When retirement approaches, managing taxes and retirement accounts like your IRA becomes crucial. Many people consider converting their traditional IRA into a Roth IRA as a way to avoid mandatory withdrawals known as Required Minimum Distributions (RMDs) that occur when they turn 73.
But is converting your IRA the right decision for you? Let’s break it down and see how this might work, especially if you earn $90k per year and have a $900k IRA.
Understanding Roth IRA Conversions: The Basics
Converting an IRA to a Roth IRA allows you to pay taxes on the funds now rather than later when you might be in a higher tax bracket. While there’s no way to avoid RMDs entirely after you hit 73, a Roth IRA conversion can reduce their impact. If done carefully, you can minimize the taxes on the conversion by spreading out the process over a number of years instead of converting everything at once.
The main benefit of converting an IRA to a Roth IRA is that Roth IRAs are not subject to RMDs, unlike traditional IRAs. This can be a significant advantage for many retirees who want more control over their retirement income and tax situation. Additionally, once you reach age 59 ½ and have held the Roth IRA for five years, you can withdraw funds tax-free. This makes Roth IRAs a powerful tool for retirement planning.
In your case, you’re earning $90,000 per year and have $900,000 in your IRA. The question to consider is: How much of that IRA should you convert each year?
Roth Conversion Tax Impact
The first thing you should consider is the tax effect. Assuming you’re filing as a single taxpayer and your taxable income is $125,000 for 2023, you’ll fall into the 24% tax bracket.
This means that your federal tax bill would be around $20,076. If you decide to convert $90,000 from your IRA to a Roth IRA, your income would increase to $215,000, pushing you into the 32% tax bracket. This will cause your tax bill to jump to $43,200, which is an extra $23,124 in taxes just for this conversion.
This is a simplified example, but it shows how a conversion can push you into a higher tax bracket and increase your current tax bill. However, the advantage of this strategy is that once the funds are converted to a Roth IRA, they grow tax-free, and you won’t have to pay taxes on future withdrawals after age 59 ½, provided you follow the five-year holding period.
However, if you chose to convert the full $900,000 IRA into a Roth IRA all at once, your tax bill would skyrocket. Your income would increase to $1,025,000, placing you in the top 37% bracket, and your taxes would jump to $366,678, about $130,000 more than the gradual conversion. This is why many people prefer a gradual conversion strategy to avoid such a large one-time tax burden.
Tax Strategies to Make Roth Conversion Easier
A gradual conversion plan sounds like a better option than converting the entire amount at once. The key idea is to avoid spiking your taxes in a single year. If you convert $90,000 each year, your tax bill will gradually increase, but it won’t overwhelm your current income. On the other hand, converting a larger amount each year could push you into higher tax brackets, leading to more taxes than you might want to pay.
But there’s a catch: simply converting 10% of your IRA every year won’t fully empty your IRA after 10 years. Since your account will likely grow with investment returns, you’ll still have a balance left in your IRA by the time you hit 73.
Let’s break it down. If you convert $90,000 annually at a 7% average return, you will have about $500,000 left in your IRA after 10 years. The IRS tables for RMDs suggest that you would have to take about $20,000 in withdrawals during your first year of RMDs, which is relatively low. However, if your goal is to avoid RMDs entirely, you would need to convert more each year.
This is where a customized approach becomes necessary. If your goal is to reduce the impact of RMDs, you’ll need to carefully model how much of your IRA to convert each year based on expected returns, tax brackets, and your retirement goals. It’s important to ensure that you are converting enough to minimize the tax burden but not so much that you end up paying excessive taxes in a single year.
How Much Should You Convert to Avoid RMDs?
If your goal is to avoid RMDs completely, you’d need to convert a larger portion of your IRA. In this case, converting $128,000 each year would empty your IRA by the time you’re 73.
This could be the best way to eliminate RMDs, but it does come with a higher tax bill. For example, converting $121,000 would bring your taxable income to $253,000, pushing you into the 35% tax bracket, and you’d face a federal tax bill of about $70,000 annually.
Alternatively, you could aim to stay within your current tax bracket and convert just enough to keep your income at the top of the 24% bracket. In 2024, the highest amount of income for the 24% bracket is $191,950. If you convert $66,950 each year, you can avoid crossing into the 32% tax bracket, which would help keep your tax bill lower.
This is where understanding your tax bracket and how much you can convert each year without pushing yourself into a higher bracket becomes crucial. By staying within your current tax bracket, you can minimize the additional tax burden while still gradually converting your IRA to a Roth IRA. Over time, this strategy can help you manage your tax liability and avoid large tax spikes.
Other Factors to Consider
While these examples provide a solid foundation, remember that the process of Roth IRA conversion should account for various factors. Changes in tax rates, future income, and market returns are just some of the things to consider when planning for Roth conversion.
For instance, you might want to keep the money in the Roth IRA as part of your estate planning. Roth IRAs are not subject to RMDs, making them an excellent tool for passing wealth onto heirs without causing them to face tax penalties from required withdrawals. If you plan to leave your Roth IRA to your children or grandchildren, converting your IRA to a Roth IRA now can help reduce their tax burden in the future.
Additionally, if you’re planning to take money out of the Roth IRA before age 59½, keep in mind that you would face a five-year waiting period before you can withdraw the funds without taxes and penalties. This rule doesn’t apply if you are over age 59½, so it’s less relevant to your situation. However, if you’re under 59½, this could affect your decision-making process.
Working with a Financial Advisor
Roth IRA conversions are complex and personalized. They depend heavily on your current and expected income, tax strategy, and retirement plans. A financial advisor can help you make the right decision based on your goals and your unique financial situation.
If you’re not sure how to start, some tools can match you with financial advisors. Websites like SmartAsset offer a free tool that connects you with advisors near you, and you can interview them for free before deciding who’s the right fit. A good financial advisor will help you evaluate the best conversion strategy for your financial situation and ensure you are optimizing your tax strategy.
Bottom Line
Converting your IRA into a Roth IRA can be a smart way to avoid RMDs and the associated taxes, but it requires careful planning. Gradually converting $90,000 each year can work for some people, but if your goal is to avoid RMDs entirely, you may need to convert more.
Finding the right strategy for your Roth conversion will depend on your specific tax bracket, financial goals, and timeline. A financial advisor can guide you through the process to make sure you’re making the best decision for your future.
Roth IRA conversions are a valuable tool for retirement planning, but they require a strategic approach to minimize taxes while ensuring you don’t run into RMDs when you retire. Whether you choose a gradual conversion or a more aggressive approach, it’s important to work with a professional who can help you navigate the complexities of tax planning.
Disclaimer: This article has been meticulously fact-checked by our team to ensure accuracy and uphold transparency. We strive to deliver trustworthy and dependable content to our readers.
Leave a Comment