You know the old saying about “death and taxes,” right? We always want to delay the former, but sometimes postponing the latter is not the best idea. It takes holistic tax planning to protect your retirement living standards.
In fact, there is one move you can make during the critical ages up to 72 that provides remarkable results: Have you ever considered a Roth conversion?
How might inflation impact your Social Security benefits? Will the next COLA be enough to live comfortably on? Learn here.
The role of a Roth
Financial planning can help you lessen your tax liabilities (meaning how much you are assessed to owe). This can potentially allow you to keep more of your hard-earned money. Individual Retirement Accounts (IRAs) are a key component of that planning. Their job is to get you to save for retirement by letting you deduct contributions and postpone taxes on growth until you withdraw the money.
You must begin taking required minimum distributions (RMDs) at age 72. Those withdrawals are taxed at your ordinary rate rather than the lower long-term capital gains rates. Roths entice contributions differently: They don’t give you an immediate tax deduction—your contributions are post-tax.
However, if you follow the rules, all withdrawals are tax-free. That can mean decades of tax-free growth for your retirement nest egg. However, more importantly for this discussion, Roth IRAs have no RMDs. This gives you complete control over your withdrawals.
There’s just one catch: You can’t contribute to a Roth IRA if your income is above a set limit. No such limits exist for conventional IRAs (although your deductions may be capped if you also belong to a workplace retirement plan). Clearly, Roth conversions are a way to get around those income limits, pay your taxes early, and receive tax-free income later in life.
Reasons for a conversion
A Roth conversion can be a great way to move money from your conventional IRA and qualified workplace retirement plans to a Roth IRA—without the penalties incurred if you are younger than 59 ½ (and without regard to income caps, as well). Whatever your age, you must include the moved money in your annual taxable income.
After that, the Roth gives you tax-free distributions and no RMDs. If you are wondering why you should consider converting to a Roth IRA now rather than waiting to pay taxes starting at age 72, the reason is simple: A series of partial Roth conversions can save you money on your taxes in the long run.
The Social Security torpedo
The generally-accepted retirement advice is to fund your plan first with taxable income, followed by tax-deferred money and any tax-free income. Distributing taxable accounts first allows you to enjoy reduced taxes on long-term capital gains (LTCG). That’s something you can’t do with conventional IRAs and workplace plans.
One culprit in this story is Social Security. If you are a high-net-worth individual, your benefits can be a nuisance because they are taxable. They create a so-called “tax torpedo” that can trigger higher Social-Security-benefits-related taxes, putting you into a higher tax bracket. They may also raise your income enough to make you vulnerable to the 3.8% Medicare surcharge tax if your modified adjusted gross income (MAGI) exceeds $200,000.
Whether or not you retire before you’re a 70-year-old, the optimal solution is to postpone claiming Social Security until you are required to (at age 70). Up to then, you want to reduce your savings, if necessary, by first taking long-term capital gains from your non-sheltered brokerage accounts (since they may be taxed as low as 0%).
Roth Conversions to the rescue
Roth conversions are a way to convert tax-deferred income to tax-exempt money. Each year until age 72, you move a portion of your tax-deferred retirement accounts to a Roth IRA and pay the taxes. It’s ideal timing for retirees since they are no longer drawing a salary and are taking advantage of low long-term capital gains rates.
It makes just as much sense to those still working since they can offset the Roth taxes with 401K contributions, as well. Either way, you are reducing a future tax liability (in terms of your RMDs) with tax-free income from a Roth IRA.
The key is limiting your Roth conversions to the extent you can offset the taxes they generate with deductions like those from 401K contributions if you continue to work. Tax loss harvesting (selling off taxable assets at a loss) is one way to generate these offsetting deductions.
You can also limit the conversion amount to remain in the 0% LTCG tax bracket. This is also the perfect time to convert part of your other retirement accounts to a Roth IRA because:
Your taxable income is relatively low, thanks to your retirement (or 401K deductions), low long-term capital gains tax rates, postponed Social Security benefits, and the delay in RMDs until age 72.
The Roth account is tax-free. This means that it won’t add to the tax burden created by your SSBs and RMDs.
Once you reach age 70, you can reduce the pace of your Roth conversions so that you continue enjoying 0% LTCGs. However, if you don't moderate the amount you convert, your income could push you into the 15% or 20% capital gains tax bracket. If possible, you should complete your conversions by age 72 to avoid all RMDs and the taxes they generate.
The role of fiduciary investment advisors
It is challenging, at best, for affluent retirees to manage their income taxes on their own while maximizing their after-tax income. Global View Investment Advisors is a fiduciary financial advisor in Columbia, SC, that provides tax planning strategies to help maximize your after-tax retirement income.
We can help you now with 2022 year-end tax planning strategies while developing a long-term plan to minimize future tax obligations. Additionally, we can help you devise security sales after retirement to generate optimal long-term capital gains and help offset losses.
Using this information, we can show you the most efficient way to convert your tax-deferred retirement money to a Roth IRA. With proper planning, you can have tax-free income for distribution at the pace that makes sense for you, regardless of RMD rules.