If you expect your tax rate this year to be less than what it will be after you are 70½, consider a Roth IRA conversion. You will pay income tax on the funds you convert from a traditional IRA, but it will be at a lower rate than when withdrawals are made later from the traditional IRA as part of a required minimum distribution (RMD). I see this opportunity present itself most often for clients in a job transition, when their income has fallen, and for clients in their 60s who are retired or semi-retired and not yet collecting Social Security.
I’ll start out with brief explanation of how traditional IRAs and Roth IRAs are taxed. With a traditional IRA (or 401K), money is contributed to the account “pre-tax,” meaning you either take a deduction on your tax return for an IRA contribution (or in the case of a 401K, your reported income on your W2 excludes the 401K contribution). Earnings within the IRA/401K then grow tax deferred. When funds are withdrawn during retirement, any withdrawals are taxed in the year of withdrawal. The IRS requires that IRA/401K account holders start withdrawing money, if they haven’t already, at age 70½. This is called a required minimum distribution (RMD).
With a Roth IRA, you don’t take a deduction in the year you make the contribution; therefore the contribution is considered to be “after-tax.” However, the entire account balance can be withdrawn tax free if the account has been in existence for five years and the account owner is over 59½. There is no RMD for a Roth IRA if you are the original account holder and have not inherited it.
How do you decide between a Roth and a traditional IRA? If your tax bracket is the same when you make a contribution as when you take a withdrawal, it makes no difference which type of IRA you invest in. The after-tax amount of your withdrawal will be exactly the same.
However, during their working years most people are in a higher tax bracket than they will be in retirement. In this case, they are better off contributing to a traditional IRA (or 401K), taking the deduction at the higher rate. (A common exception is young people just starting out in the work world who are likely in a lower tax bracket than they will be when they retire. They are better off funding a Roth first, assuming they are not giving up a company 401K match.)
But what if your income drops because of either a job transition or retirement/semi-retirement? In this case consider moving a portion of a traditional IRA to a Roth. This is what a “Roth Conversion” is: simply transferring money from a traditional IRA account to a Roth IRA account. For tax purposes, the amount transferred is considered a distribution and is taxable income in that year. The advantage is that the traditional IRA has become smaller and the amount you transfer is not subject to an RMD and thus not taxed after you reach 70½.
So what how much should you convert? The answer to that question is the amount that will “fill up” the lower tax bracket. Unlike contributions, there is no limit on the size of a Roth conversion. I’ll use an example.
John and Jane, age 65, are a married couple who are both working part time. They have decided to delay taking Social Security until age 70. They are supplementing their income with withdrawals from a savings account, and their total taxable income is $55,000. That puts them in the 15% tax bracket (taxable income is income after itemized/standard deductions and exemptions). Taking into account their Social Security and RMDs from their IRAs, they anticipate that their marginal tax rate, post 70½, will be 25%. The best strategy for them in 2016 would be to do a Roth conversion of $20,300. This would bring their taxable income to $75,300. In 2016 this is the cutoff between the 15% and 25% brackets. While they would pay tax in 2016 of $3,045 ($20,300 x 15%), they would avoid paying tax later of $5,075 ($20,300 x 25%), saving them $2,030 in taxes.
The key to benefitting from the tax advantages of a Roth conversion is understanding what your tax rate will be during retirement (primarily after 70½). This means putting together a financial plan that will allow you to estimate your tax rate throughout retirement. You’ll also need to forecast your current year’s taxes before the end of the year. Unlike IRA contributions, where you have until April 15 to make a prior year contribution, Roth conversions must be completed by December 31.The best time to do this analysis is in the fall once you have a good read on your current year’s income. If your money is in a 401K account, you’ll need to do a rollover to a traditional IRA before doing the conversion.
As always, feel free to reach out if you think we can help you with this type of strategy.