When you have a large amount of savings in pre-tax accounts like a 401(k) or IRA, you might face tax problems down the road. Roth conversions are a potential solution, but the question becomes how much you should convert to Roth in any given year.
Picking the right amount to convert is part art and part science. First, it’s important to make sure the strategy makes sense, and then you need to decide how aggressive to be. For example, do you want to convert significant amounts (or everything from pre-tax accounts)? Or, do you just want to make a dent in things to manage taxes in the future?
On this page, we’ll review some steps you can take to arrive at the right amount to convert to Roth this year. The details follow, but a summary, you’ll:
- Estimate income for the year.
- Review IRMAA levels to manage Medicare premiums.
- Manage federal income tax rates and issues.
- Evaluate ACA credits or health subsidies (if any).
- Pick a margin of safety, if applicable.
- Arrive at the amount to convert.
Those items don’t cover every single thing you need to know, but you’ll have some valuable information if you follow that process.
Continue reading below, or get similar information from this video.
Estimate Your Income
The first step is to understand where you stand. Figure out how much income you’ll have for the year in question—which might be this year.
Your existing income sources determine how much more room is left for conversions.
Things to think about here include:
- Any earnings from employment
- The amount of Social Security benefits included in taxable income (up to 85% of benefits), if any
- Withdrawals from pre-tax retirement accounts
- Dividends and interest from taxable investments and bank accounts
- Roth conversions
- Capital gains
- Anything else that adds to your income
This is your starting point, and any conversions will go on top of that income.
Review IRMAA Levels
If you’re on Medicare, your income may affect how much you pay in premiums for Medicare Part B and Part D. As income rises, you might face additional monthly charges, often known as IRMAA.
The details get complicated, but for now, let’s assume you’re familiar with IRMAA. Now is the time to figure out if you’re already above any IRMAA thresholds and explore how Roth conversions might push you into higher levels.
The question: What amount of IRMAA (if any) are you willing to pay?
Paying IRMAA isn’t necessarily a bad thing. It might be worth the cost if you benefit from meaningfully lower IRMAA costs or tax costs in the future. But when IRMAA is a surprise, it’s often unwelcome. And there’s no point in paying extra if you won’t benefit from that expense over the long term.
Look at how Roth conversions might impact your healthcare costs, and decide if it’s worth it. Sometimes it makes sense to lump conversions into fewer years to avoid paying IRMAA for an extended period. In other cases, spreading out conversions over numerous years and keeping your income low makes sense—it just depends on your situation and your goals.
If Roth conversions will cause you to cross an IRMAA threshold, it may be wise to convert almost up to the next level. That’s because you’re paying the penalty at that level anyway, so you might want to just “fill” that level, assuming everything else looks good. That said, remember that IRMAA uses “cliff” thresholds. Going over the limit by $1 means you pay the full surcharge for that level, so leaving a safety margin is a decent idea—don’t get too close.
As an advanced strategy, you can project future IRMAA costs throughout retirement. Compare how much you’ll pay with and without conversions, and keep in mind the time value of money.
Manage Federal Income Tax
Income taxes are among the biggest concerns when you’re thinking about Roth conversions. The idea is generally to pay taxes at the lowest rate possible, which requires making some assumptions.
Of course, there are other considerations, and the level of your income affects several areas of your finances. In addition to influencing Medicare premiums, your income can cause more of your Social Security to be included in your taxes.
With Roth conversions, your goal may be to reduce or minimize income over the long term. And a primary goal for retirees is often to manage the size of required minimum distributions (RMDs) later in life. Those distributions force you to take income you may not want or need, and your taxable income may rise to problematic levels.
So, how much should you convert to manage your income?
You’ll need to make some assumptions about the impact of conversions. By converting dollars today, you should see smaller RMDs down the road. Plus, you’ll potentially have tax-free dollars available in Roth accounts. You can withdraw those Roth dollars when you need funds but you want to avoid additional income in any given year.
The questions here become:
- How much additional income tax are you willing to pay each year to make conversions?
- What rate is acceptable?
- Will additional income complicate your taxes or cause you to lose any benefits?
One example of a potential complication is net investment income tax (NIIT). If your income rises above certain levels, you may pay an extra 3.8% on some types of income. Roth conversions—especially large ones—can push you over the limit, causing unexpected taxes.
Other issues may also arise, so review your taxes carefully with a tax expert before making any decisions. For instance, you might lose eligibility for certain deductions or tax credits, which may make conversions less attractive. In some situations, you might see a dramatic increase in Social Security taxation.
With careful planning, it may be possible to convert some without significant negative tax consequences.
Other Health Costs
It’s not just IRMAA. Your income can affect how much you pay for healthcare before Medicare. So, while Roth conversions might seem appealing, it’s important to consider the tradeoffs.
ACA credits or other subsidies can make the Roth conversion decision complicated. In some cases, you face conflicting goals. For example:
- You might want to convert, which increases income today, and
- You might want to keep your income as low as possible for healthcare benefits
If your income gets too high, your subsidies decrease or go away entirely. And those subsidies can be meaningful. Whenever you’re using ACA credits, state programs, or you have other benefits, it’s critical to keep those benefits in mind as you evaluate conversions.
Margin of Safety?
Once you have a target conversion level in mind, it might make sense to add a margin of safety.
For example, if you want to convert $50,000 for the year to avoid the next IRMAA level, getting too close could be problematic. Again, if you exceed the IRMAA threshold by just $1, you’ll have to pay the full surcharge for the year.
Unfortunately, surprises can happen. You might earn more from dividends and interest than you expect, or the need to sell something late in the year might create capital gains.
So, how close do you want to cut it?
Reducing your target conversion amount can help you absorb those surprises. The right amount of safety margin will depend on your finances and your desire for safety. A $10,000 cushion might be too high for some people and too small for others.
How Much Can You Convert to Roth?
There’s no dollar limit on how much you can convert. You can decide on a reasonable amount by estimating federal income tax rates now and in the future, and by reviewing other important factors. For example, you may want to manage health care costs as you convert, staying below key limits each year.
In some cases, substantial conversions make sense. You might be able to reduce your income in the future dramatically, and big conversions help you accomplish that. As long as you’re okay with the various “costs” today, it might be a reasonable strategy.
How to Convert Without Paying Taxes
Roth conversions typically lead to additional taxes, but that’s not always the case. If your income is low, you may be able to convert in a 0% tax bracket. For example, if your total income including conversions is less than your standard deduction, you might be able to convert tax-free.
Backdoor Roth contributions can also (potentially) be tax-free.