You can be sure that the IRS will take a portion of your tax-advantaged retirement savings accounts. The only question is when.
A unpleasant truth? Maybe. The chance to plan ahead for your retirement accounts? Of course.
Experts on retirement savings say there may be better and worse times for people to pay taxes on their IRAs, 401(k)s, 403(b)s, and other tax-deferred accounts, if they haven’t already.
People say that finding a good time is both an art and a science that depends on the numbers and rules. But it also includes harder questions like what a person will need and pay in taxes in the future.
Devin Carroll, owner of Carroll Advisory Group in Texarkana, Texas, said that changing retirement money into a form that doesn’t get taxed might not be right for everyone.
He did say, though, that people should know how to change a standard IRA or other tax-deferred account to a Roth IRA.
As Thomas Jarecki, national head of wealth planning at KeyBank’s KEY 0.48% Key Wealth Management, put it, “there is no best time to do it.”
It is possible to become very tactical when you want to pull the gun, he said, when someone really wants to make a move.
What you need to do to change a standard IRA to a Roth IRA
Transferring money from a standard tax-deferred account like an IRA to a Roth IRA is what it all comes down to.
People put money into an IRA before taxes, and they don’t have to pay taxes on it until they take the money out. When people over 59½ take money out of their account, it is taxed as income. (They can, of course, pull it before that age, but there are some situations where they will be fined 10%.)
People who own IRAs are forced to take out a certain amount every year, starting when they turn 73. This is called the “required minimum distribution.”
In contrast, a Roth IRA is supported with money that has already been taxed. The money is taken out of the account tax-free because it has already been taxed.
There are income caps for Roth contributions that take inflation into account. People who file as single can’t put money into a Roth IRA after their modified adjusted gross income goes over $161,000. The maximum amount that married couples can claim is $240,000. Backdoor Roth transfers let families with high incomes avoid the income limits on Roth IRAs while still putting money away in the accounts.
“You are paying your retirement taxes ahead of time in the Roth account,” said Katherine Tierney, a senior financial strategist at Edward Jones.
You can take money out of your account before you turn 59½ without having to pay taxes or fines. However, taxes and fines may be applied to gains that are shared. That depends on why the money is being taken out and how long the account has been open.
When the owner of a Roth IRA dies, the IRS already takes its cut, so there are no RMDs.
The rules are the same for people with 401(k)s and other tax-deferred workplace plans who don’t move their money to an IRA when they leave.
Why change an IRA from a regular one to a Roth one?
It’s a good idea to do a Roth switch if you think your tax rate will go up in the future and you want to lower your future tax bill, said Tierney. She said that person might be just starting out in their job and will make more money in the future.
Carroll said it could also be someone who is getting close to retirement and wants to start getting money from sources like Social Security.
Tierney added, “It also makes sense for people who want to leave their heirs something less taxed.” There are rules about how to take money out of a family IRA, but most people who are not married have 10 years to do so.
But Jarecki said it can be hard to think that far ahead, whether you’re planning for retirement or something else. It may sound great to have a tax-free retirement account, but it’s actually very hard to make that happen.
“Humans pay a lot more attention to the present,” he said. “Often, the effects on our finances today are greater than the possible benefits we might get in the future.”
Whenever is the best time to change your IRA to a Roth?
Carroll said that he talks with clients about “runway periods.” At these points, they have a way to make money to pull off the move, but it’s not an endless one. “It often starts when the money stops coming in from work,” he said. When you make less money, you pay less in income taxes and have more room to move money around without going over your tax brackets.
The amount that was changed is added to a family’s updated adjusted gross income by the IRS.
He also said that the paths get shorter when income from Social Security, Medicare, pensions, and RMDs start coming in. People can start getting Social Security benefits as early as age 62. Depending on how much other money they make, these benefits may be taxed. Also, pension payments are taxed.
Carroll said that people who are preparing should also be aware that converting an IRA will change how much their Medicare premiums cost. And you can go back two years, so this window starts at age 63, not 65 when you sign up for Medicare.
Carroll thinks that both of those effects are costs of change “and shouldn’t stop people from doing it.”
The uncertainty about the future of the tax code shouldn’t be a big part of how someone thinks about converting their IRA, says Jarecki.
If politicians can’t agree on something, important parts of the tax code will go back to how they were in 2017 when the Trump tax cuts end at the end of 2025. Among them are five of the seven tax groups going back to higher rates.
There are many things to think about, such as who will be president and which group will run Congress. Carroll and Jarecki both said they thought taxes would go up in the future, but it’s hard to say what else will happen.
Jarecki said it’s good to keep up with what’s going on on Capitol Hill, but don’t get too focused on it.
“You don’t want to base your decision to convert on what might or might not happen in two years or twenty years,” he said. “That can’t be the only thing that affected your choice.”
It’s not all or nothing with Roth changes.
Jarecki agreed that the time right after retirement might be a good time to convert an IRA, but only if it is planned ahead of time. He said that one important thing is to save enough money ahead of time to cover normal living costs plus the taxes on the conversion.
Jarecki said, “You need the money to pay those taxes.” Some of the money that was changed could be used to pay taxes, but he and others do not suggest that you do that.
That person doesn’t have to convert the whole IRA amount at once when they decide to do so, Jarecki said. “This isn’t a case of all or nothing.”
“You can do partial conversions,” Tierney agreed. “That’s what we do every year.” Tierney said that people who convert their money little by little can see what other income they have coming in and change just enough to stay below the next tax bracket.
She said that’s why the end of the year is a good time to think about any kind of Roth change. By then, a person has a good idea of how their taxes are going and how their portfolio did over the course of the year. While a stock market that isn’t doing well can be bad, it can be good for people who are doing a Roth conversion because their holdings will be smaller and their tax bill will be lower because the value of their stocks will be lower.
“Down markets can be an attractive time for someone who is already thinking about a Roth conversion,” Tierney said. This is because the person might be able to “convert the same amount of shares for a lower tax bill.”
