Is this something to be considered early in retirement?

IRAs have become a very important element of retirement security. The Individual Retirement Account was added to the tax code in 1974, along with the ERISA overhaul of retirement plan regulation. Contributions may be deductible, depending upon the taxpayer’s income, and distributions are taxable as ordinary income. The Roth IRA became available in 1998. No deductions for contributions, but if all conditions are met all the distributions from a Roth IRA during retirement are tax-free.

Some 58 million households owned an IRA as of year-end 2024, more than 40% of households. However, about 88% of IRA assets are held in traditional IRAs, over $14 trillion. The reason for the disparity is that traditional IRAs have been used, through a rollover of the funds, to preserve the tax deferral for distributions from 401(k) plans and other qualified retirement plans. The contribution limit for such plans is far higher than the limits for IRAs.

The Roth conversion option

A traditional IRA may, at the option of the account owner, be converted to a Roth IRA. There are no income restrictions on who may exercise the conversion option. However, there is a price to be paid, as the entire amount of the conversion must be included in ordinary income.

For larger IRAs, that can be an intimidating tax bill. But when one works through the math, conversion to a Roth may be a very good idea, especially early in retirement.

The optimum conditions are that the taxpayer no longer has wage income, has not yet started Social Security benefits, and has other financial resources to draw upon to meet expenses, such as an after-tax investment portfolio. In that situation the cost of conversion to a Roth IRA may be relatively low.

As one moves up the income brackets, the tax bill may begin to seem less like a bargain.

Big benefits

There are three benefits offered by the Roth IRA to take into account.

1. Planning flexibility. Minimum annual distributions are required from traditional IRAs once the owner reaches age 73. There are no such requirements for Roth IRAs. The required minimum distributions are not large in the early years on a percentage basis, but the only way to avoid them is to arrange for a distribution to charity (limited to $100,000 per year).
2. Tax freedom. After five years, distributions from the Roth IRA during retirement are not included in income. The income taxes have effectively been pre-paid.
3. Lower taxes on Social Security benefits. Those required minimum distributions from traditional IRAs may have the side effect of increasing the taxes the retiree must pay on Social Security benefits received. Singles with adjusted gross incomes below $25,000 and married couples below $32,000 do not have to worry about taxes on benefits. For singles with AGI from $25,000 to $34,000, up to 50% of their benefits will be taxed, and above $34,000 up to 85% will be taxed. For married couples, the 50% inclusion bracket is $32,000 to $44,000, and 85% above $44,000.

Unlike many other elements of the tax code, these boundaries have never been adjusted for inflation. Thus, more and more Social Security benefits are being subject to income taxation as the years go by.

What is best for you?

Conversion of a traditional IRA to a Roth IRA is a major life decision, definitely worth paying for professional advice before undertaking. The decision must be put into the context of the taxpayer’s total resources and wealth management objectives.

The tax consequences of a conversion may be softened by doing partial conversions over time. It’s not an all-or-nothing decision. The conversion might be handled at 20% per year for five years, for example. Or a larger share might be converted in a year when one’s income is low, putting the transaction in a lower tax bracket.

Do you have a question concerning retirement planning? Call us at 920-563-6616 ext. 3070, or email wealth@bankwithpremier.com.