Monish Verma is the Founding Partner and CEO of Vardhan Wealth Management, a wealth advisory firm in Michigan.
Many investors view Roth conversions as a tax-saving tactic, paying taxes today to avoid larger tax liabilities later. For high-net-worth (HNW) families, however, they can serve a broader purpose.
Roth IRAs can create a tax-free pool of capital that can serve as a tax-free retirement income source or benefit future generations.
I have seen many investors with large, qualified accounts let those assets continue to grow until retirement, withdrawing funds only when the required minimum distribution (RMDs) period begins. But challenges can arise when that happens, including having an RMD so large that it pushes you into a higher tax bracket, because the IRS treats distributions from traditional IRAs and 401(k)s as ordinary income. Another challenge that may result is leaving large tax liabilities for future generations, particularly if the inheritors receive such funds during their peak earning years.
To avoid those common mistakes, I often advise investors to consider a Roth conversion during what we refer to as the optimal retirement runway. Here’s what that looks like.
Finding The Optimal Window For Roth Conversions
A retirement runway is the period when you are no longer at peak earnings potential but before RMDs begin. Perhaps you are scaling back from full-time work and transitioning to consulting or serving as a board member. This phase, while you are in a lower tax bracket, can be a great time to convert IRA assets to a Roth and benefit from a reduced tax bill.
This window of opportunity typically occurs in the 60s to early 70s, before RMDs begin at 73. During this approximate 10-year window, I often counsel clients to begin a disciplined cadence of converting a set amount into a Roth account each year, determined by the maximum amount that keeps them in their current tax bracket while adding the income.
In addition to paying taxes on the income at a lower rate today, your IRA account balances are reduced, lowering the future RMD and the associated future tax liability. Moreover, the Roth assets then grow and compound tax-free sooner.
Roth conversions are not the right option for everyone, however. They will not work for you if you don’t have sufficient after-tax funds to cover the tax liability; being in certain tax brackets also makes this option less appealing. Before proceeding with this strategy, you or an advisor must carefully evaluate your current tax situation.
Roth Conversions: More Than A Retirement Strategy?
Traditional IRAs generally require beneficiaries to withdraw inherited assets within 10 years after the original account owner’s death. Those withdrawals are treated as ordinary income, potentially creating a large tax burden for children who inherit these assets when they may already be in a high tax bracket.
By contrast, Roth distributions are generally tax-free. As a result, for some HNW individuals, Roth conversions can serve as a multigenerational wealth builder and provide heirs with tax-free income rather than income that may be lowered by future taxes.
This strategy is particularly relevant for many HNW individuals whose retirement spending needs are already covered by their RMDs, Social Security and other investment accounts. I encourage those clients to view their Roth account not as a retirement income source but instead as a multigenerational wealth bucket. By converting the assets while in a lower tax bracket, the family preserves more wealth for future generations.
Because traditional IRA distributions increase taxable income, while Roth distributions do not, converting to a Roth can help control tax liabilities and keep investors within their tax bracket. Moreover, if someone needs additional liquidity in retirement, the assets can be accessed without incurring a tax bill, creating greater flexibility.
How This Works For Physicians, Executives And Business Owners
Roth conversions are often an appropriate strategy for C-suite executives and physicians who have substantial capital in their retirement accounts and whose earned income declines significantly upon retirement.
Consider a doctor in his mid-60s with qualified accounts totaling seven figures, more than he will ever need for his lifestyle. Now partially retired and serving on some medical boards, he could spend 10 years converting $250,000 annually into a Roth IRA. The result would be lower future RMDs, tax-free growth of Roth assets and a lower tax burden for his children.
In my experience, entrepreneurs and business owners are more likely to leverage a Roth conversion at or before the time of monetization. One of my business owner clients converted $2 million from the sale of the business from an IRA to a Roth account. Existing liquidity paid the taxes up front, and the account can now grow into the millions, tax-free. This capital will likely be passed along as multigenerational wealth, with the option to use it if necessary or keep it as tax-free capital for future generations.
Not Just For Retirees
It is also important to note that Roth conversions are not exclusive to IRAs. Under new legislation, many employee-sponsored plans now offer in-plan Roth conversions within their 401(k) plans, allowing employees to convert a portion of their retirement savings from the pre-tax bucket to the Roth bucket within their 401(k) plan. While the converted amount will be recognized as taxable income, the assets can then grow tax-free in the Roth account.
This can be a valuable strategy for clients who want to build their tax-free assets prior to retirement. Many of my C-suite clients who are still employed have begun leveraging this tactic as part of their long-term legacy planning.
Final Thoughts: A Flexible, Multipurpose Strategy
For many people, Roth conversion, when used thoughtfully and strategically, offers much more than tax savings. It is one of the many approaches that HNW families can use to control overall tax liabilities, reduce future RMDs, enhance retirement flexibility, pass along tax-free wealth to beneficiaries and overall preserve more wealth for future generations. It’s important to speak with your financial advisor early on about how Roth accounts might fit into your retirement portfolio for the greatest benefit to yourself and your legacy.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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