If you have your retirement savings in a traditional IRA or 401(k) plan, you’ll eventually have to start taking required minimum distributions (RMDs). But those can be a huge hassle.
Not only can RMDs raise your taxable income and push you into a higher bracket than you want to be in, but they can also have other consequences. They could mean being taxed on your Social Security benefits and having to pay more for Medicare.
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For these reasons, some people to convert their retirement savings to a Roth IRA before RMDs begin. Doing so means not only getting more control over your money, but also, enjoying tax-free withdrawals when you do decide to tap your savings.
But Roth conversions can be costly — namely, because the money you convert is taxable. If you want to reduce your Roth conversion tax bill, there’s one key move to consider making.
Relocating could help ease the tax sting
Roth conversions aren’t just taxable at the federal level. If you live in a state with an income tax, those conversions could be subject to state taxes, too. Depending on where you live, the cost there could be substantial.
That’s why you may want to consider relocating to a state that doesn’t have an income tax during your Roth conversion window. If you’re moving a large sum of money into a Roth IRA, ditching your home state for one without an income tax could potentially save you hundreds of thousands of dollars.
Let’s say you’ve managed to accumulate a $4 million IRA. You may decide to convert it to a Roth IRA to avoid RMDs.
At the federal level, you’re looking at a pretty significant tax bill on a $4 million conversion, though you can ease the pain by spreading that conversion out over a good number of years.
Meanwhile, let’s say you live in Massachusetts, which has a flat tax rate of 5%. On $4 million, you’re looking at $200,000 in state taxes alone. If you relocate to Florida and start doing that Roth conversion, it should cost you $0 in state taxes. That’s $200,000 in savings.
Make sure to establish residency first
If you’re going to move to a no-income-tax state to do your Roth conversions, it’s important to time things carefully. Some states may try to come after you for taxes on your Roth conversions if you don’t fully establish residency in your new state before starting them.
So let’s say you decide to move from Massachusetts to Florida for Roth conversion purposes. Before you start moving money into a Roth IRA, you should, ideally:
- Buy a home in Florida or sign a rental agreement.
- Get a Florida driver’s license or register to vote in Florida.
- Set up utilities and bills in your name going to your Florida address.
This “proves” to your home state that you’ve truly cut ties and are a full-fledged resident of your new state.
A tough decision
Of course, uprooting your life to save money on Roth conversion taxes is a big deal. And if you have a smaller retirement account balance to convert or live in a state with low income taxes, it may not be worth it.
Going back to our example, if you’re a Massachusetts resident with a $500,000 IRA to convert, you’re looking at $25,000 in state taxes. That’s a lot of money, but not $200,000. And it may be worth paying those state taxes if you love your neighborhood and don’t want to relocate.
The point, however, is that in some cases, relocating to a state without an income tax to do your Roth conversions could save you a very significant sum of money. So it’s worth running the numbers and exploring your options if you have a large retirement plan balance to convert and the idea of trying out a new state is reasonably appealing.
