My Retire Years

Tag: taxes

  • What a Roth Conversion Actually Is (I Had This Wrong for Years)

    For years I assumed Roth conversions were a strategy for wealthy people trying to dodge future estate taxes — something for a different tax bracket than mine. Now that I’m actually retired and looking at my own accounts, I understand why that assumption was backwards. Roth conversions are arguably most valuable for exactly the situation a lot of new retirees find themselves in: a window of unusually *low* taxable income, sitting between a full-time paycheck and the start of Social Security and RMDs.

    Here’s the mechanic in plain terms. A Roth conversion means moving money from a traditional IRA (or similar pre-tax account) into a Roth IRA. You pay ordinary income tax on the converted amount in the year you convert — there’s no way around that part — but once it’s in the Roth, it grows tax-free and can be withdrawn tax-free in retirement, with no RMDs during your lifetime. You’re essentially choosing to pay tax on the money now, at today’s rate, in exchange for never owing tax on it — or its future growth — again.

    The reason this matters more in early retirement than while working is the size of the tax bill you’re choosing to trigger. Convert while you’re in the 32% bracket during your working years, and you’re paying a steep price to move that money. Convert during a year where your only income is modest and you haven’t started Social Security or RMDs yet, and you might be able to convert a meaningful chunk while staying in the 12% or 22% bracket instead — the exact same dollars, converted at a fraction of the tax cost, simply because of *when* you did it.

    I’m currently in exactly that window. My paycheck stopped in August. My Social Security doesn’t start until October, and even once it does, it’s a fraction of what my full working income was. Between now and whenever RMDs or a larger income stream kick back in, I have several years where my taxable income is naturally lower than it’s been in decades — and lower than it’s likely to be again once RMDs start pushing money out of my accounts whether I want it or not.

    A few things I’ve learned that aren’t obvious from a quick explanation:

    The tax is due in the year of conversion, and it has to be paid from funds outside the IRA if you want the conversion to actually work in your favor — paying the tax out of the converted amount itself just shrinks how much actually lands in the Roth, and if you’re under 59½, that withheld portion can even trigger a separate early withdrawal penalty on top of the income tax.

    Conversions are irreversible. The “recharacterization” option that used to let you undo a conversion was eliminated by the Tax Cuts and Jobs Act back in 2018. Once you convert, that decision is final for that tax year, which means getting the amount right matters more than it used to.

    A five-year clock starts on each conversion for penalty-free withdrawal of the converted principal if you’re under 59½ (a separate five-year rule applies to earnings and to your very first Roth account generally). At my age this is less of a live concern, but it’s a real trap for anyone converting earlier in life and assuming Roth funds are always penalty-free to touch.

    The strategy of doing this deliberately, year by year, in calculated amounts rather than all at once, is usually called a Roth conversion ladder — and that’s exactly what I’m building for myself, which I’ll walk through in the next post.

    One complication I had to research before converting anything: the pro-rata rule, which applies if you have any after-tax (non-deductible) contributions mixed into a traditional IRA alongside pre-tax money. The IRS doesn’t let you cherry-pick the after-tax portion to convert tax-free while leaving the pre-tax portion behind — any conversion is treated as coming proportionally from both pre-tax and after-tax dollars across all your traditional IRAs combined, based on IRS Form 8606 tracking. If you’ve ever made a non-deductible IRA contribution, or rolled over an account with an after-tax component, this rule directly affects how much of a given conversion is actually taxable, and it’s a detail that’s easy to get wrong without pulling your actual Form 8606 history first.

    I’m not a tax advisor. Roth conversion decisions depend heavily on your specific tax situation, and mistakes here are costly and irreversible — talk to a CPA before converting any meaningful amount.

    Frequently Asked Questions

    What is a Roth conversion?

    It’s moving money from a traditional IRA into a Roth IRA, paying ordinary income tax on the converted amount now in exchange for tax-free growth and tax-free withdrawals later, with no lifetime RMDs.

    Why convert to a Roth IRA in early retirement instead of while working?

    Early retirement often creates a window of unusually low taxable income before Social Security and RMDs begin, letting you convert at a lower tax rate than you’d pay during working years or once RMDs push you into a higher bracket.

    Can I undo a Roth conversion if I change my mind?

    No — the option to reverse a conversion (recharacterization) was eliminated by the Tax Cuts and Jobs Act in 2018, so conversions are final for that tax year.

