As clients approach retirement, they are typically in the peak earning years of their careers, and tax deductions are a priority. However, if you plan to retire before age 72, there may be an opportunity to do some long-term tax planning with a strategy called partial Roth conversions. This article will illustrate the concepts to educate retirees who may be able to plan for a more tax-efficient retirement. Please note that this article purposefully oversimplifies some of the more complex items to illustrate the key concepts and overall strategy, rather than explain the many nuances and rules that a qualified professional would need to understand before recommending this strategy.
Types of Tax-Advantaged Retirement Savings Plans
Tax-advantaged retirement plans generally fall into two buckets: Pre-tax options such as a Traditional IRA, 403(b), 401(k), SEP IRA, SIMPLE IRA (“first bucket”) or post-tax options such as a Roth IRA or Roth 401(k) (“second bucket”). When you’re saving toward retirement, the IRS allows you to choose when you want to pay the taxes on your income. Contributions to your accounts in the “first bucket” (403(b), 401(k), etc.) reduce your current income for tax purposes, and you will have to pay the income taxes when you make withdrawals from your account in retirement.
A Roth IRA (“second bucket”) is the opposite—you pay the taxes on your income in the tax year you make the contribution, but withdrawals from the account (and all the growth from your investments) is tax-free. The key to deciding which bucket to save toward in any given tax year depends on what your income will be now compared to future years. HINT: Pay the taxes while in lower brackets.
Tax-Efficiency and Required Minimum Distributions
A key factor for folks who want to remain tax-efficient in retirement is paying special attention to the taxable income that will be generated from Required Minimum Distributions (RMDs). The year in which you turn 72, you are required by the IRS to withdraw money, and pay taxes, on distributions from retirement accounts in the aforementioned “first bucket.” Each year, you will need to withdraw a higher percentage of your retirement accounts subject to RMDs; therefore, your income tax liability from RMDs generally increases through your retirement. By comparison, Roth IRAs (but not Roth 401(k)s) do not currently have forced distributions—you are welcome to take tax-free withdrawals as needed, but they are not mandatory. Let’s look at an example to illustrate.
John and Susan each plan to retire this year at age 65, and each makes $200,000, for a total household income of $400,000. Each has saved $1 million in their 403(b) accounts and another $500,000 in a joint taxable investment account outside of their retirement plans. They had the exact same earnings histories and are eligible for Social Security benefits of $2,600 per month each at their Full Retirement Age of 66 and 4 months (more if they wait to collect past age 66). Susan plans to wait until she’s 70 to collect Social Security to maximize her benefits, and John will collect at his Full Retirement Age.
They have some options for replacing their income when their paychecks stop at 65 to fund their needs above what Social Security will provide.
Let’s look at two options.
Option 1: Their first option would be to take distributions from their taxable investment account and allow their retirement accounts to continue to grow tax-deferred for another seven years after they retire.
The clients will enjoy the first seven years of retirement in the lowest tax brackets, and their taxes will be remarkably low relative to their working years. Their only income comes from turning on Social Security at appropriate times and from the dividends, interest, and capital gains on their taxable account. Their 403(b) plans continue to compound and grow tax-deferred until the year they both turn 72.
At that point, they will be permanently stuck in higher brackets, with the potential to jump from the 24% to the 32% marginal bracket if one of them should pass away and the surviving spouse must file as a single individual instead of as married, filing jointly (lower marginal tax brackets for single filers). In summary, they would enjoy seven years of extremely low taxes and then pay higher taxes from RMDs for the rest of their retirement years after age 72.
Option 2: They could take distributions from their taxable investment account and convert portions of their retirement accounts to Roth IRAs (taxable event).
In scenario two, the clients would use the first seven years of retirement to shift assets from their pre-tax 403(b) accounts into Roth IRA accounts. This is accomplished by taking the income they need from their taxable investment account (relatively low tax impact on capital gains—the dividends and interest are taxable whether they are taking distributions or not) to fund their ongoing expenses and lifestyle, and strategically transferring portions of their 403(b) into Roth accounts each tax year until they reach the age at which RMDs are required. Since Roth IRAs do not have required distributions until after you die, these accounts can be left alone to compound tax-free over your lifetime and fund higher spending years in the future (for example, long-term care costs).
The long-term effect of this strategy is that it can help prevent the RMDs from forcing John and Susan into higher tax brackets, therefore saving taxes in future retirement years by “filling up” the lower marginal tax brackets. John and Susan were able to defer income taxes while they were in the 32% marginal bracket while working and chose to instead pay the income taxes at the 10%, 12%, and 22% rates. They also reduce the tax risk that RMDs force them back into the 32%+ brackets by shifting assets from an account that requires RMDs to one that does not.
The estimated lifetime tax savings from this hypothetical strategy would be about a half million dollars, or $487,784. The strategy also leaves more assets for their legacy (see chart below) and much more in assets once taxes are accounted for (while taxes still have to be paid on assets in the “first bucket”).
With Roth Conversions
Without Roth Conversions
|Pre-tax / “First Bucket”||$1,385,822||$3,830,010|
|Tax-free / “Second Bucket”||$4,157,285||$0|
The Impact on Beneficiaries
Finally, we should note how this would affect their beneficiaries. Both “buckets” (pre-tax and tax-free accounts) must be liquidated within ten years after the second spouse’s death. Since the Roth IRA can be liquidated tax-free at any point, beneficiaries could get another decade of tax-free compound growth on Roth IRAs after inheriting them (assuming they do not need the money earlier).
Deferring distributions on pre-tax accounts until just before the tenth year generally would not work well, since it would mean they have to withdraw the entire account balance in one tax year, with nearly half of their inheritance going to Uncle Sam (between state and federal income taxes). It is usually better to spread the pre-tax retirement account withdrawals over ten tax years, depending on the beneficiary’s financial plan and needs.
Selecting the Correct Strategy
There are other ways to accumulate assets into tax-free Roth accounts, and this is only one strategy. If you plan to retire before 72, consider speaking with a fiduciary financial planner or tax professional to determine if this strategy may be a good fit for your long-term plan and to get their help implementing it to avoid costly mistakes along the way.