Does a Roth Conversion Strategy Make Sense After You Retire?

Roth individual retirement accounts (IRAs)—established in 1997—are popular investment accounts for one simple reason: tax benefits! 


Many contribute to Roth IRAs before retirement to build up tax-free income for retirement. But did you know that you can also utilize Roth conversions after you stop working, too? 

Key Takeaways

  • Roth IRA conversions can build up your tax-free income during retirement.

  • The key to Roth conversions is to convert at a lower tax rate than you will experience with future distributions from your Traditional IRA.

  • Building up tax-free investments can help you manage your tax liability before collecting Social Security and starting required minimum distributions (RMDs).

What’s a Roth IRA?

Roth IRAs allow your investments to grow tax-free because you contribute using after-tax money from earned income. 


You can make tax-free withdrawals on your contributions at any time. If you’d also like to make tax-free withdrawals from your earnings, you’ll need to be at least 59 1/2 and keep the money in the account for at least five years, also known as the five-year rule—more on that rule below.


But there are contribution limits and income restrictions for contributing to these accounts.


  • 2022 Contribution Limits: $6,000/year (or $7,000/year if you are 50 or older)

  • 2022 Modified Adjusted Gross Income (MAGI) Limits: $144,000 if filing individually or $214,000 if filing jointly 


These limits usually prohibit high-net-worth investors from directly contributing to Roth IRAs, so many people plan to convert to a Roth account later. Sometimes called a “backdoor Roth IRA,” Roth conversions let you convert funds from a Traditional, SEP, or SIMPLE IRA into a Roth IRA. You can also convert assets from other traditional accounts, like a 401k.  


Conversions inherit the same tax benefits and distribution rules as if you had contributed directly to the account.  


There’s one—potentially prominent—catch to conversions. Roth IRAs are after-tax investments, so to enjoy the benefit of tax-free withdrawals from a Roth IRA, the IRS assesses tax during the year you make the conversion. If you convert $100,000, you could have a significant check to write to cover taxes. 


As you can imagine, precision is critical. Let’s start with the five-year rule to help you answer the question: 


When should I complete a Roth IRA conversion?

The 5-Year Rule and A Roth Conversion in Retirement

Remember the two requirements for making tax-free withdrawals from your Roth IRA earnings? 


  1. Be at least 59 ½ years old.

  2. Invested money must stay in the account for at least five years. 


The five-year clock starts when you invest the money for all Roth IRA investments, whether directly contributed or converted. As an example, if you convert $100,000 to a Roth IRA when you’re 55, you must wait until you’re 60 to make withdrawals on the earnings. 


Violate either of these requirements, and you may need to pay a 10% early distribution penalty and ordinary income tax on your earnings. 

Paying the Tax Bill on a Roth IRA

Remember that you’ll always pay taxes one way or another. Tax-deferred dollars make up Traditional IRAs, so when you convert those dollars to a Roth IRA (made up of after-tax dollars), you’ll pay taxes on the converted amount in the year you make the conversion per the IRS pro-rata rule*. 


Here are a few tips to make that taxable amount more manageable:


  • Though it’s difficult to predict, try to complete a Roth IRA conversion if you believe you’ll move up a tax bracket in the future. 

  • Break up your conversion amount over a few years to reduce the upfront tax liability. Remember the five-year rule, and the tax percentage could change from year to year. 

  • Try to avoid paying taxes using money in your newly converted Roth IRA. It’s tempting, but you’ll eliminate tax-free income if you do.


*The IRS uses the Pro-Rata Rule to determine how tax-deferred money should be taxed upon withdrawal.

Why Early Retirement Can Be Ripe Roth Conversion Territory

Roth IRA conversions aren’t just reserved for the wealth accumulation stage of life, and there are no age restrictions like some other retirement account options. 


While the up-front tax payment may make you think about completing it before you have a fixed income, it can be advantageous to wait until early retirement under the right conditions. 


The key to optimizing the benefits of a Roth IRA conversion is to complete it when you are in a lower tax bracket than you will be in the future


When you first retire, you may not be receiving social security, pensions, required minimum distributions (RMDs), and other income that can bump you up to the next tax bracket. While in a lower tax bracket, you may pay less in taxes when you convert. 


Managing taxes may seem like a full-time job for as much as we talk about it, but surprise taxes are extra straining on a fixed income. Building up tax-free dollars will give you more control over your tax situation and help you effectively manage your income in retirement

The Value of Roth IRAs

Roth IRAs can bring immense value to your retirement income strategy. Unlike traditional IRAs, distributions from a Roth IRA are tax-free, including any investment gains if you follow the rules. Not only do you save income, but it’s also much easier to manage taxes post-retirement.


Roth IRAs are also one of the only accounts without required minimum distributions (RMDs). That means you can withdraw as little or as much as you need without worrying about penalties. You can also pass on the money (and tax benefits) to your heirs, making Roth accounts excellent for estate planning. 


As mentioned, when you convert to a Roth IRA, you bypass the contribution limits if you were to invest directly. Direct contributions cap at $7,000 a year (if you’re at least 50), while conversions have no cap (just a one-time tax bill). 


A conversion is just one more way to diversify your investments. And diversification helps build safety nets during prosperous and uncertain market conditions.

Careful Roth Conversion Considerations

Roth conversions are incredible retirement tools when applied appropriately. We’ve talked a lot about the “when,” but there are other considerations. 


Putting together your retirement income is like assembling a puzzle. It’s important to get dates and milestones lined up to avoid penalties. 


For example, Medicare IRMAA (income-related monthly adjusted amount) is an additional charge to your Part B and D premiums if you earn over $91,000 a year for single filers or $182,000 a year for joint filers. It’s determined by your income tax returns two years prior. For example, if you receive Medicare in 2022, then Medicare reviews your 2020 tax return to determine IRMAA. 


The Social Security Administration (SSA) recalculates IRMAA annually, so converting a considerable amount to a Roth IRA in one year could result in a higher premium. There are published surcharge buckets to help you plan for the extra expense. 


You can manage those surcharges by breaking up your conversion amounts over a few years and keeping your income under the IRMAA threshold. 


Between Medicare, taxes, RMDs, and maintaining a livable income during retirement, there are several deadlines to juggle. You don’t need to figure out how they fit together alone. Schedule a free consultation with an advisor at Metanoia. We’ll help you map it out.