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The Roth Conversion Ladder: Your Key to Tax Savings

Converting your Traditional IRA funds to Roth can bring a slew of benefits: increased tax flexibility in retirement, no Required Minimum Distribution requirements, legacy benefits, and more. But obstacles lie in the way – a potentially huge tax bill, the possibility of getting pushed up a tax bracket, and implications for your Social Security benefits and Medicare premiums, potentially striking a blow to your carefully developed lifelong tax strategy and financial plan. However, by staggering your conversions via a Roth Conversion Ladder, you can reduce the financial impact of conversions.

The Roth IRA vs. Traditional IRA

The Traditional IRA is an excellent retirement investment account that lets you defer taxes on contributions and earnings until you begin withdrawing your funds in retirement. You get a tax break for the years you contribute to your account. However, your withdrawals are counted as taxable income and may affect your Social Security and Medicare benefits. Additionally, they can even push you up a tax bracket (like a Roth conversion) and come laden with Minimum Required Distributions (RMDs) once you reach 73 years of age.
A Roth IRA functions quite differently from a Traditional IRA. You first pay taxes on your contributions, and then your earnings grow tax-free. When you withdraw funds from your Roth IRA, you don’t need to pay taxes on the earnings, and your tax situation won’t be affected as long as you follow Roth withdrawal rules. There are no RMDs, and you can let those funds grow as long as you want, and upon your passing, any leftover funds can get passed to beneficiaries tax-free.
However, you may find yourself in a situation where it was optimal to contribute to a Traditional IRA in your younger years but later on, determine that it would be more beneficial to have a part or all of those funds converted to Roth. Perhaps you’d like more savings for your later years, beyond the RMD age, or would like to pass on a sizeable nest egg to your beneficiaries. Whatever the reason, there are nuances you must consider before converting the desired amount.

The Tax Bill

Let’s examine how a Roth conversion can affect your tax bill. If you are married and filing jointly with a gross income of $120,000 and want to convert $500,000, you will jump up from a 22% tax bracket to a 35% tax bracket. Your tax bill will be an astounding $140,000 on the converted funds alone. You’ll also need to pay that tax bill by the next quarterly estimated tax payment due date, and waiting until April of the next year may see you paying late tax payment penalties. Other aspects of your tax situation may be affected as well, such as certain credits and deductions.
Not only have you substantially increased your tax bracket, but you now owe a considerable sum of money relatively soon. Figuring out how to pay that tax bill is an issue on its own; you can use converted funds to pay the bill (setting your earnings ability back significantly), cash out other Traditional IRA assets (you may owe a penalty, plus taxes again), sell other brokerage assets, or pay cash, if you have it on hand.

The 5-Year Rule

After converting your $500,000 and paying that tax bill, you may still have another issue. If you need your funds within five years, you will owe income taxes on any earnings withdrawals, and if under 59 ½, a 10% penalty on the funds you withdraw. To avoid these issues, you must wait five years to make withdrawals and/or wait until reaching age 59 ½.

The Impact on Social Security and Medicare Benefits

If you’re already retired or receiving Social Security benefits, converting a significant amount from a Traditional IRA to a Roth IRA could affect your Social Security income and Medicare premiums.

Social Security Taxation

Generally, Social Security benefits may be subject to federal income taxation based on your combined income, which includes your regular income and other sources of income, such as rental income, pensions, investments, and half of your Social Security benefits. If your combined income exceeds certain thresholds, up to 85% of your Social Security benefits may be taxed.

Medicare Premiums

While the Roth conversion’s impact on Medicare premiums may not be immediate, it could affect your costs a couple of years down the road. Medicare Part B and Part D premiums are determined based on your modified adjusted gross income (MAGI) from two years prior. A Roth conversion can elevate your MAGI for the year, potentially putting you into a higher premium bracket for Medicare services in the future.

Roth Ladder Conversions

Staggering your Roth conversions isn’t merely a method to limit immediate tax liability; it’s a comprehensive strategy that optimizes your tax situation over the long term. This approach aims to reduce not only your overall tax bill but also the various complications associated with Roth conversions, like the five-year rule for withdrawals and the possible impact on Social Security and Medicare.

When to Start Converting

The timing of your staggered conversions is crucial. If you’re planning to retire at age 60, it’s wise to start this process well before that time—for example, at age 54. Beginning earlier gives you a longer runway to spread out the conversions, which can help keep you in a lower tax bracket.

Calculating Conversion Amounts

Assuming you are in the 22% tax bracket and filing jointly with a salary of $120,000, you could convert up to $98,450 each year to remain in the same tax bracket. However, this is a simplified scenario. You’ll need to consider not just your salary but also other forms of income and deductions that could affect your taxable income for the year. This is where financial planning tools or consulting a tax advisor can provide valuable insights.

Navigating the Five-Year Rule and Penalties

The five-year rule for Roth IRAs specifies that you must hold your converted funds in the Roth account for at least five years to withdraw earnings tax-free and without penalties. By staggering your conversions and starting at age 54, you ensure that by the time you’re 60, your earliest converted funds will be eligible for tax-free withdrawal, thereby avoiding the complications related to the five-year rule.

Ongoing Tax Liabilities

Even with a Conversion Ladder, you will still incur tax obligations. Using the previous example, your tax bill on the converted $98,450 would be approximately $21,659. While this is still a substantial sum, it pales in comparison to the whopping $140,000 tax hit you’d incur by converting $500,000 all at once.

In Conclusion

While the allure of tax-free growth and withdrawals in a Roth IRA can be compelling, the immediate financial hit from a one-time conversion may create a ripple effect, affecting your Social Security income, Medicare premiums, and tax strategy.
A Roth Conversion Ladder, on the other hand, allows you to plan methodically, convert manageable amounts, and stay within a preferable tax bracket. This approach dilutes the immediate tax burden and minimizes the impact on other areas of your financial life. To truly benefit from this strategy, however, careful planning and consulting with a financial advisor are essential steps. By doing so, you can align your Roth conversion with your broader financial goals, ensuring a smoother transition into a more tax-efficient retirement.

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

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  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.

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