Traditional IRAs and 401(k)s are a great way to save for retirement (and lower your taxes at the same time). However, once you retire and start taking distributions, you'll have to pay taxes on the money -- and since many retirees are living on limited income, more taxes at that point may strain an already tight budget. Converting your retirement accounts to Roth accounts can help you avoid this issue.

How Roth accounts save you money

If you open a Roth account during your working years and make contributions, then you will pay standard income taxes on the money you put into the Roth account -- but once you start taking money out, those distributions will be tax-free. This has ramifications that go beyond the relief of not having to pay taxes on your retirement income.

For example, Social Security benefits may be taxed if the recipient has enough taxable income to hit a certain threshold. If your main source of retirement income is distributions from Roth accounts (which, being tax-free, don't count toward the Social Security tax calculation), you'll be unlikely to have enough taxable income to pass that threshold. So, not only will you save by not having to pay taxes on your Roth distributions, you'll also be skipping taxes on your Social Security benefits. It also saves you from required minimum distributions and the work involved in calculating them, since Roth accounts aren't subject to RMDs.

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Roth conversions

If you've put all of your money into traditional retirement savings accounts, all is not lost -- even if you've already retired. It's never too late to do a Roth conversion, which means moving funds from your traditional retirement account into a Roth account.

However, there is a significant obstacle to doing a Roth conversion on a large sum of money. When you take money from a tax-deferred retirement account and put it into a Roth account, you're required to pay taxes on that money as though you'd withdrawn it. For example, let's say you have $300,000 in a traditional IRA, and you decide to put all of that into a Roth IRA. That $300,000 will count as income for tax purposes, which means (using the 2017 tax brackets) a single-filer would have to pay the IRS $82,399 in taxes on the converted funds! Few retirees would be able to afford such a tax burden.

Getting around the Roth conversion tax hurdle

The simplest way to solve this tax problem is to split your Roth conversion up over several years. For example, let's say that instead of moving the whole $300,000 into your Roth account at once, you decide to take five years to do the full conversion (which means moving $60,000 per year into the Roth). Again using the 2017 tax brackets, that same single-filer would only have to pay the IRS $10,739 per year on the converted money. The total tax burden for the conversion, over five years, would be $53,694. That's still a lot of money, but it's a whole lot less than the $82,399 you'd owe in taxes if you did the conversion all at once.

Taxes end up being much lower when you split the conversion over several years because you're staying out of the higher tax brackets, which means you're keeping your tax rates lower. The more proactive you are about converting your traditional retirement accounts to Roth accounts, the longer you can take to switch over the full balance -- and the lower the taxes you'll pay. In the above example, if you were able to stretch the conversion over 10 years instead of five, you'd pay just $4,034 per year in conversion taxes, for a total of $40,338.

Is a Roth conversion really a good idea?

For some retirees, sticking with a traditional tax-deferred account is the way to go. If your distributions aren't putting you over the Social Security taxable threshold, and your annual income tax burden is pretty minimal, then there's no reason to make the change. Other retirees find that the best deal is a compromise -- to convert some, but not all, of their tax-deferred funds to a Roth account.

Having some money in each type of account gives you maximum flexibility on how to generate retirement income. During years when you only need a little income from your retirement savings accounts, you can limit yourself to your RMD and let your Roth accounts keep growing. If you need more, but don't want to have a big tax burden, you can take as much as you can afford to pay in taxes from your traditional IRA and supplement with a distribution from your Roth IRA. By managing your distributions based on tax considerations, you can end up with the lowest possible tax burden -- and that means your income will stretch significantly further.

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