Editor’s note: This is the final part of a seven-part series. It dives more deeply into the third strategy for defusing a retirement tax bomb, which is Roth conversions. If you missed the introductory article, you may find it helpful to start here.
Because they offer tax-free qualified withdrawals, Roth IRAs and Roth conversions can be a critical strategy for defusing the retirement tax bomb that traditional IRAs, 401(k)s and other pre-tax savings accounts can set you up for in retirement.
A Roth conversion is when you transfer money out of a pre-tax retirement account into an after-tax Roth. Typically, every dollar you convert is taxed as ordinary income, unless the pre-tax account was also funded with after-tax dollars.
Here’s the problem though: Most people who are facing a retirement tax bomb and are still working probably have high incomes and are in a high marginal tax bracket. The last thing they want is a Roth conversion, which adds to their income and would be taxed at high tax rates.
Instead, this is a good strategy to consider in low-income years, especially for people who retire early in their 50s and early 60s who may have several years to do conversions before Medicare means testing surcharges, Social Security income and RMDs kick in. Many of my clients do several years of annual Roth conversions starting early in retirement.
Three Windows for Roth Conversions
The first window for Roth conversions is the years before enrolling in Medicare, but recall that Medicare means testing has a two-year look-back so your income at age 63 determines your Medicare Part B and Part D premiums when you’re 65. A prime window for Roth conversions is between retirement and age 62. If you do end up triggering Medicare means testing for a year or two while you do Roth conversions, you may find it’s still worthwhile. And you may be able to appeal Medicare means testing surcharges through IRS form SSA-44.
The second window for Roth conversions is between retirement and when you start taking Social Security or pension income, at which point your income may be significantly higher and you may want to do smaller Roth conversions. This is an additional argument for deferring Social Security benefits for several years.
The final window lasts until required minimum distributions (RMDs) begin at age 72. If you’re still sitting on a retirement tax bomb at that point, the conversion window has probably closed.
Carefully Examine Your Tax Bracket
There are a few other concepts to keep in mind with Roth conversions. One is trying to “fill up” lower marginal tax brackets until you reach a marginal tax bracket where conversions no longer make sense. For example, for 2022 if you’re married and retired at 60 with no income coming in, and you want to do a Roth conversion of $172,000, then the first $20,550 of conversion income is taxed at only 10%, the next $63,000 is taxed at 12% (to $83,550), and the next $88,450 is taxed at 22% (to $172,000). If you accidentally go over a tax bracket dividing line, say you converted $180,000 instead, it’s not that big a deal because only the amount over the starting point of the 24% tax bracket ($178,151) is taxed at 24%.
Similarly, if you have a year with low income because of, say, a job loss, this can be a great time to do a Roth conversion, provided you have the resources to pay the taxes (though you may not if you’ve lost a job).
Two Other Timing Considerations
Another good time to do Roth conversions is when markets are down. Why? Because for any given conversion amount, you’re getting rid of a larger percentage of the tax liability. For example, if you have $500,000 of tax-deferred assets and do a $50,000 Roth conversion, you eliminate 10% of the tax liability. But if the market was down 20% so that your tax-deferred assets had fallen to $400,000 and then you do a $50,000 Roth conversion, you’d face the same tax bill but you eliminate 12.5% of the tax liability.
Finally, the IRS requires any Roth conversion to have occurred at least five years before you access the money or you may be charged taxes and early withdrawal penalties. But Roth accounts usually are the last accounts you want to withdraw money from so your tax-free money can keep growing, so this is rarely a problem.
The Bottom Line for Our Retirement Tax Bomb Series
This wraps up my seven-part series examining retirement tax bombs. We looked at three major problems with retirement tax bombs, which included RMD income, Medicare means testing and inherited tax liability.
We also looked at three strategies for defusing retirement tax bombs, including shifting contributions from pre-tax to Roth, asset location and Roth conversions.
I hope you’ve found these articles helpful. Here are the links to all of the articles, plus two bonus articles that examine more retirement tax bomb issues and how to deal with them:
- Part 1: Is Your Retirement Portfolio a Tax Bomb?
- Part 2: When It Comes to Your RMDs, Be Very, Very Afraid!
- Part 3: Watch out! RMDs Can Trigger Massive Medicare Means Testing Surcharges
- Part 4: Will Your Kids Inherit a Tax Bomb from You?
- Part 5: How to Defuse a Retirement Tax Bomb, Starting With 1 Simple Move
- Part 6: Using Asset Location to Defuse a Retirement Tax Bomb
- Part 7: Roth Conversions Play Key Role in Defusing a Retirement Tax Bomb
- Bonus article 1: 2 Ways Retirees Can Defuse a Tax Bomb (It’s Not Too Late!)
- Bonus article 2: Can My Pension Trigger a Retirement Tax Bomb?
David McClellan is a partner with Forum Financial Management, LP, a Registered Investment Adviser that manages more than $7 billion in client assets. He is also VP and Head of Wealth Management Solutions at AiVante, a technology company that uses artificial intelligence to predict lifetime medical expenses. Previously David spent nearly 15 years in executive roles with Morningstar (where he designed retirement income planning software) and Pershing. David is based in Austin, Texas, but works with clients nationwide. His practice focuses on financial life coaching and retirement planning. He frequently helps clients assess and defuse retirement tax bombs.
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