In over 15 years as a financial advisor, by far the most under-utilized tax savings technique that I have come across is using Roth IRA conversions in the early years of retirement to save money down the road. In my experience, at least 50% of retirees should consider the strategy, meaning work with an advisor to run the numbers to determine if it makes sense for them, and at least 25% should take advantage of the strategy as a tax savings tool. That being said, in my experience less than 1% of prospective clients that I speak with have done this, and most of the time their advisor has never even mentioned it. For some clients, this lost opportunity adds up to tens or even hundreds of thousands of dollars in lost tax benefits, and can also lock them into overpaying for Medicare premiums, saddling their heirs with huge tax burdens, and a laundry list of otherwise easily avoidable tax traps. Before we dig into the details of the strategy, let’s take a step back to review for those who aren’t familiar with the issue.
What is a Roth Conversion?
A Roth conversion involves moving funds from a traditional individual retirement account (IRA) or a pre-tax retirement account, such as a 401(k) or 403(b), into a Roth IRA. This conversion is a taxable event because you are essentially converting pre-tax funds into after-tax funds.
What are the Tax Advantages of Roth Conversions?
Tax-Free Withdrawals: Qualified withdrawals from a Roth IRA are tax-free. This means that if you anticipate being in a higher tax bracket during retirement or believe that tax rates will increase in the future, converting to a Roth IRA now can allow you to withdraw funds tax-free in retirement.
No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not require minimum distributions during your lifetime. This provides greater flexibility in managing your retirement income and potential tax liability.
Estate Planning Benefits: Roth IRAs offer potential estate planning advantages, as the funds can be passed on to beneficiaries tax-free.
How Do Roth Conversions in Early Retirement Save on Taxes?
When you retire early, you may have a period of lower taxable income before you start receiving Social Security benefits or other forms of retirement income, such as RMD’s, which now do not begin until age 73. This lower income presents an opportunity to convert some of your traditional IRA or 401(k) funds into a Roth IRA at a potentially lower tax rate. Often this is referred to as "filling up the bucket", in which case you are wanting to make sure that you "fill up" all of a lower tax bucket in the hopes that you will avoid "spilling over" into the higher tax bucket down the road.
By managing the timing and amount of Roth conversions strategically, you can optimize your tax situation by taking advantage of lower tax brackets and potentially reducing future tax liability. Think of it as choosing to pay taxes on money now at a low tax rate, instead of down the road when you are in a potentially higher income tax rate, when you are receiving your social security income and Required Minimum Distributions. The image below may help explain.
Other Considerations For Roth Conversions
It is important to work with a knowledgeable financial planner and tax advisor before using this strategy. You will want to take into account whether a Roth conversion may trigger other unforeseen taxes or costs, such as the IRMAA increased premiums for Medicare Part B and D. With the changes to Roth Recharacterization rules, it is more difficult to undue a mistake in this area, so you will want to make sure that you have covered your bases and reviewed with your accountant before proceeding.
If you withdraw money from a converted Roth IRA within the first five years after the conversion, you'll have to pay the 10% penalty on any withdrawals if you are under age 59.5. That includes withdrawals of the amount you initially converted, even though you've already paid taxes on that amount.
If you are worried about paying the taxes due from your Roth conversion, this may be a time to get creative and do some more long-term planning. For clients who give regularly to charity, we may take the opportunity to establish a Donor Advised Fund which can allow us to lump our charitable donations for the next decade or so into a fund for designated giving, reducing our income and ensuring that they will be able to deduct the charitable gift, now that the standard deductions have increased so much. Charitable remainder trusts or other complex estate planning tools can also play a role for wealthier clients, who may end up being able to convert large IRA amounts to tax-free Roth IRAs in the process.
As I initially stated, in my experience the partial Roth conversion early in retirement is the most under-utilized tax savings technique available. The majority of investors near retirement or in early retirement should at least check the numbers to determine if this strategy would benefit them. Feel free to reach out to book a meeting if you would like to learn more or discuss whether this strategy would benefit you.