Moving into retirement is an exciting opportunity to live fully. It can be a time to travel, explore new hobbies, or spend time with grandchildren.
For many, this period at the start of retirement can also be an opportunity to provide additional financial security—and minimize lifetime taxes—by making partial Roth conversions.
The Retirement “Tax Valley”
Many retirees will be in a lower tax bracket early in retirement than they were just before retirement while they’re still working—or than they will be in later in retirement. To understand why, consider Jim and Susan (both age 61) who recently retired.
While working, Jim and Susan had a combined household income of $250,000. This put them right in the middle of the 24% tax bracket for a married couple. At retirement, Jim and Susan have the following assets:
- $1 million (Jim’s IRA)
- $1 million (Susan’s IRA)
- $100,000 (Jim’s Roth IRA)
- $500,000 (Taxable account – with a $300,000 cost basis)
- $300,000 (Cash savings in bank accounts and CDs)
- $800,000 (House – No Mortgage)
Jim and Susan will also have the following income in retirement:
- $50,000 (Jim’s annual pension – starting at age 65)
- $30,000 (Susan’s annual pension – starting at age 65)
- $40,000 (Jim’s annual Social Security – Starting at age 70)
- $35,000 (Susan’s annual Social Security – Starting at age 70)
In addition to that income, Jim and Susan will each have to start taking required minimum distributions (RMDs) out of their IRAs starting at age 72. Assuming they don’t make withdrawals from the IRA between now and age 72, and that the accounts grow at 7% annually over the next 11 years, they would each be worth about $2.1 million by age 72. They would each have an RMD of about $76,650 the year they turn 72 ($2,100,000 / 27.4).
This would potentially give them a taxable income at age 72 of about $308,300 from pensions, Social Security, and their RMDs. This puts them back at the top of the 24% tax bracket, and they could easily move up to the 32% tax bracket or higher.
However, in their first years of retirement, they could basically have no taxable income if they are using cash savings and the taxable investment account to fund their goals if they choose to do so. Is it a smart idea to minimize taxes this much during these early retirement years?
Strategic Roth Conversions Early in Retirement
Let’s say that Jim and Susan would have $0 taxable income in early retirement. Their modest interest, dividend, and realized capital gain income is offset by their $25,900 standard deduction.
If they each convert $65,000 annually from their IRA to their Roth accounts ($130,000 total), they will initially pay tax on that conversion primarily at the 10% and 12% rates, with just a little being taxed in the 22% bracket each year.
If they do this each year until age 72 when their RMD begins, they would have about $1,079,000 in each IRA, assuming 7% annual returns. This would reduce their initial RMD at age 72 by about half. Their taxable income at age 72 would be reduced by about $74,500 and their tax liability by about $17,880 since they were in the 24% tax bracket.
Much of the earlier conversions each year would have been taxed at 10% or 12% rates, resulting in less overall tax being paid during their lifetimes.
Protection Against Rising Tax Rates
The example above shows the benefits of Jim’s and Susan’s Roth conversions, assuming tax rates stay the same. If 10 years from now, tax rates on higher earners increase, they will have less income being taxed at those higher levels due to the smaller IRA balances and smaller RMDs.
They would also have about $1,000,000 in each Roth IRA by age 72, assuming a 7% rate of growth. This can be withdrawn tax-free if additional money is needed. This is always a benefit but especially so in a world where overall tax rates are higher.
Roth Conversions to Take Advantage of a Market Decline
In addition to the benefit of taking Roth conversions when in lower tax brackets, Jim and Susan can take advantage of market declines to make strategic Roth conversions.
Say a market decline in the first six months of the year produces the following negative returns:
-10% (Large US stocks)
-15% (Large international stocks)
-20% (Small US stocks, small international stocks, emerging market stocks)
This becomes a great opportunity for Jim and Susan to strategically move some of the small US, small international, and emerging market stocks from the IRA to the Roth accounts. Assuming the investments recover as expected, Jim and Susan can pay tax on the conversion when the prices are down and enjoy a significant tax-free recovery after the investments are in the Roth account.
Additional Factors to Consider
There are several other factors for Jim and Susan to consider when making Roth conversions early in retirement.
When purchasing individual health insurance in retirement before Medicare begins, retirees may qualify for subsidies to reduce the cost of their premiums based on their taxable income. In Jim and Susan’s case, they have retiree healthcare from their employer that doesn’t qualify for tax subsidies, so this is not a factor.
Once Medicare Part B benefits start at age 65, there is an additional IRMAA premium cost when taxable income increases beyond a certain level. In 2022, this additional premium begins when income is above $182,000 for a married couple.
For retirees who expect to have money at the end to leave to an heir, Roth conversions can be an important part of an estate plan, as leaving Roth assets to heirs are significantly more valuable than leaving traditional IRA money to heirs.
While they won’t be a perfect solution for everyone, for the right families, Roth conversions early in retirement can be a powerful tool to minimize taxes over your lifetime and maximize overall expected wealth.
This can be one more tool to ensure the ability to make the most of retirement and really live fully!
Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.
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After college, Chris moved to South Korea where he worked for the army as a financial counselor. He helped everyone from 18-year-old service members getting their first real paychecks, to those approaching retirement, and saw the stress caused by spending too much money early in life, as well as the stress of sacrificing too much earlier on and missing out on the opportunity to really live fully. He became a financial advisor to help people find clarity in reaching goals and to work with them to find balance between planning for tomorrow and living fully today.
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