Early Retirement Roth Conversions to Reduce Lifetime Taxes
Retirement is an exciting opportunity to live to the fullest. It can be used for traveling, exploring new hobbies, or spending time with grandchildren.
By converting a portion of their 401(k) or 403(b) contributions to Roth IRAs, many retirees can increase their financial security and reduce their lifetime tax burden.
The Retirement “Tax Valley”
Many retirees will be in a lower tax bracket early in retirement compared to right before retirement or later in retirement. To comprehend why, consider Jim and Susan, who recently retired at age 61.
Jim and Susan earned a total household income of $200,000 while employed. This placed them in the middle of the married couple’s tax bracket of 24%. Jim and Susan have the following assets upon retirement:
- $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 receive the following retirement income:
Jim’s annual pension, beginning at age 65, is $50,000.
$30,000 (Susan’s annual pension — starting at age 65)
Beginning at age 70, Jim’s annual Social Security benefit is $40,000.
Susan’s annual Social Security benefit, beginning at age 70, is $35,000.
In addition to this income, Jim and Susan must begin taking required minimum distributions (RMDs) from their IRAs at the age of 72. Assuming they do not take from their IRAs between now and age 72, and assuming their funds increase at a rate of 7% per year for the next 11 years, their IRAs would be worth around $2.1 million each by age 72. The year they turn 72, they would each receive an RMD of approximately $76,650 ($2,100,000 / 27.4)
This would give them a possible taxable income of around $308,300 at age 72 from pensions, Social Security, and RMDs. This places them back in the highest tax rate of 24%, and they might easily move up to the 32% tax bracket or higher.
However, in their initial years of retirement, individuals could have virtually no taxable income if they opt to fund their goals with cash savings and a taxable investment account. Is it prudent to minimize taxes to this extent during early retirement?
Strategic Roth Conversions Early in Retirement
Suppose Jim and Susan had no taxable income in early retirement. Their small income from interest, dividends, and realized capital gains are mitigated by their standard deduction of $25,900.
If they each convert $65,000 annually from their IRAs to Roth accounts ($130,000 total), they will initially pay tax at the 10% and 12% rates, with a small amount taxed at the 22% rate each year.
If they do this every year until age 72, when their RMD begins, they will have around $1,079,000 in each IRA, assuming a return of 7% per year. This would approximately halve their baseline RMD at age 72. Since they were in the 24% tax bracket at age 72, their taxable income would be reduced by approximately $74,500 and their tax burden would be reduced by approximately $17,880.
A significant portion of the earlier conversions each year would have been taxed at 10% or 12%, resulting in less total tax paid over their lifetimes.
Protection Against Rising Tax Rates
The preceding illustration illustrates the benefits of Jim and Susan’s Roth conversions, assuming tax rates remain unchanged. If, in ten years, tax rates on higher earnings increase, they will have less income to be taxed at those higher levels since their IRA balances and RMDs will be smaller.
Assuming a growth rate of 7%, they would likewise have around $1,000,000 in each Roth IRA by the age of 72. This can be withdrawn tax-free if further funds are required. This is always advantageous, but especially so in a world with higher total tax rates.
Roth Conversions to Take Advantage of a Market Decline
Jim and Susan can take advantage of market drops to undertake strategic Roth conversions, in addition to the benefits of Roth conversions when in lower tax bands.
Suppose that a market downturn over the first half of the year results in the following negative returns:
-2% (Bonds) (Bonds)
-10% (Large US stocks) (Large US stocks)
-15% (Large international stocks) (Large international stocks)
-20% (Small US stocks, small overseas equities, emerging market stocks) (Small US stocks, small international stocks, emerging market stocks)
This presents Jim and Susan with an excellent chance to strategically transfer certain small U.S., small international, and emerging market securities from their IRAs to their Roth accounts. Assuming the investments recover as anticipated, Jim and Susan can pay tax on the conversion when prices are low and enjoy a substantial tax-free return once the investments have been transferred to a Roth account.
Additional Factors to Think About
There are a number of other variables for Jim and Susan to consider when converting to Roth early in retirement.
Depending on their taxable income, retirees who get individual health insurance before Medicare begins may be eligible for subsidies that reduce the cost of their premiums. In the case of Jim and Susan, their retiree healthcare coverage does not qualify for tax subsidies, therefore this is irrelevant.
If your taxable income exceeds a set threshold once Medicare Part B benefits begin at age 65, you must pay an extra IRMAA fee. In 2022, this additional premium begins when a married couple’s income exceeds $182,000.
Roth conversions can be an integral aspect of an estate plan for retirees who hope to leave money to an heir, as leaving Roth assets to heirs is much more valuable than leaving standard IRA money to heirs.
Roth conversions early in retirement can be a strong tool for minimizing taxes during your lifetime and maximizing your overall expected wealth, while they are not the optimal answer for everyone.
This can be an additional tool for maximizing retirement and living life to the fullest!
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