Paying $0 in federal income tax during retirement might sound like the ultimate tax-planning victory. After decades of paying taxes on your earnings, investments, and retirement savings, reaching a point where you owe nothing can feel like evidence that you planned exceptionally well. But a $0 tax bill can also represent a missed opportunity.
Each year, the tax code allows taxpayers to recognize a certain amount of income at little or no federal income tax. The standard deduction is the most obvious example. If you have no income that would otherwise be subject to tax, there is nothing for that deduction to offset, and its potential tax benefit for that year can go unused.
This becomes particularly important when planning Roth conversions. Moving money from a traditional retirement account to a Roth can be a valuable way to manage future taxes, but converting too much can leave you with minimal taxable income later in retirement. If nearly all your retirement savings are eventually held in Roth accounts, you may have very little pretax income left to take advantage of deductions and other opportunities to recognize income at favorable rates.
The challenge, then, is not only to decide whether Roth conversions make sense, but also to determine how to balance the amount you convert today with the taxable income you may still want available in future years. Your stated federal tax bracket is only one part of the calculation, as Social Security taxation, Medicare premiums, capital gains, qualified dividends, deductions, healthcare subsidies, and other provisions can affect the actual cost of recognizing additional income. Understanding how these pieces interact can help you determine how much of your pretax balance to convert, how much to leave untouched, and whether to pay taxes now or down the road.
Why Roth Conversions Can Be Valuable
A Roth conversion moves assets from a tax-deferred retirement account, such as a traditional IRA, into a Roth IRA. The amount converted is generally included in taxable income for that year, which means you are choosing to pay taxes today in exchange for the benefits of having those assets in a Roth.
Once the money is in the Roth IRA, it can continue growing without annual taxation, and qualified withdrawals can eventually be received tax-free. Roth IRAs also do not require lifetime required minimum distributions for the original owner, which can give retirees greater control over how much taxable income they recognize later in retirement. That flexibility can make Roth conversions particularly attractive during the years immediately after retirement, particularly if you retire before Social Security and RMDs begin. During this period, your paycheck may have disappeared or declined, while other sources of taxable income have not yet begun. The result can be a period when taxable income is considerably lower than it was during your working years and potentially lower than it will be later in retirement.
A Roth conversion allows you to take advantage of that window by deliberately recognizing some income while the tax cost is relatively attractive. Converting part of a traditional IRA can also reduce future RMDs, create another source of tax-free retirement income, and provide more flexibility when managing taxes later.
You Can Convert Too Much
Much of the discussion around Roth conversions focuses on the danger of doing too little. If a large traditional IRA continues growing until RMDs begin, those mandatory distributions can create significantly more taxable income later in retirement. That income may increase federal taxes, affect Medicare premiums, and reduce your ability to control the sources of your retirement income. There is a legitimate reason to address that risk before RMDs begin, but that does not mean the ideal traditional IRA balance is zero.
Consider someone who retires in their early 60s with a large traditional IRA and begins making aggressive Roth conversions. Each year, they deliberately recognize additional income and pay the associated tax, eventually moving most of the IRA into a Roth. When they reach the age when RMDs would otherwise have become meaningful, there is little to no money in the traditional IRA.
Their future tax bill may be impressively small, but that does not necessarily tell us whether the conversions were worthwhile. To answer that question, we also need to know how much tax they paid to create that outcome and how much tax they would have paid if they had left some of the money in the traditional IRA. If they paid tax at a higher rate to make the conversion than they would have paid on future distributions, reducing the traditional IRA may actually have increased their lifetime tax bill.
Preserving Future Tax Capacity
One reason it may make sense to leave some money in a traditional IRA is that taxpayers generally have deductions available to offset taxable income each year. For many households, the standard deduction can shelter a meaningful amount of income from federal income tax. To the extent other income is not already using that deduction, future traditional IRA distributions may be able to take advantage of some of that remaining tax capacity. If you have enough ordinary income to use those deductions, they have real value. If you have almost no ordinary income because you previously converted nearly all your traditional IRA assets, some of that opportunity may go unused.
This creates a potential problem with converting too aggressively. You might voluntarily recognize additional income in your 60s and pay tax on a Roth conversion, only to reach your 70s and discover that some of the money you converted from the traditional IRA could have been distributed at little or no federal income tax because deductions would have offset the income. In other words, reducing future taxable income is not automatically beneficial if you paid more tax to eliminate that income than you would have paid when it eventually arrived.
This is one reason some future RMD income is not necessarily a planning failure. An RMD that is absorbed by available deductions or taxed at a relatively low effective rate can be a perfectly reasonable part of a retirement income strategy. The goal is to reduce future RMDs when they are likely to create a tax problem, without eliminating pretax assets that could provide useful income at favorable rates.
