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Nov 10, 2020

Manage Your Tax Strategy with Systematic Partial Roth Conversions

Social Security


Most investors are aware of the benefits of placing retirement assets in a Roth IRA or 401(k). While the contributions are made with after-tax dollars, the distributions are tax-free, all the growth is accrued tax-free, and there is no required minimum distribution once you retire. However, because these vehicles are relatively new, few investors reaching retirement today have had the benefit of funding a Roth IRA or 401(k) during their career. The good news is that since 2010, every investor who has assets in a qualified retirement account has been eligible to convert some or all those assets to a Roth. For some of these retirees, making systematic partial Roth conversions may confer long-term benefits to a retirement plan.

The transition into retirement brings about many changes. One of those changes is the nature, and in many cases the amount, of income taken each year. It is not unusual for a retiree to find themselves in a lower tax bracket within the first few years of retirement. However, many retirees also have a significant portion of their assets in a Traditional IRA. If you were to retire at age 60, the assets in your IRA could grow significantly larger during the twelve-year period before you have to begin taking required minimum distributions (RMD). It is not unusual for this growth to create a large enough RMD to force a retiree into ever higher tax brackets as they age. This is where systematic Roth conversions can help.

If an impending sizeable RMD from an IRA is going to move you into a higher tax bracket in the future, it may make sense to shrink the size of that IRA by “filling” the lower tax brackets early in retirement. What does this mean? If your income is sufficiently low in the early stages of retirement, you may have the opportunity to utilize partial Roth conversions without moving into a higher tax bracket. The logic behind this is that once you reach the age where you have to take RMDs, your ability to utilize lower tax brackets may be gone forever.

Here’s an example of how it could work: If you’re a married couple in the early years of retirement with a taxable income of $150,000, it may make sense for you to “fill up” the rest of the 22% tax bracket by converting roughly $20,000 of your IRA assets to a Roth IRA. If you can sufficiently shrink the IRA over time, you can then go beyond $20,000 and dip into the 24% tax bracket. The key is to figure out if you can pay taxes at a lower rate today than you’ll be able to in the future on the same dollars.

You’ll need to be careful with this. Every dollar converted from a Traditional IRA to a Roth IRA is deemed ordinary income, so converting large sums of assets to a Roth IRA in any given year may negate your future advantage by pushing you into a higher tax bracket. Doing smaller systematic conversions over the course of many years, while you’re in lower tax brackets, may result in marginally higher taxes today - but significantly lower taxes in the future.

This is not a one-size-fits-all strategy. Converting qualified assets to a Roth IRA may not be feasible because of your specific tax circumstances or income needs. Remember, unlike a Roth contribution, each Roth conversion will carry its own five-year waiting period before you can withdraw those assets without penalty. This makes the systematic strategy attractive, as those will roll off year after year in the future.

The ability to intentionally take advantage of the progressive nature of the tax code is reserved to individuals with a high degree of control over their income. This control tends to be the highest in the early years of retirement - and it gets forfeited after RMD age is attained. Before you make any distributions, talk to your financial advisor and tax planner to make sure you’re getting the most from your systematic Roth conversion strategy.

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