Roth IRA Conversions for Maximum Tax Efficiency

As you approach retirement, you might find yourself with a nice nest egg in your 401k or traditional IRA. However, the looming issue of taxes on distributions you take during retirement might make you reconsider your choices.

The good news: converting to a Roth IRA can provide significant benefits, including tax-free withdrawals and growth. When performing a Roth conversion, it’s important to understand how to do so strategically to maximize tax efficiency.

Today, we’re breaking down how to perform a Roth conversion, its benefits, and how to optimize your retirement planning when doing so.

Why perform a Roth conversion?

The simple version is that Roth accounts remove the tax burden associated with any distributions you take during retirement. This includes required minimum distributions (RMDs). This is because Roth accounts are funded with after-tax dollars. Every time you contribute to a Roth account, you must first pay income tax on the money you contribute. Therefore, RMDs are not considered taxable income. This also allows your Roth account to grow tax-free.

Compare this to a traditional IRA or 401k, which are funded with pre-tax dollars. With these accounts, your contributions can actually lower your tax burden in the year you make them. However, you’ll need to pay income tax on any distributions you take during retirement.

Will you retire in a lower tax bracket? Probably not!

Many people believe they will enter a lower tax bracket after retiring, reducing their overall tax burden. This assumption comes from expecting a decreased income as they move from full-time employment to living off their retirement savings.

The idea of entering a lower tax bracket in retirement is appealing because it could lower your overall tax burden. This would let you keep more of their hard-earned money for personal expenses, leisure activities, and other pursuits.

However, not all retirees move to a lower tax bracket after transitioning away from full-time work. Many will remain in their current tax bracket, while others could actually move up a bracket.

Reasons for not entering a lower tax bracket in retirement include:

  1. No more 401k contributions: 401k contributions are tax-deductible. Once you stop contributing to your plan, you no longer receive this particular tax benefit. This could potentially raise your tax burden.
  2. Erasing your debt: While paying off your debts can offer you more cash on hand during retirement, it can also raise your taxes. This is because many forms of debt (such as student loans and mortgages) are tax-deductible.
  3. Rising taxes: Tax rates are never set in stone. The government recalculates and reconfigures them more regularly than we’d like. A scheduled increase to tax brackets is already coming in 2026, with no way to predict what might happen beyond that date.

Taken together, this reveals an unfortunate truth: much of the advice you’ve received about preparing for retirement could be wrong.

But if these issues actually cause a tax problem after you’ve retired, what can you do?

How do I fix my retirement tax problem?

Now that we know the problem retiring can cause to our tax burden, we can discuss strategies for resolving it. One of the primary strategies for reducing our retirement tax problem is by performing a Roth conversion. Typically, this means converting a traditional IRA to a Roth IRA. However, you could also convert a 401k or other eligible retirement plans into a Roth IRA.

The basic steps required to perform a Roth conversion look like this:

  1. Check eligibility
  2. Decide how much to convert
  3. Open a Roth IRA account with a plan administrator or financial institution
  4. Fill out the conversion paperwork
  5. Pay the tax
  6. Enjoy tax-free growth and income

Does this look too simple? Of course, this is just the bullet-point version of the process. Your financial or tax advisor can walk you through it in more detail. But ultimately, it really is as simple as it looks.

However, you can use a few strategies to maximize your tax savings and create your ideal retirement.

How can I make my Roth conversion more tax efficient?

When considering a Roth conversion, it’s essential to strategize for maximum tax efficiency. This is because the conversion process involves transferring funds from a traditional IRA or 401(k) to a Roth IRA. Doing so could generate a tax bill. However, with careful planning, you can optimize your conversion to minimize taxes and maximize the benefits of your Roth IRA.

In the steps to performing a conversion listed above, the first four are pretty straightforward. It’s step five that gives most people pause. What if I don’t want to pay the tax? It’s this step that kills more Roth conversions than anything else.

Step five is the big one. This step kills more Roth conversions than anything else. What If I don’t want to pay the tax? Most people don’t have the funds available to pay the tax. Or, they would have to take so much out of their 401k that it wouldn’t make sense.

