Financial experts are advising aging US seniors to consider a strategic move with their 401(k) accounts that could potentially save them thousands of dollars in taxes during retirement. This strategy involves converting traditional IRA or 401(k) accounts to Roth IRAs. Roth conversions involve transferring funds from pre-tax retirement accounts to Roth IRAs, which are funded with post-tax dollars.
This means that account holders will pay taxes on the converted amount at the time of the conversion. However, future withdrawals from Roth IRAs are tax-free, and they are not subject to Required Minimum Distributions (RMDs) while the account holder is alive. Brent Ehmke, a 72-year-old retired aerospace executive from Plano, Texas, realized he would face a substantial tax bill due to over $100,000 in annual RMDs from his tax-deferred retirement account, combined with other income sources like Social Security, pension, and investments.
“I’m asking myself, ‘Holy cow! Did I make a mistake? Did I wait too long?'” he remarked. To avoid increased taxes and other financial repercussions, experts suggest making strategic Roth conversions over time.
This approach prevents retirees from being pushed into higher tax brackets and helps manage overall tax liabilities more effectively.
Financial savings through Roth conversions
Additionally, maintaining lower income levels can help avoid increases in Medicare premiums and the 3.8% net investment income surtax.
“When you do a Roth conversion, you could find yourself in a higher tax bracket that year or see your Medicare premium rise,” sources indicate. To mitigate this, small, incremental conversions over several years are recommended. Roth IRA conversions generally make financial sense if the tax rate at the time of conversion is lower than the expected tax rate on future withdrawals.
Moreover, Roth conversions are advantageous for those who wish to leave tax-free money to their heirs. Higher-income earners who do not require their RMDs or those with lower expenses in retirement are ideal candidates for this strategy. It’s also beneficial for covering tax-deductible long-term care expenses, which might be better paid from a traditional IRA account rather than a Roth IRA.
To maximize the benefits, seniors should keep the Roth IRA’s five-year rule in mind: earnings are only tax-free if the account has been open for at least five years. Therefore, Roth conversions are more suitable for those who do not need access to the funds in the near term. While the strategy may seem counterintuitive initially, Roth IRA conversions offer substantial tax benefits and financial flexibility for many retirees.
However, it’s important to carefully assess one’s financial situation and consult with a financial advisor before making such a decision, as Roth conversions are irreversible and must be thoughtfully planned.