Filling a Tax Bracket Does Not Solve the Problem
Another common approach to Roth conversions is to look at your current federal income tax bracket, determine how much room remains, and convert enough to fill the bracket. Someone in a relatively low bracket might reasonably conclude that they should take advantage of every available dollar before crossing into the next one.
The appeal of this strategy is clear because federal tax brackets provide a convenient benchmark for evaluating the cost of a conversion. Unfortunately, the stated tax bracket does not capture everything that can happen when another dollar of income is added to a retirement plan. What ultimately matters is your effective marginal tax rate, which measures the tax consequences associated with the next dollar of income. In retirement, that cost can differ significantly from the marginal federal income tax bracket printed on a tax table.
For example, depending on where you fall within the Social Security taxation formula, additional Roth conversion income can cause more of your Social Security benefits to become taxable. In a situation where an additional $1,000 conversion causes another $850 of Social Security benefits to become taxable, the conversion could result in $1,850 of additional income being subject to tax. This can make the effective marginal tax rate on the conversion considerably higher than the stated tax bracket suggests. Additional income can also affect the taxation of long-term capital gains and qualified dividends, phase out deductions, reduce Affordable Care Act premium subsidies, push income above the threshold where existing investment income becomes subject to the net investment income tax, or push a Medicare beneficiary across an IRMAA threshold and increase Medicare premiums.
These interactions mean that someone who appears to have plenty of room remaining in a relatively low federal tax bracket may face a much higher effective cost on the next portion of a Roth conversion. Conversely, there may be future years in which income can be recognized at a lower effective rate even if the nominal tax bracket appears similar. The amount of room remaining in a tax bracket is therefore useful information, but it should not determine the conversion amount on its own. To see how these interactions stack up for your own income sources, our workshop, Using Tax Maps to Enhance Tax Planning Decisions for Retirement, walks through how to map the effective marginal tax rate on each additional dollar of ordinary income and preferential income, such as long-term capital gains and qualified dividends.
The Timing of the Tax Matters
The fundamental decision behind a Roth conversion is not whether you would prefer tax-free money to taxable money. Given the choice, tax-free money is obviously attractive. The real decision is whether paying the tax required to create that Roth asset today is preferable to paying the tax that would otherwise be due in the future.
Making that decision requires comparing the effective tax cost of recognizing income today with the potential cost of recognizing it in future years. Suppose an additional conversion would subject a portion of your income to a relatively high effective marginal rate today. If leaving that money in the traditional IRA means it will eventually be distributed at a lower effective rate, converting it now may simply accelerate a tax bill and increase its cost.
The opposite can also be true. If today’s effective marginal rate is attractive and future RMDs are likely to push income into a substantially less favorable range, recognizing the income now may reduce lifetime taxes and improve future flexibility.
The difficulty is that we cannot know future tax rates, investment returns, account balances, or tax laws with certainty. Retirement tax planning therefore involves making reasonable assumptions, revisiting them regularly, and preserving enough flexibility to adjust as circumstances change.
Rather than starting with the assumption that the traditional IRA should eventually disappear, the analysis should consider how much pretax income you are likely to have in future years and how much of that income can be absorbed at attractive effective tax rates. From there, you can evaluate whether additional Roth conversions improve the plan or simply move taxable income from a potentially less expensive future year into the current one.
A Low Tax Bill Is Not the Same as a Good Tax Plan
There is something psychologically appealing about eliminating taxes. A retiree who reaches their 70s with almost everything in Roth accounts and very little taxable income may understandably feel that years of careful planning paid off. The only way to know, however, whether that strategy worked is to consider what it cost to get there.
If they paid tax at relatively attractive effective rates during earlier years to avoid substantially higher rates later, the Roth conversions may have accomplished exactly what they intended. If higher rates were paid early only to eliminate distributions that could later have been sheltered by deductions or taxed at lower effective rates, the strategy may have solved a problem that did not need to be solved.
Having room left in a low tax bracket does not necessarily mean you need to use it. Rather than targeting a tax bracket, the conversion decision should focus on the effective marginal rate you would pay today compared with the rates at which you reasonably expect to recognize that income later.
Retirement tax planning is ultimately about deciding when taxable income is worth recognizing and when preserving the ability to recognize that income later has greater value. Roth conversions can be an exceptionally useful tool for managing that tradeoff, but their value comes from using them selectively rather than simply maximizing them. The objective is to make thoughtful use of the tax opportunities available throughout retirement so that you are not paying more tax today simply to avoid paying less tax tomorrow.
Want to learn more? Listen to Episode 248 of the Retire With Style Podcast.
