Saving for retirement in a traditional Individual Retirement Account effectively shelters income from taxes while you’re in your high-earning years. But a Roth IRA, which allows withdrawals tax free in retirement when tax rates may be higher, is also appealing.

If you haven’t balanced your investments in both types of accounts—or if you couldn’t start a Roth because your income was too high—you can convert some or all of your traditional IRA savings into a Roth IRA. You must pay taxes on the converted funds, but if you have cash on hand to cover that cost, an IRA to Roth conversion may have advantages—even near or after retirement.

Whether it makes sense to do so depends on several factors—chiefly time, costs, taxes, your income level and how your income impacts other benefits. You’ll reap the benefits of a tax-free Roth income stream if you expect to be in a higher tax bracket after retirement, or if you are retiring in a state with a high income tax. 

Converting to a Roth makes sense if you have plenty of income and will not need your retirement savings until quite late in life. Traditional IRAs require savers to start taking distributions at age 72 (recently raised from age 70½). Roth IRAs don’t have this requirement. You can keep contributing after-tax dollars to a Roth at any age and let these savings grow tax-free as long as you like.

However, avoid converting too close to when you will need the funds. Contributions must be held in the Roth for five years in order to be distributed tax-free and penalty-free. Withdrawing from a Roth IRA early, before the five-year mark or age 59 1/2, incurs a 10 percent penalty. 

The advantage of no Roth IRA taxes pays off in other ways as well. Unlike traditional IRA distributions, qualified distributions from a Roth are not counted as income when calculating how much of Social Security benefits are taxed. Relying on a Roth may provide a more comfortable income yet keep you below the maximum income threshold, which helps you keep more of those benefits. 

Converting to a Roth may also offer advantages in estate tax planning. Roth distributions are tax-free to your heirs as well, although they may be required to take a required minimum distribution (RMD). Payouts from a Roth will not bump your beneficiaries into a higher tax bracket. Also, if your assets are considerable, paying the tax to convert a traditional IRA to a Roth could significantly reduce the size of your taxable estate and help your heirs minimize or avoid paying estate taxes. 

One cost to watch for is that a Roth conversion could activate surcharges on Medicare premiums assessed for high earners, at least temporarily. At incomes above $85,000 for singles or $170,000 for married couples filing jointly, seniors must pay a surcharge for Medicare Part B, for outpatient care and medical equipment, and Part D, for prescription drug coverage. Known as the Income Related Monthly Adjustment Amount (IRMAA), these combined monthly surcharges can add up to between $798 and $4,433 per year. 

When converting to a Roth, the RMD from the traditional IRA may push Modified Adjusted Gross Income over the Medicare threshold. Surcharges are calculated based on the previous two years’ income, so the impact on premiums may last beyond the current tax year.

However, future Roth distributions will be tax-free and will not increase income in subsequent years. The cost of a temporary surcharge may be more than offset by tax savings and lower Medicare surcharges in the following years. In addition, the surcharge can be reduced or avoided by converting to a Roth at age 62 or earlier, thereby reducing qualified income significantly in the two tax years before hitting Medicare eligibility at 65. Finally, a traditional IRA can be converted to a Roth IRA through multiple small conversions so that income never reaches the top thresholds for the surcharge. 

If you are not yet Medicare eligible and are purchasing healthcare on the Affordable Care Act exchange, converting to a Roth IRA might help reduce your reportable income and qualify you for healthcare premium tax credits, which can be taken as subsidized premiums. Again, timing is important: make the conversion five years or more before you plan to begin drawing income to avoid penalties. 

Balancing the costs and benefits of converting your IRA assets to a Roth can be complex. Contact us and we can help calculate the costs and determine what’s right for you.

— Toni Shears