Early Retirees: Why Now Is the Time to Convert Your IRA to Roth

Key Takeaways

• Take advantage of lower-tax-bracket years before required minimum distributions begin to do Roth conversions.
• Beneficiaries’ tax situations can influence whether a conversion makes sense.
• Prioritize retirement income needs over conversions.
• Roth conversions can reduce future RMDs and increase tax-free assets.
• Using non-IRA funds to cover taxes can maximize your Roth IRA conversion.

Christine Benz: Hi, I’m Christine Benz from Morningstar, and thanks for joining us for a limited-edition series, Your Tax Playbook for Retirement, With Ed Slott. In this installment, Ed and I will be digging into one of his favorite topics, Roth IRAs, and when to convert traditional IRA balances to Roth. Ed, thank you so much for being here.

Ed Slott: Oh, it’s great to be back with you, Christine. Thanks.

Benefits of a Roth IRA Conversion

Benz: It’s always great to talk to you. We want to give kind of a playbook for people who are thinking about retirement and taxes in retirement, and we want to talk about what is one of your favorite topics: the IRA conversions. Why would someone even consider converting a traditional tax-deferred account like an IRA to a Roth IRA? What are the benefits and the potential drawbacks? Because converting obviously does result in a tax bill.

Slott: Right. And that’s true. I’m a big Roth conversion fan. Anybody that’s seen any of my programs and your videos and your seminars knows—because it saves you, for many people, I’d say most people, it saves a lifetime of taxes. And that’s how you have to do planning with the end in mind, not saving taxes one day or one year. Yes, it costs more upfront, but you get something for your money. I call it tax freedom. You get the ability to grow the account absolutely income-tax-free for the rest of your life and beyond, even after the Secure Act 10-year rule for beneficiaries; 10 more years of absolutely income-tax-free growth for 10 more years after death. So, you get something for your money. The other advantage is that, when converting now, first of all, you want to convert when you believe your rates will be the lowest.

The actual tax rates are historically low right now, and they will continue to be, I believe, at least for another few years. The One Big Beautiful Bill Act, one of the key parts of that bill was the extension of the reduced rates permanently. Now, that word, “permanently,” in tax law does not mean the same thing as permanent in the dictionary. In tax law, it means until a future Congress changes the rules. But I think we have low rates now, and if you can convert while you have known rates—known rates that you can count on—you can control your taxes using up the low brackets, the 12%, 22%, 24% brackets. If you don’t convert, the IRA will continue to grow. Remember, it doesn’t stop growing because you didn’t convert. The IRA is a kind of paradoxical asset. It both grows and erodes at the same time.

How could that be? Well, it grows from earnings, but so does Uncle Sam’s share, and you don’t know what that share will be. In the future, there are no known rates, so you have the advantage of having the known rates now and being low. You don’t know what future rates will be or what your future rates will be. It takes that unknown away. But there are people that don’t like the idea of paying money upfront. They don’t trust the government, or they think Roths will go away. They don’t see the financial sense of paying a tax before you have to. But as I said, if you see the long-term big picture, it also depends on who you’re doing the conversion for. You might be doing it for yourself, or you might be older and say, “It really doesn’t benefit me given my age. I mean, paying the cost of the conversion now in my 70s or 80s is not worth the benefit, given my limited life expectancy.”

But then you might say, “Well, I’m doing it for my children or grandchildren.” My children or grandchildren; when I say children, adult children, they might be in their 50s when they inherit, or 60s, and they may be in their own highest earnings years. The last thing they want is to inherit a tax bill. Let’s face it, they still inherit the money. It’s just an extra tax. But as a parent or a grandparent, you may want to do that for them to, in essence, get them to inherit absolutely income-tax-free money. It depends on what your purpose is in doing it. But if you’re looking at the long-term big picture and you’re paying tax at the lowest rates, the Roth really works. That’s why I’m a big Roth fan, but you have to get over that hurdle of paying money now. The best way to do it is to not think of it as a payment of tax. Think of it as an investment in your future financial security because this tax will have to be paid. Not paying it now doesn’t take it off the table. It’s not if, but when.

Tax Planning Considerations for Beneficiaries

Benz: I want to follow up on that idea of potentially, if you’re planning to leave the assets to a child, grandchild, whatever. What if that person is likely to be in a lower tax bracket when they inherit those funds from you? Are you better off not converting? If you’re a highly taxed person, are you better off leaving it to the person who might pay tax on that bundle of money at a lower tax rate?

Slott: Yes. Matter of fact, when I talk about conversions, I always couch that, so I’m glad you brought that up. For many people, it may pay; I wouldn’t say convert everything. I would leave a bedrock layer of traditional IRAs, not only for the beneficiaries that might be in a lower bracket. Remember, you look at lifetime planning and beyond, multigenerational. Who can pay the lowest taxes? I hate to tell this story, but this is a story I actually had from a client. We’re talking about Roth conversions, and the same question came up. He says, “I have three kids. They’re all losers. They will never be in a high bracket, so why should I convert? They’ll pay almost nothing in taxes.” I agree. So, that’s a benefit for them. But the other reason of keeping some traditional IRAs, if you’re charitably inclined and want to do qualified charitable distributions, you do that from a taxable IRA.

