs who use a spreadsheet to see the benefit of doing a Roth conversion. It also indicates how much tax they would pay in any given year. That way you can say, ‘I’m better off if I only convert this much this year because of my other income sources.’ We hone that down to determine the best situation for the client.” – Bud Kasper

A Rule Conversion Rule of Thumb – Don’t Just Think About Yourself When Doing a Roth Conversion

We’ve been talking about the benefits and potential tax implications for you when considering Roth conversions, but there’s still more to it than that. What about your spouse? If you were to pass away before your spouse, they will become a single tax filer. Think about the tax implications of that with what tax bracket they’ll now be in.

“The single filer is penalized. They’ll have a higher tax. Well, guess what? If you have the Roth, there won’t be any tax on it. Therefore, the penalty won’t be as onerous as if you didn’t have it that way.” – Bud Kasper

Paying as Little Tax as Possible Over Your Lifetime

Before we move on in our discussion about Roth conversion rules in retirement, we want to circle back to Bud’s second to last quote. He mentioned looking at how much tax someone would pay in a given year. We do look at that, but that’s only part of the process with Roth conversions and tax planning as a whole. We want to look at how you can pay as little tax as possible over your lifetime.

When you’re building a financial plan, you can show what the total tax is going to be over your lifetime if you don’t do any Roth conversions. Then, you can see what it will look like if you do Roth conversions.

“Then, you can say, ‘What happens if a spouse passes away early?’ What will the difference be then? Or what happens when the money passes to the next generation? With the SECURE Act coming upon us in the last few years, it has complicated how IRAs are passed to the next generation. That is one of the reasons why we’ve seen so many people say that the Roth conversion makes a lot more sense.” – Dean Barber

Traditional IRAs Are a Bad Wealth Transfer Vehicle

The biggest asset that’s typically passed down to the next generation is a traditional IRA or 401(k). Effective this year after the passing of SECURE 2.0 in December, if you die after your Required Beginning Date, which is April 1 of the year after you turn 73, your children must continue to make Required Minimum Distributions. On top of that, they must completely the IRA following the 10th year following the year of death.

“There could be scenarios where someone in their 50s is inheriting large IRAs from their parents who are in their 70s or 80s. These large IRAs are going to be forced out as ordinary income for someone who is in their peak earning years. The chance of that being taxed at close to the highest bracket is very likely.” – Dean Barber

So, when looking at Roth conversions, think about converting to the top of the 12% or 22% bracket depending on your situation. You just need to remember that as long as you live in the U.S. and have money or make money that taxes will be a fact of your life. Roth conversions can help minimize those taxes, but you need to focus on mitigating them over your lifetime rather than in one year. As you’re considering Roth conversions or other tax planning strategies, don’t forget to download our Tax Reductions Strategies guide so that you can keep Uncle Sam out of your pockets.

DOWNLOAD: TAX REDUCTION STRATEGIES

Is Congress Going to Take the Roth IRA Away?

While Bud and Dean are big advocates of the Roth IRA, there have been concerns for several years now that Congress will take it away. People have noted those concerns for why they don’t want to do Roth conversions, but Dean doesn’t think that should keep you from doing so.

“Back in the late 1990s, Congress had a special rule that allowed people to do conversions and then take that tax and spread it out over a three-year period. I had a lot of clients back then that converted the entire IRA to Roth IRA, paid the taxes over the next three years, and are in a tax-free environment today. Distributions out of Roth IRAs don’t count under the provisional income rule.” – Dean Barber

If you’re unfamiliar with the provisional income rule, it determines whether your Social Security becomes taxable. So, those people Dean was working with aren’t paying any taxes on their Social Security or distributions on the Roth IRA, but they’re in a tax-free environment in retirement. But that requires planning. Roth conversions shouldn’t be something that are only considered in retirement.

“You need to start thinking about Roth conversions in your 40s or 50s. That will help dictate which account you put money into because you need to have tax diversification to do Roth conversions in retirement. You need to have some money in taxable accounts to pay the tax on the conversion. I’m not saying that it doesn’t work to pay the tax out of the IRA when you convert it, but it’s just not as advantageous.” – Dean Barber

A Big Retirement Misconception

Dean mentioned that some people don’t want to do Roth conversions because they think the Roth IRA could go away, which made him think of another retirement misconception. A lot of people assume that they’re going to be in a lower tax bracket in retirement, but those people could be in for a big surprise with that assumption.

