A retiree, aged 64, holds $650,000 in a traditional IRA. This individual is considering converting the funds to a Roth IRA to address future tax implications.
Required minimum distributions, or RMDs, must begin at age 73 for those using traditional pre-tax retirement accounts. For someone with $650,000 growing at an estimated 7% annually, the account could reach approximately $1.37 million by age 75. The first RMD at that point might be around $95,000.
This mandatory withdrawal, when combined with other income, can increase overall tax liability. For example, a single filer with $75,000 in other taxable income could see their tax bracket rise from 22% to 24% with a $95,000 RMD.
Converting the entire $650,000 IRA to a Roth at once would result in a significant tax bill. For a single filer, this could trigger the highest marginal tax rate of 37%, leading to an income tax charge of approximately $193,000, not including other potential taxes.
A financial advisor suggested a gradual conversion strategy. The approach involves converting portions of the IRA over several years to keep taxable income within the current marginal tax bracket. For instance, converting $28,350 could raise a $75,000 income to $103,350, staying within the 22% bracket for a single filer in 2025.
Funds remaining in the traditional IRA during this process would continue to grow. However, the future RMD amount would be reduced, providing more tax flexibility. Roth accounts are not subject to RMD rules.
The conversion strategy includes considerations like the five-year rule, which imposes a 10% penalty on withdrawals within five years of conversion for those under age 59½. This rule does not apply to individuals aged 59½ or older.
Tax brackets and investment returns may change over time, affecting the strategy's outcome. The retiree was advised that Roth conversions may be most suitable if they expect to be in a higher tax bracket after retirement.
Consulting a financial advisor was recommended to determine if this strategy is appropriate. The advisor can assist with RMD planning and other tax-related retirement strategies.