By Badgley's Financial Planning Team

The oldest baby boomers began to turn 70 in 2016 and according to AARP, approximately 10,000 are turning 65 every day. Many of these workers have been saving for decades in a tax-deferred retirement plan (such as a 401k or IRA). Until now, the money they have invested, and the growth of their investments, has not been taxed. However, once they turn 70 ½ the IRS will require them to take fully taxable annual distributions from their account, otherwise known as Required Minimum Distributions (RMDs). In contrast, Roth IRAs do not require RMDs and the growth is not taxed if the account is held for five years and to age 59 ½, whichever is longer. Converting to a Roth IRA is a potential strategy for reducing your tax burden in retirement.

What does this mean?

For many retirees, the onset of the RMD phase will not only cause an increase in income but can also move the investor into a higher tax bracket. The income from the RMD will be in addition to any other income the retiree is being taxed on, such as social security, pensions and capital gains, and it will be taxed at a retiree’s marginal (top) tax rate. This tax is owed whether the retiree needs the income or not and can significantly reduce the investor’s control over their tax bracket in retirement. It is also possible that this extra income could increase a retiree’s Medicare premiums (starting at Modified Adjusted Gross Income of $85,000 for individuals, and $170,000 for married couples).

Smoothing out the tax rates

One strategy that may lead to more after-tax wealth in the long run is to “smooth out” the tax brackets over time by purposely generating more taxable income in the first years of retirement in order to potentially be in a lower tax bracket for the remaining years and decades. For many investors, this will be accomplished automatically through retirement distributions for living expenses in their 60’s. However, for retirees who have other sources of cash flow from personal savings or taxable investment accounts, they can consider the option of a partial Roth conversion.

With a Roth conversion the investor chooses to pay the tax now on the amount converted in exchange for tax-free growth on those funds going forward. The most typical situation where a Roth conversion makes sense is when an investor is temporarily in a lower tax bracket than he/she expects to be in the future. An example would be an investor who retires at age 62. Because he/she is no longer receiving earned income, he/she will likely be in a lower tax bracket.

The traditional advice would be for this investor to continue to defer his/her retirement account until RMDs are required at age 70 ½ and live off of taxable savings. This would result in a very low tax bracket from ages 62–70, followed by a significantly higher tax bracket at age 70 ½ when the investor is forced to take RMDs (and has started collecting Social Security as well). This higher tax bracket could cause wealth to erode in the later decades of retirement, potentially during the same time that more income is required for health care and long-term care. Also, as noted earlier, the retiree may find himself/herself paying higher Medicare premiums post age 70 ½.

Another way to look at this is that the investor “wasted” the lower tax brackets for eight years and is now forced to pay taxes at a higher rate due to the nature of his/her income. By intentionally realizing some income in the lower tax brackets prior to age 70 ½, this retiree may be able to “smooth out” his/her tax bracket over a multi-decade retirement and end up with more after-tax wealth.

How it works

Beginning in 2010, the IRS allowed investors to make partial conversions of their IRAs regardless of income. The strategy is to calculate your expected taxable income and then “fill up” the lower tax brackets by converting enough of an IRA to a Roth to get as close to the top of the bracket as possible without moving into a higher bracket. In 2018 for married taxpayers filing jointly, taxable income (after deductions) of up to $77,400 pay a 12 percent rate. If you are willing to fill up the 22 percent bracket, the same taxpayers can earn up to $165,000. By strategically doing a partial conversion each year to engineer your income up to the 12 percent or 22 percent bracket, you will be sheltering those funds in a Roth IRA where they will not face RMDs and can be withdrawn free of income taxes later in retirement.

Risks to the strategy

There is a level of uncertainty to these potential strategies. The IRS can change their guidance and Congress can change the laws regarding Roth conversions, as well as future tax rates. In fact, there was a significant change to both in the recent Tax Cuts and Jobs Act (TCJA). Prior to 2018, investors were able to make a Roth conversion and then have until their tax filing deadline the following year to re-characterize (undo) the conversion. This allowed a precise targeting of income so you could do a larger partial conversion and then partially re-characterize it if your income ended up in a higher than expected tax bracket. The option was eliminated by the TCJA starting in 2018.

Going forward, investors should be extra careful when planning their conversion amount by keeping a detailed accounting of their expected income from other sources and waiting until late in the year to do the conversion since there is not a second chance to undo the conversion.

It is possible that a future Congress could add a Required Minimum Distribution to the Roth IRA where the growth on the distribution would still not be taxable, but would no longer grow tax free in the account. It is also possible that Congress could add a consumption tax such as a Value Added Tax (VAT) or national sales tax (potentially with an income tax rate reduction), which would reduce the value of your Roth IRA tax savings.

Despite these uncertainties, we see various strategies that may potentially minimize the impact of taxes during retirement. Careful consideration with your financial planner and accountant to assess your options could be very beneficial.