3 Reasons to Make Roth IRA Conversions Early in Retirement

Using a traditional IRA or 401(k) to save for retirement is a great way to supercharge your savings. The big advantage of those accounts is that you can deduct your contributions from your taxes. With a lower tax bill, you'll have more money to invest and save for your future.

By the time you retire, you could have a sizable nest egg in those pre-tax accounts along with some money in a taxable brokerage account. The smartest investors will take the opportunity to convert at least some of their money from those pre-tax accounts to a Roth IRA in their earliest retirement years. Here are three reasons why.

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1. It helps you control your tax rate

Once you stop working, you'll be in complete control of your income and how you "earn" it, so to speak. Controlling your income is essential to controlling your tax rate.

If you can delay Social Security and manage your capital gains from your taxable account, you can convert funds with relatively little owed in taxes. And once the funds are converted to a Roth account, you'll never owe income taxes on them or the continued growth of those funds ever again.

The key to controlling your tax rate is understanding how the government taxes different income sources. Any amount you withdraw or convert from a pre-tax retirement account will count as ordinary income for tax purposes. Long-term capital gains receive preferential tax treatment, and you could end up paying 0% in federal income taxes on gains in the early years of retirement. A portion of your Social Security income may be subject to ordinary income tax if your other income is above a certain threshold.

As such, the best time to take advantage of low tax rates is before you start Social Security and while you have lots of capital gains to take from a taxable brokerage account, i.e., early in retirement. Clever planning can lock in an extremely low tax rate for your Roth conversions.

2. It will reduce your required minimum distributions

Required minimum distributions on pre-tax retirement accounts begin at age 73 for anyone born before 1959, or 75 for those born in 1960 or later. (Those born in 1959 should expect to take RMDs starting at age 73.) Your RMD is based on each pre-tax retirement account's balance at the end of the previous year.

Oftentimes, retirees face the problem of RMDs forcing them to withdraw more than they need to. That results in a high tax bill, which eats away at the money you'll have left for later in your life, to give to charity, or to pass on to your heirs.

Roth IRAs are exempt from RMDs, but you can't use a Roth conversion to count toward your required distribution. As such, the more you can convert before you reach age 73 (or 75), the more control you'll have over the amount you withdraw. That can save you a lot in taxes over the long run.

3. It will help you keep more of your Social Security

As mentioned, part of your Social Security income may be subject to ordinary income tax if your total income is too high. Importantly, Roth IRA distributions won't count toward your total income, but traditional IRA withdrawals do.

The metric the IRS uses to calculate how much of your Social Security income is taxable is called combined income. It equals half of your Social Security benefits plus your adjusted gross income plus any nontaxable interest earned. The table below shows how your combined income will affect how much of your Social Security income is taxable.

Data source: Social Security Administration.

If you can convert your traditional retirement account funds to a Roth account before you start collecting Social Security, you'll be in a much better position to avoid taxes on your benefits later.

It's all about thinking long-term

Roth conversions (and direct contributions) cost more upfront, but they have the potential to save much more than they cost later on. It all comes down to taxes and being able to control your income. Making conversions early in retirement prepares you to keep your taxable income low once RMDs and Social Security kick in.

You might only have a few years of retirement where you have a real opportunity to save on taxes long-term by strategically making Roth conversions. Take advantage of the opportunity if you can.

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