By W Financial Advisors • Wealth Wednesday Brief • 3–5 min read
SCENARIO
Nancy retired at 63. For the first time in her working life, she had no W-2 income, no side business revenue, and no Required Minimum Distributions yet. Her Social Security wouldn't begin until 66, and her spending was coming from a taxable brokerage account her advisor had specifically set aside for this phase.
To most people, this looked like a quiet financial period between careers and retirement income. To her advisor, it looked like an opportunity.
"These may be the lowest-tax years of your life," he told her. "If we don't use them deliberately, we may end up paying significantly more in taxes over the next 25 years than we needed to."
That conversation led to a three-year Roth conversion strategy that, by his projections, may save Nancy and her heirs a substantial sum in lifetime taxes.
THE CONCEPT
A Roth conversion involves moving money from a traditional IRA or 401(k), where contributions were made pre-tax, and all withdrawals are taxed as ordinary income, into a Roth IRA, where future growth and qualified withdrawals are tax-free.
The conversion itself is a taxable event: the amount converted is added to your ordinary income in the year of conversion. The appeal of doing this during lower-income retirement years is that the conversion can be done at a lower marginal rate than you might face in later years, when Required Minimum Distributions, Social Security benefits, and potentially other income sources all combine to push your taxable income higher.
The fundamental question in a Roth conversion analysis is: will the tax rate you pay today be lower than the rate you (or your heirs) would otherwise pay later? In many cases, the answer during the early retirement years is yes.
EXAMPLE
Here's a simplified illustration. James is 65, recently retired, and has $900,000 in a traditional IRA. He has no Social Security yet and is living on brokerage account withdrawals that generate modest capital gains. His taxable income this year is approximately $28,000.
The 22% federal tax bracket for a single filer in 2024 begins at $47,150 (IRS figure, adjusted annually for inflation; confirm current threshold at irs.gov before publication). That means James has roughly $19,000 of "bracket space," meaning room to add income at the 22% rate before hitting the next bracket.
His advisor suggests converting $19,000 of his traditional IRA to a Roth this year, filling the bracket. Next year, they'll evaluate again. Over several years, a portion of James's large IRA may be repositioned into a Roth, reducing future RMDs, potentially keeping him below IRMAA Medicare premium thresholds, and leaving his heirs assets that they can inherit and withdraw tax-free.
STRATEGY
A thoughtful Roth conversion strategy typically involves:
- Identifying your "conversion window." This is typically the period between retirement and the later of: Social Security commencement, age 73 (RMD start age), or any other anticipated income increase. The wider this window, the more time you have to convert strategically.
- Calculating your bracket space. Determine how much you can convert in a given year before reaching the next marginal tax bracket or triggering IRMAA surcharges. Converting to the top of the 22% or 24% bracket is a common strategy.
- Paying the conversion tax from outside the IRA. If possible, pay the tax due on the conversion from taxable account assets rather than from the IRA itself. This preserves the full converted amount in the Roth and maximizes the long-term benefit.
- Evaluating the time horizon. The longer converted assets remain in the Roth before withdrawal, the greater the benefit of tax-free compounding. For assets intended for heirs, this consideration may be even more pronounced.
COMMON MISTAKE
One of the most common mistakes is converting too much in a single year, which can push income into a materially higher bracket or trigger IRMAA surcharges that wipe out the benefit of the conversion. A Roth conversion that makes sense at the 22% bracket may not make sense at 32%.
Another mistake is waiting too long. Once RMDs begin at 73, your taxable income is no longer fully within your control; the IRS mandates minimum distributions regardless of what other income you have. The years before 73 are the ones with the most flexibility.
KEY TAKEAWAY
Roth conversions during early retirement, executed thoughtfully and within the right income brackets, may be one of the most effective ways to reduce your lifetime tax burden. The window is real, but it closes.
SOURCES & REFERENCES
- Internal Revenue Service. Publication 590-B: Distributions from Individual Retirement Arrangements. Life expectancy factors from the Uniform Lifetime Table. irs.gov.
- Consolidated Appropriations Act, 2023 (SECURE 2.0 Act), Division T, signed December 29, 2022. RMD age increased to 73 for individuals who turn 72 after December 31, 2022.
This material is for informational and educational purposes only and should not be construed as personalized investment, tax, or financial advice. All examples are hypothetical and for illustrative purposes only and do not represent the experience of any specific individual. Actual results will vary. All investing involves risk, including the possible loss of principal. There is no assurance that any investment or tax strategy will be successful. Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax-free withdrawals on qualified distributions. To qualify for tax-free and penalty-free withdrawal of earnings, a Roth IRA must meet a five-year holding requirement and withdrawals must occur after age 59½ or due to death, disability, or a first-time home purchase (up to $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes. Distributions from traditional IRAs and employer-sponsored retirement plans are taxed as ordinary income and, if taken prior to age 59½, may be subject to a 10% federal tax penalty. IRA contribution limits and tax implications may apply. This information is based on current tax laws, which are subject to change. The impact of a Roth conversion will depend on your individual circumstances, including future tax rates, income levels, and time horizon. Cetera Wealth Services, LLC exclusively provides investment products and services through its representatives. Although Cetera does not provide tax or legal advice, or supervise tax, accounting or legal services, Cetera representatives may offer these services through their independent outside business. This information is not intended as tax or legal advice.
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