If you took advantage of the down market in 2022 to convert some of your IRA to a Roth, you’re about to get a reality check of how much that will cost you when you file your tax return. Tax-saving strategies can sound good in theory, but you might feel differently when you see the actual bill.
“Sometimes it’s a hard sell, because they’re paying taxes they wouldn’t otherwise. Even if you show them over a lifetime that they’re saving money, they’re hesitant,” says Kenneth Waltzer, a certified financial planner based in Los Angeles. Since you can no longer take back Roth conversions like you previously could with a “recharacterization,” you need to be sure of your financial decision.
Roth conversions are mostly the concern of those with large IRA or 401(k) balances who have other funds to cover living expenses in retirement. The Roth conversion strategy entails moving as much as you can out of tax-deferred accounts before you start required minimum distributions, which is now age 73. It’s common to start as early as 60, when you might be transitioning to retirement or have the financial ability – maybe you’re done paying for college, the house is paid off or you’re simply making more than you spend.
Most people take a multiyear approach to spread out the financial burden, being mindful of where they fall in the income parameters of their tax bracket. “We figure out the most they can take and not go into the next bracket,” says Waltzer.
From there, it’s a matter of pacing it out. If, for instance, you have $1 million saved for retirement in a 401(k), you might start moving $50,000 a year into a Roth at age 60. By 73, you might only have about $350,000 left in the account, depending on market performance. Your RMD would then be much smaller, and you wouldn’t have to worry about future taxes on the money that’s growing in the Roth – and your heirs would inherit tax-free for 10 years if you don’t spend all the money during your lifetime.
The tax bill on that $50,000 depends on the rest of your financial situation – namely, your filing status, other income and deductions. Those who have already started to take Social Security have the additional consideration of what the extra income does to the taxation of their benefit – up to 85% of the benefit could be considered taxable income. Those on Medicare need to watch the calculation of their annual Part B and D premiums to avoid what are known as IRMAA surcharges. But if you’re in the 22% bracket, say, you can ballpark that $50,000 in additional income would add around $11,000 in federal taxes, and you may also owe state and local income taxes, depending on where you live.
What’s your tax mind-set?
The math of a Roth conversion is one thing, how you feel about taxes is another. Retirement expert Ed Slott says he gets asked all the time whether a Roth conversion is right for a particular person, given their circumstances. At a presentation, one woman asked him about the impact of a conversion on her Medicare premiums and said if she had to pay more, she’d be pretty angry. Slott responded, “If that would make you angry, do the conversion anyway.”
“Because then you’re just mad for one year, but if you didn’t convert, you’d be angry for the rest of your life,” Slott told her.
But that Medicare hitch does, indeed, make some people feel a pinch. Waltzer had a client who started a Roth conversion strategy in 2016 when she was 71 and her account was worth $240,000. She did conversions of around $8,000 for three years in a row and then stalled, mostly because of the Medicare premium. “It’s a gotcha,” says Waltzer.
Another of Waltzer’s clients was put off more by the amount of cash she needed to have handy to cover the tax. You can pay the tax on a Roth conversion with funds from the IRA, but that’s like “paying tax on tax,” says Waltzer, so he advises clients to cover the amount due out of their pockets and convert the maximum amount they can to the Roth.
This retired schoolteacher was married and planning to convert a large amount over time because her IRA was $700,000, so she took out $25,000 the first year. That was enough for her and her husband, and they stopped. “They are very tax sensitive and they didn’t like the idea of paying extra taxes,” says Waltzer.
Many people may simply run out of time because they start a Roth conversion plan and expect to continue it past the age of taking RMDs, but then can’t keep it going.
“Roth conversions get more expensive at that point,” says Slott. This is mostly because RMDs have to come first. So if you have $500,000 in a tax-deferred account and you’re 76, you might have to take out around $20,000 and pay income tax on that to satisfy the RMD. Then if you try to convert more on top of that, you could end up owing too much in taxes to stomach it.
“That’s why people in their 60s might be more of an ideal candidate for Roth conversions,” says Slott. “The moderate, best long-term approach is a series of small conversions over time.”
Got a question about the mechanics of investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write me at [email protected].
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