How Roth conversions help defuse your IRA tax "time bomb."

You worked hard for many years.

You diligently made pre-tax contributions to your employer’s savings plan.

And now you’re ready to celebrate retirement as a “millionaire.”

But there’s just one problem: Taxes.

You may be in for an unpleasant surprise once you realize all the “tax-deferred” savings you made to a 401(k), 403(b) or Traditional IRA can come with a steep tax bill in retirement.

Many financial professionals, myself included, consider taxes as a “ticking time bomb” lurking inside many large retirement accounts. Unfortunately, this bomb can explode more than once.

· Need to withdraw a large, lump sum from your IRA? BOOM!

· Ready to begin “required minimum distributions” (called RMDs) at age 73? BOOM!

· What if you die and your spouse goes from "married filing jointly” to the “single” tax rate? BOOM!

· Plan for your kids to inherit your IRA? BOOM!

One of the best ways to defuse the bomb is strategically converting Traditional IRA assets to Roth IRA assets. IRA-to-Roth IRA conversions can make the tax bomb more like a firecracker.

Understanding conversions starts by understanding that Traditional IRAs are taxed differently in retirement than Roth IRAs.

With Traditional IRAs – and 401(k)s and 403(b)s – withdrawals are taxed as ordinary income at your marginal tax rate. This is by design: Your money was untaxed on the way in, and it was allowed to grow tax-deferred, so now the IRS just wants “its share” when the money comes out.

Depending on your personal tax situation, that “share” can be quite large. Consider the example of a Georgia retiree in the 22% married filing jointly tax bracket who wants to pull $250,000 from his Traditional IRA as a lump-sum. The state and federal income tax on that amount is about $70,500, meaning his $250,000 withdrawal is actually a $320,500 withdrawal.

If you think you can avoid taxes by not touching the money, think again. That’s because the IRS forces you to withdraw a certain amount every year through RMDs, which for most people start at age 73 under current federal law.

Even worse, RMDs are designed to increase as you age. For example, if you had a $1 million Traditional IRA with an annual average investment return of just 9%, your first RMD would be about $37,700 (with about $8,300 to the IRS). Ten years later, at age 83, that increases to about $84,259 (with $18,537 to the IRS). By age 93, you would have to withdraw a whopping $164,428 (with $36,175 to the IRS). The better your investments perform, the higher your RMD gets – and the more in tax you will pay.

Therein lies the beauty of Roth IRA accounts. Because money you put into a Roth IRA has already been taxed, there are no taxes on the money you take out, so long as you own the account at least five years and wait until age 59 1/2.

IRA-to-Roth IRA conversions enable you to defuse the bomb by strategically moving Traditional IRA assets to a Roth IRA during years your tax rates are low – usually right after you retire but before you start receiving Social Security income – so to avoid paying higher taxes during your later retirement years through RMDs. Since Roth IRAs do not have RMDs, conversions effectively drain the “pool” of assets on which RMDs are based.

Devising an IRA-to-Roth IRA conversion strategy can be challenging and complicated. You not only need to know your current tax situation but be able to make reasonable estimates of future tax scenarios based on anticipated retirement income – such as Social Security and pensions – as well as deductions, potential changes in filing status and Medicare premiums.

A knowledgeable financial advisor, often working in collaboration with your tax professional, can help analyze these variables to determine an IRA-to-Roth IRA conversion strategy that is optimized to your personal situation. But in general, people with significant Traditional IRA assets will likely benefit from conversions if they:

· Are retired and anticipate higher future income (Social Security benefits or RMDs for example).

· Are currently in a low tax bracket but could be in a higher bracket in the future due to retirement income or change in tax filing status (surviving spouse filing single for example).

· Have a spouse or children they want to shield from high taxes as a beneficiary.

· Might need a large lump sum (for home purchase, vehicle, etc.) from their IRA.

Click here to learn more about the benefits of Roth IRAs compared to Traditional IRAs. Or use one of our calculators to help you determine what is best for you.