The tax code includes many perks that encourage workers to save for retirement, including the tax-advantaged growth of retirement accounts like 401ks and IRAs. To maximize tax-deferred compound growth, it makes sense to leave your money in a pre-tax retirement account for as long as possible. The downside of this approach is that it can result in a future tax liability.
For individuals with large retirement balances, the yearly required minimum distributions (RMD) after age 72 can push them into higher federal and state income tax brackets. Additionally, the greater the taxable income, the more the retiree will be taxed for social security and Medicare premiums. This “tax bomb” can become a significant problem that may jeopardize an individual’s overall retirement plan.
One strategy that can help individuals reduce the size of their RMDs is to take partial distributions from an IRA to “fill” the lower tax brackets if they retire before RMDs start. This approach, however, causes individuals to forego the tax-deferred growth incentives discussed previously.
A Roth IRA is an individual retirement account funded annually with taxed contributions. Investments grow tax free, and when individuals reach retirement age, they don’t pay taxes on the distributions.
By investing in a Roth IRA and using a strategy of partial Roth conversions during the early years of retirement, retirees gain the benefits of a tax-preferred account while minimizing their tax exposure. Roth conversions simply involve moving money from an IRA to a Roth IRA, and generating taxable income with the intent of taking enough to use up those lower tax brackets in the early years.
The goal is to spend from the portfolio in a more tax-efficient manner to whittle down a pre-tax account and stop it from growing too large. Balance is the key here, as to not take too much or too little to get the best after-tax result.
The Roth conversion strategy is one that we recommend taking advantage of during “normal” times. Even though the current situation is far from normal, I recommend this strategy if you can take advantage of it. With markets fluctuating as they are now, converting can be a great bargain: You pay a tax bill on a lower balance now in exchange for tax-free growth in the future when the markets bounce back.
In terms of actual tax rates, there may never be a better time to use this strategy given the likelihood of higher taxes in the future. For example, the current tax law sunsets after 2025, and higher tax rates are almost guaranteed because of the enormous coronavirus-related stimulus bills that lacked built-in revenue offsets.
While we highly recommend this approach, you should always take great care before implementing any complex strategy. For instance, the ability to recharacterize unwanted conversions was removed in 2018 in the Tax Cuts and Jobs Act. To ensure this complex strategy is executed properly and in conjunction with your overall financial plan, we recommend you consult your financial advisor and accountant before taking action.