Preparing for retirement involves more than just saving; it is about managing your wealth thoughtfully to ensure it lasts. One strategy we frequently discuss with our clients is the Roth IRA conversion. While gradually moving funds from a traditional IRA to a Roth IRA can offer significant advantages, the specific way you go about it matters deeply.
Often, financial advice suggests converting a flat percentage of your portfolio—say, 20%—each year. Today, we want to explore why this one-size-fits-all approach might not serve your best interests and look at a more personalized strategy that aligns with your financial roadmap.
The Appeal of the Roth Conversion
Before looking at the mechanics of how to convert, it is helpful to review why conversions are a valuable tool in the first place:
No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not force you to take mandatory withdrawals at a certain age. This gives you complete control over when and how you use your money.
Tax-Free Withdrawals: Qualified withdrawals after age 59½ are entirely tax-free. Because they do not increase your taxable income, they can also help prevent your Social Security benefits from being taxed at a higher rate.
Estate Planning: If leaving a legacy is important to your family, Roth accounts allow your heirs to inherit funds with notable tax advantages.
The Flaw in the "Fixed Percentage" Rule
If Roth conversions are beneficial, why not simply convert 20% of your account each year until it is done? The issue lies in how the IRS views your money.
Taxes depend on dollars, not percentages: The IRS taxes the exact dollar amount you convert as ordinary income. They do not care what percentage of your portfolio that amount represents.
The risk of climbing brackets: Converting a large, flat percentage in a single year could push a significant dollar amount into a higher marginal tax bracket, leaving you with an unnecessarily steep tax bill.
Current versus future rates: The goal is to pay taxes when your rates are lowest. If you anticipate being in a lower tax bracket during retirement than you are right now, converting pre-tax funds prematurely could actually cost you more overall.
A Thoughtful Alternative: Filling the Bracket
Instead of an arbitrary percentage, a more effective method is often the "bracket top-off" strategy.
Rather than a set fraction, you convert only enough dollars each year to bring your total income up to the top threshold of your current tax bracket. For example, you might convert just enough to fill up the remainder of the 24% bracket without crossing the line into the 32% tier.
This approach maintains your flexibility. We can adjust the conversion amount based on your actual income each year—converting more during lower-earning years and pulling back during high-income years.
The Fine Print: Rules to Watch
Because we act as fiduciaries, we always look at the whole picture. A Roth conversion does not happen in a vacuum, and there are a few ripple effects to keep in mind:
Impact on other benefits: Because converted funds raise your Adjusted Gross Income (AGI), a conversion can inadvertently increase your Medicare Part B premiums, trigger taxes on your Social Security, or reduce Affordable Care Act (ACA) subsidies.
The 5-Year Rule: Each individual conversion requires a five-year waiting period before those specific funds can be withdrawn penalty-free. If you think you will need immediate access to this cash, a conversion may not be the right fit.
Navigating the complexities of tax planning and retirement income can feel daunting, but you don't have to figure it out alone. If you would like to sit down and look at how a bracket-filling strategy might fit into your overall plan, please reach out. We are here to help you build a future that brings your family peace of mind.