Or, you may have medical expenses—everybody does; you just don’t know when—that can be taken down against and deducted somewhat. There’s a differential there: a 7.5% limit against traditional IRA income. And you may want to keep a layer, too, just for those reasons, or you may have years you’re in a lower bracket. There are two sides to that coin, and the decision is really different for everybody. But if you’re just looking to power out and have everything tax-free and never having a worry about it, the Roth is a good deal. I’ve had clients over the years that did full Roth conversions just because they couldn’t stand RMDs anymore. They just couldn’t stand making the calculations, wanted to get rid of it, or if they had nondeductible contributions and had to do that pro rata rule, a lot of them just did full Roth conversions just to get rid of the problem.

I’ll tell you another thing with Roth conversions. I have a lot of experience in this with clients, with financial advisors who have advised their clients to do Roth conversions. I have never ever heard one story of buyer’s remorse for somebody who did a Roth conversion. Everybody I know, and I know a lot of people through financial advisors we train, wishes they had more Roth. Everybody that has a Roth wishes they have it more because now they see their account growing absolutely income-tax-free, 100% for them. I’ve never seen any buyer’s remorse for Roths.

Taking Advantage of Lower Tax Brackets Before RMDs

Benz: OK. Ed, we wanted to focus the conversation on people who are just embarking on retirement. You and I have often talked about how those early years of retirement can be a terrific life stage to think about conversions versus maybe later in life, perhaps when those RMDs have started. Can you talk about why that period of early retirement is often quite advantageous to consider conversions?

Slott: Yes, because you’re using lower brackets. Your big W-2s stop, so you have this dip before RMDs kick in. See, once RMDs kick in, it gets expensive to convert because then you’re locked in. Then you’re into a system that’s out of your control, but you may have those years, say 65 maybe to 73, and those are the years you should max out these low brackets with conversions. Again, if you can afford to pay the tax—nobody should go broke converting. What I’m talking about, or the people I’m talking to, are the people with overly heavily weighted IRAs, $1 million plus, and there are plenty of those people that just have piled up too much in those accounts, and this would be a good way to lower future RMDs by getting Roth conversions done before RMDs kick in.

Prioritizing Retirement Income Needs Over Roth IRA Conversions

Benz: OK. I wanted to ask about the very common predicament where someone needs money for living expenses in retirement, maybe they aren’t taking Social Security yet. In that case, am I better off just pulling income from those tax-deferred accounts and not worrying about converting? Because it seems like the tax implications would be the same; you’re paying full freight on those conversions or the withdrawals. How would you approach that?

Slott: I would say yes. If you need the money, take the money. Obviously, you’re probably in a lower bracket, and whether you spend it or convert it, as long as you’re getting it out at a lower rate, conversions would take a backseat to that, obviously, if you need the money for ongoing expenses.

How RMDs Affect Roth Conversion Strategies

Benz: OK. I wanted to ask about conversions once someone is of RMD age, so say they’re over age 73 and they’re on the hook for those RMDs from the traditional tax-deferred accounts. You hinted that in some instances it can make sense to do conversions in that period. Can you talk about that?

Slott: Yeah, it can make sense if you can afford to do it, but the conversions are more efficient before RMDs begin. Once RMDs begin, the required minimum distribution must be taken, and you have to pay tax on that money, and it can’t be converted, which stinks because you’re taking the money out. Why can’t I convert it? I paid the tax because the law says an RMD cannot be converted. You first have to take the RMD and pay the tax on that. And then, once the RMDs for all your IRAs, if you have several of them, once all the RMDs for all your IRAs are satisfied, then you can convert part or all of the remaining balance for that year. But it costs more because you have to take RMDs that you couldn’t convert and pay tax on them. It’s a little more expensive, but it can be done.

Using Non-IRA Assets to Cover the Tax Bill

Benz: OK. Final question for you, Ed. If I am doing conversions, I’ve often heard that it makes sense to have the money for the tax bill outside of the account, that I don’t want to have to take extra from my IRA to cover the tax bill. Can you talk through that?

Slott: Yeah, I agree with that. It’s best if you have outside money. Again, nobody should go broke converting. You do what you can do. What you just said is especially true if you’re thinking of converting before age 59½, because if you are having taxes withheld, let’s say you want to convert $100,000, just to throw a number out, and you’re having, I don’t know, $30,000 of tax withheld, only $70,000 will get converted. The other $30,000 is treated as a regular taxable distribution. If you’re under 59½, you’d not only have a tax, but a 10% early distribution penalty. To me, that’s a dealbreaker: paying a penalty to pay a tax. But if you’re 59½ or over and you’re not in a penalty situation, I would still say try to use outside money. Because in the example I gave, if you do a conversion and have the tax withheld, only $70,000 gets converted. It’s kind of like buying a stock for $100,000, and the minute you put it in the account, it’s only worth $70,000. You’re not getting the bang for your buck. If you have the outside money, it’s almost always better to do that.

Benz: OK, Ed, valuable insights as always. Thank you so much for being here.

Slott: OK, thanks, Christine.

Benz: Ed and I will be tackling other retirement-related tax issues in future episodes of this series, so please stay tuned. Thanks for watching. I’m Christine Benz from Morningstar.