Converting funds from a tax-deferred Rollover or Traditional IRA to a tax-free Roth IRA in retirement can be a smart move for managing your total income tax bill. Often, Roth conversions can be accomplished in lower tax brackets, protecting you from possibly higher brackets in the future and minimizing the income tax bite of Required Minimum Distributions (RMDs) from your Traditional/Rollover IRA in later years.
The earlier you can begin to efficiently convert funds to tax-free Roth assets the better. Doing so moves the growth of the converted portion of your tax-deferred accounts into income tax-free growth. The calculations can be daunting, so enlisting the aid of a CERTFIED FINANCIAL PLANNER™ professional or CPA will help.
But it is often wise not to convert 100% of your tax-deferred retirement money into a Roth IRA.
If you make charitable contributions on a regular basis, it would be more tax efficient to leave some money in your tax-deferred IRA to fund those contributions once you reach age 70 ½. The Qualified Charitable Distribution rules allow for income-tax free distributions to qualified charities once you reach this age. For more information on the QCD rules check out this post.
The bottom line here is if used to fund your charitable giving, a Traditional/Rollover IRA gives you a very tax friendly option. Each year you can make donations that will not appear as taxable income on a 1099-R. That means you contributed the funds on a pre-tax basis, they grew without income tax consequences, and then they are distributed income tax-free. Given that, for most-- any charitable contribution over $300 per year for individual filers and $600 per year for joint filers, gets no income tax break at all-- this is a great way to save on your income taxes and support worthy causes at the same time.
Another reason to avoid a 100% Roth conversion is simply that having no taxable income is not the most tax-efficient plan. There is always a level of income that is free of income taxes-- the amount of income covered by your standard deduction and/or other above the line deductions. For 2021, the standard deduction for single filers is $12,550 and for joint filers it is $25,100. This means that if you had no other sources of income, you could withdraw those amounts from a Traditional IRA income-tax free.
It is unlikely you would be in this situation, but if you have a tax-efficient taxable investment account and a small pension or social security benefit, you might have some leeway to withdraw funds from a tax-deferred account at a 0% tax rate. Again, the calculations can be tricky, particularly if you are in the social security tax torpedo range, so seek out qualified help in making these decisions.
Taxes are not fun to pay or to calculate. But smart income tax planning can add thousands or even hundred of thousands of dollars to your bottom line. Working with a financial expert who understands how everything fits together can be one of the best decisions you could make.