I hope you enjoy reading this blog post.

If you need help with your retirement planning, click here to see if we're a fit.

  • W. Scott Hurt, CFP®, CPA

Does The 5-Year Rule For Roth Conversions Mean Retirees Should Think Twice About Doing One?

Roth conversions are a prevalent retirement planning strategy, and for a good reason. In the right situations, they can significantly reduce taxes throughout your retirement and boost the value of your retirement accounts.

Let’s review the benefits and discuss some potential downsides. You may want to download our Roth conversion checklist to work through as you read.

Roth Conversion Refresh

A Roth IRA conversion is when you rollover your money from a traditional tax-deferred account into a Roth IRA. When you do a conversion, you pay income tax on the amount you convert. This strategy enables people in a higher tax-bracket to take advantage of these valuable Roth accounts.

Let’s look at a simple example. If you convert $50,000, you’d include $50,000 in your income that calendar year.

However, the exact calculation can be tricky if you have multiple existing IRAs; here, the pro-rata rule applies!

  • If your IRA balances consist entirely of traditional contributions and earnings (pre-tax), then there’s no concern. However, suppose any amount of any of your IRA balances comes from after-tax contributions (typically because you’ve made a nondeductible contribution to a traditional IRA). In that case, your conversion will be treated as though it came proportionately from your tax-deferred contributions and after-tax contributions.

  • The takeaway is that you can’t just convert your after-tax contributions if you also have a tax-deferred balance.

A big reason you might have after-tax contributions in a traditional IRA is that your income exceeds the limit to directly contribute to a Roth. For 2022, that income limit is $144,000 if you’re single and $214,000 for a couple, although those start to phase out at $129,000 and $204,000, respectively.

Roth IRAs have the same contribution limits as traditional IRAs in the 2022 tax year; $6,000 plus another $1,000 if you’re 50 or older, but they have some unique features:

  • Qualified distributions are tax-free in retirement.

  • Don’t have required minimum distributions RMDs (giving you more options and flexibility).

  • Are great vehicles to pass down wealth to heirs because they can also withdraw funds tax-free.

Roth IRAs can be important accounts for your retirement income and savings strategy.

Roth Conversions And Retirement

Now that you’re all caught up on Roth conversions, what makes them so popular for retirees?

Roth conversions can be beneficial throughout retirement as it helps you build up your tax-free income bucket for retirement savings, leverage lower tax brackets, and help with estate planning and legacy planning (i.e., passing wealth to beneficiaries tax-efficiently).

But Roth conversions aren’t always the best choice. Retirees need to watch out for increasing their tax bracket too much. While that may sound obvious, the nuance is more powerful than you may realize.

A Roth conversion would likely be inefficient if your anticipated future tax rate is lower than your present tax rate. Worse, it could create a domino effect because other retirement expenses are based on your taxable income. If your income goes up because of a Roth conversion, you could end up:

  • Paying more for Medicare premiums via IRMAA.

  • With a larger portion of Social Security benefits subject to taxation.

  • Net investment income tax on gains from taxable investments.

Typically, a Roth conversion makes more sense for early retirees who aren’t claiming Social Security and haven’t started RMDs. They tend to have more flexibility and options to strategically implement Roth conversions because of that income flexibility.

In addition to the retirement stage, you can also consider Roth conversions in a down market. Since the IRS determines your tax bill by the amount you convert, a down market allows you to convert a more significant portion of your tax-deferred savings with a lower tax bill.

What’s The 5-Year Rule (And Why It’s So Misunderstood)

You might be hesitant to do a Roth conversion in retirement because of the five-year rule. However, that may be due to confusion about how the 5-year rule works. In fact, there are actually several different pieces to understand!

Let’s break it down to help clear up the 5-year confusion.

The 5-year rule concerning conversions say