-- Understanding the Benefits of Roth Conversions in Retirement Income Planning
Roth conversions are a powerful tool in retirement income planning, allowing retirees to maximize their retirement income while minimizing their tax burden. By converting traditional IRA assets into a Roth IRA, retirees can secure tax-free income during retirement and reduce the amount they will pay in taxes over their lifetime. This proactive strategy is especially important for those seeking to maintain flexibility with their retirement income and leave behind a tax-efficient legacy for their heirs.
The key to leveraging Roth conversions effectively is strategic planning, particularly through the tax bracket bumping strategy. This approach helps control the tax situation by converting assets in a manner that keeps retirees within lower tax brackets, avoiding unnecessary tax increases in the future.
Tax-Deferred Does Not Mean Tax-Free
Traditional IRAs are popular retirement savings vehicles, offering an upfront tax deduction on contributions. However, these accounts are subject to tax when withdrawals are made, and retirees must start taking Required Minimum Distributions (RMDs) by age 73 or 75. The issue arises because the IRS forces retirees to take these distributions whether they need the income or not, which increases taxable income.
When RMDs start, many retirees are caught off guard by the tax implications. If the account balance is substantial, RMDs can push retirees into higher tax brackets, leading to a larger tax liability than anticipated. Additionally, RMDs may also trigger IRMAA surcharges (higher Medicare premiums) and could affect the taxation of Social Security benefits.
By proactively planning Roth conversions, retirees can avoid the surprises associated with RMDs and the taxes that come with them. Converting funds to a Roth IRA helps reduce future RMDs and gives retirees the ability to withdraw tax-free income in retirement, offering more control and predictability over their financial situation.
The Key to Tax-Smart Retirement Income
A Roth conversion transfers funds from a traditional IRA or 401(k) to a Roth IRA, triggering taxes on the converted amount. While this creates an immediate tax bill, it offers long-term benefits.
The main advantage of a Roth IRA is that it doesn't require RMDs, giving retirees more control over their income and helping keep taxable income low. Additionally, Roth IRAs allow tax-free withdrawals after five years, which is especially beneficial for those expecting higher taxes in the future or wanting to avoid RMD-related tax issues.
The Power of Tax Bracket Bumping
The tax bracket bumping strategy involves converting traditional IRA assets to Roth IRAs in a way that fills up lower tax brackets, avoiding higher ones. For example, if a retiree is in the 24% tax bracket, they can convert up to the limit of that bracket, avoiding the 32% bracket.
This strategy helps control taxable income today, preventing higher taxes from RMDs in the future. By using bracket bumping, retirees can reduce future tax burdens and keep more of their money working for them.
The Case of John and Mary
John and Mary, both in their early 60s, decide to convert $70,000 annually from their traditional IRAs into Roth IRAs, filling the 24% tax bracket each year. Over several years, they reduce the balance in their traditional IRAs, lowering future RMDs and avoiding higher tax brackets when distributions begin.
This strategy minimizes their tax liability during retirement, increases tax-free income, and helps maintain control over their financial future. By leaving behind Roth IRAs, they preserve more wealth for their heirs, who will inherit them tax-free.
Roth vs. Traditional IRA for Heirs
The benefits of Roth conversions extend beyond the retiree’s lifetime. One of the most important aspects of Roth IRAs is that they can be passed on to beneficiaries tax-free. This is a significant advantage over traditional IRAs, which require heirs to pay income taxes on the withdrawals they make from inherited IRAs.
Under the SECURE Act, non-spouse beneficiaries must withdraw all funds from inherited IRAs within 10 years, often resulting in large taxable distributions. If these distributions coincide with the beneficiary’s highest earning years, the tax burden can be substantial. However, when heirs inherit a Roth IRA, they can withdraw funds tax-free, ensuring that more wealth is passed down and preserved.
An inherited Roth IRA must also be withdrawn within 10 years. However, with careful planning, if beneficiaries can wait 9-10 years before withdrawing the funds, they can allow their inherited Roth IRAs to grow tax-free with the market for the next 9-10 years and then withdraw their balance at that time, maximizing their tax-free inheritance. This approach could turn a $1 million Roth IRA into a $2 million Roth IRA with average market performance.
When Roth Conversions Don’t Make Sense
While Roth conversions offer many benefits, they may not be right for everyone. If a tax rate is expected to be lower in the future, there may be less benefit to converting assets today. For example, if retirement income will be significantly lower than current income, it may be better to wait until tax rates decrease before considering a conversion.
For retirees with lower income early in retirement, this can be an ideal time to complete Roth conversions before Social Security, pensions, RMDs, or other income sources begin. Certain investments, like CDs that raise taxable income, may also limit how much can be converted, so there are several factors to review before moving forward with a Roth conversion strategy.
It’s essential to carefully assess individual tax situations before committing to a Roth conversion strategy. Working with a retirement income specialist can help determine whether this strategy aligns with long-term financial goals and tax planning needs.
Roth conversions are an effective way to reduce taxes, increase retirement income, and leave a legacy for future generations. However, to maximize the benefits of this strategy, working with a professional who specializes in retirement income planning and tax-efficient strategies is essential.
At Beneficial Wealth, Stephen Bene and Jeff Costello are experts in retirement income planning, tax-efficient strategies, and multi-generational wealth transfer. Their experience in Roth conversions can help navigate the complexities of this powerful tool, ensuring that financial goals during retirement and beyond are achieved.
About Beneficial Wealth
Beneficial Wealth is a financial planning firm founded by Stephen Bene, CFP, and Jeff Costello, CFF, NSSA. With years of experience in retirement income planning, Social Security optimization, and multi-generational tax planning, the firm helps clients create tax-efficient strategies to maximize their wealth during retirement and beyond.
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Stephen Bene, CFF, NSSA and Jeff Costello, CFF, NSSA
Beneficial Wealth,
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Name: Stephen Bene
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Organization: Beneficial Wealth
Website: https://beneficialwealth.com/
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