Here is a real-life example that shows the power of Roth conversions early in retirement.

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Mike Bernard, CFP® offers advisory services through KFG Wealth Management, LLC dba Korhorn Financial Group. This information is for general financial education and is not intended to provide specific investment advice or recommendations. All investing and investment strategies involve risk including the potential loss of principal. Asset allocation & diversification do not ensure a profit or prevent a loss in a declining market. Past performance is not a guarantee of future results….(read more)

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Early retirement can be a dream for many people who want to escape the corporate grind and enjoy the freedom of their golden years. However, the prospect of living off your savings for 30 to 40 years can be daunting, especially as you may face unexpected expenses like medical bills, home repairs, or family emergencies. That’s why savvy early retirees use Roth conversions to maximize their retirement income while minimizing their tax bill.

A Roth conversion is a financial strategy that allows you to transfer funds from a traditional IRA or 401(k) account to a Roth IRA. Unlike traditional accounts, which are funded with pre-tax dollars and taxed upon withdrawal, Roth accounts are funded with after-tax dollars and offer tax-free withdrawals in retirement. This means that if you expect your tax rate to be higher in retirement than it is now, you can save money by converting your traditional funds to Roth funds while you’re still earning income.

Here’s how it works: let’s say you retire at age 55 and your income for the year is $50,000. You have $500,000 in a traditional IRA that you plan to use for retirement income. If you withdraw $50,000 from your traditional IRA, you’ll pay income tax on that amount, plus any additional taxes on Social Security income or investment gains. However, if you convert $50,000 of your traditional IRA to a Roth IRA, you’ll still pay income tax on that amount, but you won’t have to pay tax on any future withdrawals. This can be especially valuable if you expect your tax rate to increase in the coming years, either because of rising tax rates or because of a change in your financial situation.

Roth conversions can also be a valuable tool for managing your retirement income. By converting some of your traditional funds to Roth funds each year, you can gradually shift your retirement income from taxable sources (like traditional IRA distributions) to tax-free sources (like Roth IRA withdrawals). This can help you stay within a lower tax bracket and avoid triggering the Medicare premium surcharge.

Another advantage of Roth conversions is that they allow you to “fill up” your lower tax brackets with income. Because traditional account withdrawals are taxed as ordinary income, they can push you into a higher tax bracket even if you don’t need the additional income. By contrast, Roth account withdrawals are tax-free, so you can withdraw as much or as little as you need without increasing your tax bill. This can be especially valuable in years when your income is low, either because of early retirement or because of a market downturn.

Of course, Roth conversions are not suitable for everyone. If you expect your tax rate to be lower in retirement than it is now, you may be better off sticking with traditional accounts. Similarly, if you’re currently in a high tax bracket and converting a large sum of money to Roth funds would push you into an even higher tax bracket, you may want to hold off until your income decreases.

Ultimately, the power of Roth conversions in early retirement lies in their ability to help you maximize your retirement income while minimizing your tax bill. By gradually shifting your retirement income to tax-free sources, you can reduce your tax burden and enjoy a more comfortable retirement. If you’re considering early retirement, talk to your financial advisor about whether Roth conversions make sense for your situation, and start planning now to take advantage of their many benefits.