“Our industry taught me, Bud, and so many other advisors to tell people to always contribute to traditional because you’ll be in a lower tax bracket in retirement. We were at a little bit more impressionable ages back then. But when you look at it, it’s not a simple rule. Maybe you should have some in traditional and some in Roth or maybe it should all be Roth or all traditional? I don’t know until I’ve completed your financial plan. To me, this is a complex math problem.” – Dean Barber

You might like trying to solve complex math problems, but a financial plan isn’t something that should be solved alone. You need to work with a CFP® Professional that really understands how to prepare a financial plan. And that CFP® Professional needs to work with a CPA that understands financial planning and can look at the plan from a tax perspective. Then, you can start making educated financial decisions that are based on your unique situation.

Online Retirement Calculators Won’t Give You a Correct Answer

A lot of people think that they can get the answer to how much they need to retire with an online retirement calculator. But there are several things that those calculators don’t account for, so they can’t give you an accurate answer.

It’s Not What You Make; It’s What You Keep

When Dean and Bud joined the Ed Slott Elite IRA Advisor GroupSM in 2006, one of the first things Ed told them was, “It’s not how much you make; it’s how much you keep.” Ed wasn’t talking about fluctuations in the market and potential losses on investments. He was talking about what Uncle Sam takes away from you.

If you make a mistake on an investment, that can recover over time. If you make a mistake on a tax situation or miss an opportunity, Uncle Sam isn’t going to be forgiving. There’s no do-over. Year after year, we see multiple people that are overpaying their taxes and they don’t even know it.

“They’re not overpaying their taxes because someone has prepared their tax return wrong. They’re overpaying their taxes because they’re missing opportunities. And they’re missing opportunities because they’re not working with a CFP® Professional that’s working with a CPA that’s looking at the plan from a tax perspective.” – Dean Barber

The Roth 401(k) Match

Bud describes the relationship between CFP® Professionals and CPAs as perfection. It allows the CFP® Professional and CPA to show off their skill set and it’s all for the best interest of the client. He and Dean also have one last thing to share about SECURE 2.0 that could be an opportunity for you. That’s the opportunity for employers to offer a Roth 401(k) match.

“Prior to the SECURE Act 2.0, employers had to match to the traditional side of your 401(k). It’s not yet clear what the ramifications are for the employee or employer of a match that’s done inside the Roth. Remember that all Roth contributions must be after-tax contributions. So, if the employer matches to the after-tax portion, who paid the tax on the employer’s contribution? Is that a tax due to the employer at the corporate level or an additional tax to the employee?” – Dean Barber

That money is going to need to come from somewhere. Is it going to come in the form of higher costs for services or products down the road? Is it going to come in the form of reducing the match dollar amount or percentage to the 401(k)? The employee right now is saying, “Not my problem,” but we’ll keep you posted on any updates from Congress.

Do You Have Questions About the Roth Conversion Rules?

We hope that we’ve been able to provide you some insight on Roth conversion rules that can help you with your retirement planning. Again, there are a lot of follow-up questions that come up after deciding to contribute to Roth or traditional. When should you be saving to what bucket and how much? To get the answers that are specific to you, you need a financial plan and be working with a CFP® Professional and CPA that work together.

It truly can be an eye-opening experience to see how Roth conversions can impact your retirement. If you have questions about the Roth conversion rules and/or are ready to start building your plan, we’re here to help. You can schedule a 20-minute “ask anything” session or complimentary consultation with one of our CFP® Professionals by clicking here. We can meet with you in person, by phone, or virtually—it’s totally up to you.

We’re also giving you the opportunity to use our industry-leading financial planning tool at no cost or obligation so you can see what comprehensive financial planning looks like. And if you have any questions as you’re doing that, we’re still more than happy to answer them. You can begin building your plan by clicking the “Start Planning” button below.

Roth Conversion Rules

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We look forward to seeing how a financial plan can give you confidence that you’re doing the right things with your money, freedom from financial stress, and time to spend doing the things you love.

Roth Conversion Rules | Watch Guide

Introduction: 00:00
What is the Roth IRA?: 00:40
Roth Conversion Tax Savings: 03:47
Roth Conversions and Financial Planning: 07:40
Considering Roth Conversions BEFORE Retiring: 12:04
It’s Not How Much You Make, It’s How Much You KEEP: 15:30
Roth Company Match: 18:15
Conclusion: 21:35

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The views expressed represent the opinion of Modern Wealth Management, LLC, an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management, LLC does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.