Key Takeaways
People are surprised to learn they’ll be in the same tax bracket (or higher) in retirement as they are in their working years.
For retirees with large traditional IRAs or 401(k)s, Roth conversions can help reduce required minimum distributions (RMDs) and provide tax flexibility.
The ideal candidate for a Roth conversion is aged 62 to 70, recently retired who can potentially live off after-tax savings.
One of the things that surprises our clients as they approach retirement age is that their income in retirement can be higher – or nearly as high – than it was during their working years. Because tax-advantaged Roth accounts were not widely available during the early and mid-stage of their careers, all those years of diligent saving have left them with a sizeable nest egg – and tax burden carryover.
In addition to required distributions, those that paid into Social Security for 40 quarters will begin receiving Social Security income by age 70. Although having more money is generally beneficial, this income will also be taxed. Clients often have pensions and RMDs from retirement accounts that they can't defer past age 73, which means those monthly "paychecks" can add up to six figures in taxable income during retirement.
We can't do anything about Social Security. And we can't do anything about pensions (unless a lump sum option is given). Both streams of income are required to be taken by a specific age. Fortunately, we can do something about IRAs. We can reduce income from RMDs by doing Roth conversions earlier in life. Enter the Roth conversion strategy.
What Is A Roth Conversion?
A Roth IRA conversion involves the transfer of tax-deferred retirement assets from a traditional IRA, SEP, or 401(k), 403(b), into an after-tax Roth IRA. While the account owner must pay income tax on the money they convert, they can make tax-free withdrawals from the account in the future.
Why Do A Roth Conversion?
If an investor anticipates being in a higher tax bracket in the future (i.e., in retirement), they'll save money by paying taxes on that money now rather than later. The best candidate for a Roth conversion is someone between the ages of 62 and 70 who has recently retired and is using their after-tax savings or cash, especially if their tax liability is currently low. Age 62 is when they’re first eligible (but not required), to take Social Security benefits. At age 73, individuals are required to take distributions from their retirement accounts. This strategy aligns with our goal for all Novi clients to smooth out their effective tax rates throughout their lifetime.
Was It Wrong To Build Up My 401(k) So High?
Clients with large traditional IRAs or 401(k)s sometimes question whether they made a mistake, such as saving $2 million in a tax-deferred account. In most cases, the answer is no. For successful individuals with high incomes, it was often wise to maximize their deductions at the time by contributing to a traditional 401(k) or IRA.
Roth IRAs and 401(k)s were not introduced until later, so many of today's pre-retirees worked for years without these options. So, they couldn’t make Roth contributions during a good portion of their careers. And until recently, the contribution limits were low – if their company even offered them. Further, before 2010, there were income limitations to doing a Roth conversion. But not anymore.
We Like A Roth Conversion For Many Of Our Clients For The Following Reasons:
It reduces RMDs later in life.
It gives tax flexibility in case assets need to be distributed in a tax-free manner.
It protects children who are not financially responsible.
It gets growth in an account that can be later distributed tax-free.
It is a great legacy planning tool for children (especially high-earning children).
Real-World Example
We have two clients each looking to retire in their mid-sixties. They’re both high earners and because of their high incomes (and high tax brackets), they had mainly saved in traditional 401(k)s during their working years to reduce their taxable income. When they were looking to retire, they had large 401(k) balances, plus additional cash saved on the side. They also received some money from a piece of land that they recently sold.
They didn’t have pensions, but because of their other sources of income, we recommended delaying taking Social Security until age 70. By doing so, they only had two options: take distributions from their IRAs or utilize cash.
We opted to utilize the cash to cover expenses for the next few years, which would keep their taxes close to zero. During this period, we also recommended doing large Roth conversions to reduce their RMDs later in life and to generate tax-free growth in their Roth IRA accounts. Over the five years of this strategy, we converted about $1 million of their tax-deferred retirement account into a Roth IRA, saving them about $300,000 in taxes later in life. If we hadn’t done the conversion, their sizeable retirement account would have continued to grow in a traditional (i.e., taxable) IRA, and they would have been in the 24% to 32% tax bracket when they finally started taking distributions. Think of a Roth conversion as “tax arbitrage” in your favor.
The challenge for many people is trying to estimate what your tax situation is going to be for the next 20 to 30 years of retirement. With our help, we can work backward to figure out how to smooth out your tax obligations. I don’t recommend being a do-it-yourselfer here. Evaluating the pros and cons of a Roth conversion is something we do for all our clients as part of our standard assets-under-management fee.
Over time, we've found that while Roth conversions make sense for about one-third of Novi clients, they’re not the best option for everyone. Individuals have different cash flow needs and balances in various accounts, each with a different tax treatment. We look at a Roth conversion decision holistically based on each client’s situation, needs, and objectives.
Conclusion
If you or someone close to you has questions about their retirement plan or tax situation post-working life, please don’t hesitate to reach out. We’ve helped many clients like you in similar situations.
RYAN A. DUNN, CFP®, is a Wealth Manager at Novi Wealth
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