  • Three Ways to Soften the RMD Tax Hit (Before You’re Forced Into It)

    Once you’re required to take an RMD, you can’t decide not to — skip it, or take less than required, and the penalty is steep: 25% of the amount you should have withdrawn (reduced to 10% if corrected within a defined window under SECURE 2.0). So the RMD itself isn’t optional. What *is* still in your control is how much of a tax bill that withdrawal actually creates. I’ve been mapping out three strategies, and I’m starting on one of them well before my first RMD is even due.

    1. Qualified Charitable Distributions (QCDs). If you’re 70½ or older, you can direct up to a set annual limit (currently $105,000 per person, indexed for inflation) straight from your IRA to a qualified charity, and that amount counts toward your RMD without being added to your taxable income at all. This is different from donating cash and taking a charitable deduction — a QCD reduces your income directly, which matters even if you don’t itemize deductions, and it can help keep you under IRMAA thresholds and reduce the taxable portion of your Social Security. For anyone already charitably inclined, this is close to a free lunch: the same giving you’d likely do anyway, structured in a way that lowers your tax bill instead of just itemizing a deduction you might not even qualify for.

    2. Roth conversions before RMDs start. I’ve written about this strategy in more depth separately, but the connection to RMDs specifically is this: every dollar moved to a Roth IRA before your RMDs begin is a dollar permanently removed from the pool of money that generates future required withdrawals. It’s the only strategy on this list that actually shrinks the RMD itself, rather than managing the tax consequences of an RMD you’re stuck taking.

    3. Timing withdrawals to manage tax bracket thresholds, not just RMD minimums. Even before RMDs are mandatory, taking voluntary withdrawals in lower-income years — filling up the lower brackets deliberately — spreads taxable income across more years instead of concentrating it into the RMD years when the required amounts, and correspondingly your tax bracket, tend to be higher. This only works if you have flexibility (other income sources, or a cash cushion) that lets you choose when to pull from tax-deferred accounts rather than needing to wait until RMDs force the issue.

    A detail I almost missed: the taxable-Social-Security interaction compounds all of this. Up to 85% of Social Security benefits become taxable once your “combined income” (adjusted gross income + nontaxable interest + half your Social Security benefit) crosses set thresholds. An RMD that pushes your combined income over that threshold doesn’t just get taxed itself — it can drag a larger share of your Social Security benefit into taxable territory at the same time, which is a second, less visible tax cost of an oversized RMD.

    None of these strategies eliminate the reality that tax-deferred accounts eventually generate a tax bill — that was the deal all along in exchange for the upfront deduction. But the size and timing of that bill is more within your control in the years before RMDs start than it is once they begin. I’m using the years between now and 73 specifically to shrink the balance that will drive that first required withdrawal, rather than waiting to react to whatever number the IRS table hands me.

    It’s also worth checking your state’s tax treatment separately from the federal picture, since the two don’t always match. Some states fully tax IRA and 401(k) withdrawals the same as federal law, some offer partial exemptions for retirement income above a certain age, and a handful don’t tax retirement account withdrawals at all. I hadn’t thought to check my own state’s specific treatment until I started planning conversions, and the answer changed how aggressively I’m willing to fill a given federal bracket, since a conversion that looks efficient federally can look different once the state tax layer is added on top.

    State residency itself is worth a second look for anyone weighing a future move as part of retirement, since it can matter more to your RMD-era tax bill than most of the strategies above combined. Moving from a state that taxes retirement withdrawals fully to one that doesn’t tax them at all, timed before RMDs begin in earnest, can outweigh the benefit of any single-year tax-bracket optimization. It’s not a reason to choose where to live on tax grounds alone, but it’s a factor worth having on the table alongside the more granular, year-by-year strategies above.

    I’m not a tax advisor. QCD limits, RMD ages, and taxation thresholds are all set by current law and can change — verify current figures with a CPA or IRS Publication 590-B before acting.

    Frequently Asked Questions

    What is a Qualified Charitable Distribution?

    A QCD lets you send up to a set annual limit directly from your IRA to a qualified charity once you’re 70½ or older, counting toward your RMD without adding to your taxable income at all.

    Can I avoid taxes on my RMD entirely?

    Not entirely — but strategies like QCDs, pre-RMD Roth conversions, and timing voluntary withdrawals in lower-income years can meaningfully reduce the tax impact compared to doing nothing.

    Does an RMD affect how much of my Social Security is taxed?

    Yes — an RMD that pushes your combined income over certain thresholds can make up to 85% of your Social Security benefit taxable, on top of the RMD’s own tax.