James McGlynn CFA, RICP
Updated: Sep 6, 2020
FUNDING A ROTH—and enjoying tax-free growth—may not have been an option for many high-income baby boomers when they were working. But these folks can still get money into a Roth IRA by converting their traditional retirement accounts—and often there’s a great opportunity to do so if they retire early and find themselves in a lower tax bracket.
The first thing to know: Converting from traditional tax-deferred accounts to a Roth IRA will generate ordinary income equal to the taxable sum converted. The second thing to know: Partial conversions are typically the way to go, so you minimize the tax hit in any given year. For instance, instead of converting $100,000 in a single year, you might be better off doing four $25,000 annual conversions, so you stay in a lower tax bracket.
Partial conversions can be a great strategy if you’ve just retired, but income hasn’t yet kicked in from pensions, Social Security and income annuities. Suppose you retired early and plan to delay collecting Social Security until age 70. Soon after, you’ll also need to start taking required minimum distributions. Those RMDs will not only boost your taxable income, but also the money involved can’t be rolled into a Roth IRA. Yes, you can take your RMD and then convert an additional sum to a Roth. But the tax bills will usually be smaller if you do Roth conversions before your 70s, plus that means you start benefiting sooner from the Roth’s tax-free growth.
As you ponder if and when to convert, there are two additional considerations. First, if you want to use retirement account money to purchase longevity insurance—also known as a qualified longevity annuity contract or QLAC—you’re only allowed to use 25% of your IRA balance, with a lifetime maximum of $135,000 as of 2020. Result: Before converting too much to a Roth account, you might want to purchase a QLAC, while your IRA is still large enough to buy the maximum amount.
That brings us to the second consideration. If you convert, the federal government has a potentially nasty trap in store: IRMAA, short for income-related monthly adjustment amounts. IRMAA is essentially a Medicare surcharge that, in 2020, is levied on income above $87,000 if you’re single and above $174,000 if married. If your income exceeds these amounts, you’ll pay a higher Medicare premium. Roth conversions that bump you above these thresholds will trigger the surcharge, even if you exceed the threshold by just $1.
It gets even trickier: The federal government uses a two-year lookback, meaning it assesses your income from two years prior. In other words, Roth conversions done at age 63 will be counted as income and affect Medicare premiums when you turn 65 and file for Medicare. This is another reason to do Roth conversions as early in retirement as possible, because Roth conversions after age 62 could increase your Medicare premiums.
Sound bad? There’s another pitfall to consider if you’re married. If your spouse dies, the $174,000 IRMAA threshold drops to $87,000 the next year, when you’re filing as a widow or widower. That creates an additional incentive to convert traditional retirement accounts to a Roth sooner rather than later.
A final argument for converting in the near future: Tax rates are currently scheduled to rise after 2025. That means converting in 2026 and later years could mean a far bigger tax hit than if you convert today.