Calculating the Cost and Benefit of Roth Conversions Before Retirement

The Internal Revenue Code treats traditional savings and Roth savings very differently when you reach age 73. A 65-year-old couple with a $1 million portfolio in traditional accounts faces a steep tax climb once required minimum distributions begin, potentially pushing them into a higher tax bracket than they experienced while working.

Converting a portion of that money to a Roth IRA now allows you to pay taxes at a known rate today so withdrawals later are tax-free. This strategy is not free, but for many households in the gap years between retirement and Medicare, it creates a tax hedge that lasts a lifetime.

The Value of Tax Arbitrage

The core logic of a Roth conversion relies on tax arbitrage. You pay income tax on funds moved from a traditional IRA at your current marginal rate. If your tax rate in retirement is lower than your current rate, a conversion actually costs you money.

However, if you expect your tax rate to be the same or higher in retirement, paying the tax now locks in a lower rate. Consider the Tax Cuts and Jobs Act of 2017. Current individual tax rates top out at 37 percent but are scheduled to sunset in 2026.

Without new legislation, the top rate will revert to 39.6 percent and brackets will shift upward. Converting funds while rates are historically low acts as an insurance policy against future tax increases by Congress.

The Hidden Cost of Medicare Surcharges

You must watch your Modified Adjusted Gross Income closely because it triggers the Income-Related Monthly Adjustment Amount, known as IRMAA. Medicare uses your tax return from two years prior to set your Part B and Part D premiums.

For 2024, if your MAGI exceeds $103,000 as an individual or $206,000 as a joint filer, you pay extra. A large Roth conversion spikes your income for that year. This means a conversion done in 2024 could inflate your Medicare premiums in 2026.

You must calculate whether the tax savings from the conversion over 20 years outweigh the extra premium costs for a single year. Sometimes, doing a smaller conversion over several years keeps you below these threshold cliffs.

Where to Find the Cash to Pay the Tax

The math works best if you pay the conversion tax with money from outside your retirement accounts. If you have a $100,000 traditional IRA and you are in the 24 percent tax bracket, you owe $24,000 to the IRS.

If you pay that $24,000 from the IRA itself, you only move $76,000 to the Roth. You lose the growth potential on that $24,000 forever. If you pay the tax from a checking account or savings, the full $100,000 goes into the Roth and grows tax-free.

Using outside cash effectively allows you to shelter more money from future taxes. This requires having liquid savings available, which is why you should plan conversions years before you actually need the money.

Timing Your Conversions Around the Tax Sunset

The window between stopping work and claiming Social Security presents a golden opportunity. During these years, your taxable income often drops significantly because you no longer have a paycheck.

You might fill the lower tax brackets, such as the 10 percent and 12 percent brackets, with conversion money. For example, a married couple filing jointly might have a standard deduction of $29,200 in 2024.

They could potentially convert another $23,200 and still stay in the 12 percent bracket. Filling these low brackets with taxable conversions at a low rate is more efficient than waiting until RMDs force money out at a 22 or 24 percent rate later.

The Benefits for Your Heirs

The SECURE Act of 2019 changed the rules for inherited IRAs. Most non-spouse beneficiaries must empty the account within 10 years of the owner's death. If they inherit a traditional IRA, those withdrawals are taxable as ordinary income to them.

This can create a massive tax bill for your children during their peak earning years. If you convert to a Roth and pay the tax yourself, your heirs inherit the account tax-free.

They still must withdraw the money within 10 years, but they owe the IRS nothing. This is a highly efficient way to transfer wealth, acting as a tax-free gift to your family rather than a tax burden.

The Five-Year Rule Constraints

You cannot touch the converted money penalty-free immediately. The IRS applies a separate five-year clock to each conversion you make. If you are under age 59 and a half, you must wait five years to withdraw the converted funds or you pay a 10 percent early withdrawal penalty on the earnings portion.

Once you reach age 59 and a half, you can access your converted contributions at any time tax-free and penalty-free. However, any earnings on those contributions must also meet the five-year rule.

This makes Roth conversions a poor strategy if you need access to that cash immediately. It is strictly a long-term play for retirement security.

Do not let the fear of taxes paralyze your portfolio planning. A Roth conversion is a tool, not a mandate, and it works best when you have cash on hand to pay the tax bill without raiding the principal.

Start by projecting your taxable income in retirement and run the numbers with a calculator or a trusted fee-only advisor. If your tax rate is lower now than it will be once Social Security and RMDs kick in, converting a small amount each year can protect your heirs and your future self from the taxman.

Sources

• Internal Revenue Service, 'Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)' (2023)
• Social Security Administration, 'Medicare Premiums: Rules for Higher-Income Beneficiaries' (2024)
• Vanguard, 'The case for Roth conversions' (2022)
• Center for Retirement Research at Boston College, 'Roth Conversions as a Tax Management Tool' (2021)