When performing a Roth conversion, consider these strategies for maximizing tax efficiency:

  1. Convert during a low-income year: If you expect to be in a lower tax bracket this year than in future years, you may consider converting to a Roth IRA now. This way, you could potentially pay less in taxes on the conversion.
  2. Spread the conversion over several years: Instead of converting all of your traditional IRA assets to a Roth IRA at once, spread them out over several years. This can help you avoid jumping into a higher tax bracket and reduce the amount of taxes you owe.
  3. Time your conversion with losses: If you have investment losses in your traditional IRA, consider converting those assets to a Roth IRA. This can help offset the gains and reduce the tax bill.
  4. Pay taxes from outside funds: To maximize the growth potential of your Roth IRA, consider using outside funds to pay the taxes on the conversion rather than dipping into your traditional IRA funds.

Of course, these steps merely spread your tax burden around. What if you want to reduce your tax burden?

More good news: we’ve got strategies for that, too!

Offsetting the Income from Roth Conversion

In addition to the strategies mentioned above, consider the following tools to reduce your overall tax burden. These strategies help to offset the income from your Roth conversion. In other words, performing a Roth conversion necessarily increases your taxable income. The strategies below use the tax code to find ways of reducing your end-of-year tax burden.

With the right combination of strategies, the right financial advisor, and a little luck, you could potentially offset your increased tax burden entirely.

To offset the increased tax burden from your Roth conversion, consider the following:

  1. Discounted Asset Valuations: This strategy utilizes illiquid assets. Using the IRS tax code, this analysis takes multiple factors into account to show a paper loss on your assets. Showing a 30% to 50% reduction in your assets at the time of conversion could save you large sums in taxes.
  2. Use Energy IDCs and Solar tax credits: Oil & gas Intangible Drilling Costs (IDCs) allow investors to deduct a significant portion of their investment from their taxable income. Solar tax credits provide a percentage-based credit on the cost of installing a solar energy system. While tax deductions and credits differ, knowing the difference and using both can be an essential tool.
  3. Accelerated Charitable Contributions (DAF) or Conservation Easements: Establishing a Donor-Advised Fund (DAF) allows you to make a sizeable charitable contribution and receive an immediate tax deduction. You can then recommend grants to your favorite charities over time, helping to offset the income tax from your Roth conversion. A conservation easement helps preserve land for environmental or historical purposes. Contributing to one is considered charitable and provides a tax deduction.
  4. Offset the bill with your primary residence: This strategy is specific to the individual using it. In essence, you could finance the tax bill of your Roth conversion over 30 years and tack on another tax deduction.

Please consult an advisor and tax consultant to learn more before implementing these strategies. Everyone is different, and some or all of these strategies may not fit your needs.

How to view your 401k and IRA balance going forward

You might have noticed a trend in the advice above that can provide a helpful way to view your retirement accounts: they are, in essence, future debt. Some accounts can delay the inevitable. However, it’s income, so you’ll eventually need to pay income tax. You’ll always owe the IRS something.

And the longer you let your accounts grow, the bigger this debt becomes. For instance, imagine your account balance currently stands at $500,000. If you’re in the 30% tax bracket, you’d owe the IRS roughly $150,000. If that same account grows to $1M over the next ten years, you now owe roughly $300,000 in taxes.

Key Points to Remember

As you consider converting to a Roth IRA, keep the following key points in mind:

  1. No 10% penalty if younger than age 59 1/2: Those under age 59 1/2 incur a 10% penalty for any early distributions they might take—even when converting to a Roth IRA. You can legally take distributions without penalty if you’re 59 1/2 or older. However, you may face a penalty if you use some of the funds to pay the tax bill.
  2. Insurance products as an alternative: You can also consider rolling the funds into an insurance product that offers similar benefits to a Roth IRA, such as tax-free growth and income, along with a life insurance benefit.
  3. Roth conversions require a strategic approach: Most advisors and CPAs view Roth conversions as a simple process of moving funds and paying the tax. However, a strategic approach is crucial to maximize your tax efficiency and retirement savings.
  4. Consider future tax rates: Consider where taxes might go in the next 5, 10, or 20 years. If you expect tax rates to increase, a Roth conversion might be even more beneficial for you.