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Rose’s late-life transformation may require some tricky math.
As you approach retirement, one of the most important questions is how to manage taxes on your retirement income. For families that rely on a pre-tax investment portfolio, such as a 401(k) or traditional IRA, this means that all of your withdrawals are subject to ordinary income taxes. It also means anticipating necessary withdrawals related to IRS required minimum distribution (RMD) rules.
As a result, people in their 60s typically at least consider rolling their money into a Roth IRA. This could have significant benefits. It will eliminate taxes in retirement as well as your RMD requirements and may even increase the after-tax value of your estate.
The problem is, as you get closer to retirement, Roth conversions can get very expensive. You’ll pay quite a bit in upfront conversion taxes in exchange for these long-term income tax savings.
Let’s say you are 62 years old and have $900,000 in your 401(k) account. In this case, could you save money by converting your portfolio to a Roth IRA at $90,000 per year? Here are some things to consider. You should also consider speaking with a financial advisor for personalized guidance.
Every pre-tax retirement investment portfolio, including 401(k)s and traditional IRAs, has two main issues that families should be concerned about.
First, when you withdraw money in retirement, the portfolio will be taxed as ordinary income. This means you are taxed at income tax rates, rather than the special lower rates usually reserved for investments and capital gains. These taxes apply to all of your withdrawals, not just the portfolio’s gains, because your original contributions are tax-deferred.
Second, all pre-tax portfolios have what are called required minimum distributions (“RMDs”). This is the minimum amount you must withdraw from each pre-tax retirement account you hold. Currently, required minimum distributions begin at age 73, which means you must begin taking withdrawals of these minimum amounts during the year you turn 73. The exact amount you have to withdraw depends on the value of your portfolio and your age.
Required minimum distributions are a form of government tax planning. This is an IRS rule designed to ensure that you start triggering tax events for your pre-tax portfolio so that it can collect plan income, and penalties for not taking the full RMD will be assessed on your taxes.
The easiest way to avoid taxes and RMDs is through a Roth IRA.
There are no minimum distribution requirements for the after-tax portfolio. This is because you don’t have to pay any taxes on the funds you withdraw from these accounts.
To take advantage of this, many families consider what is called a Roth conversion. This is when you move funds from a qualified pre-tax investment portfolio (such as a 401(k) or IRA) to a post-tax Roth IRA. You can redeem any amount of funds as long as it comes from a valid pre-tax account. Once the money is transferred to a Roth IRA, it will grow tax-free, and you will pay neither income taxes nor RMDs in the future.
The problem with a Roth conversion is that you have to pay the conversion tax up front. When you convert funds into a Roth portfolio, you include the entire amount of the conversion in your taxable income for the relevant year. This will increase your taxes proportionately for the year.
For example, assume you are an individual earning $75,000 per year. Typically, you pay approximately $8,761 in income tax per year. However, let’s say you roll over $900,000 of your 401(k) to a Roth IRA this year. This would bring your taxable income for the year to $975,000 and the total income tax you owe would be $315,958.
If you are over age 59 1/2, you can withdraw funds from your investment portfolio to pay these taxes. For example, your Roth conversion could increase your taxes for the year by approximately $307,197. If you took this money out of your portfolio, you would be left with $592,803 in your Roth IRA after taxes. If you are 59 1/2 or younger, or if you want to keep your money where it is, you will need to have another source of funds to pay these taxes.
A fiduciary financial advisor can help you understand the Roth conversion rules and calculations based on your situation and assumptions. Use this free tool to get matched.
As we explained above, conversion taxes can be a huge disadvantage of a Roth conversion.
Specifically, the closer you are to retirement, the more likely it is that the cost of conversion taxes will generally outweigh your future tax savings. Later in your career, you’ll likely be in a higher tax bracket, and if you’re closer to retirement, you’ll transfer more money and your Roth IRA will have less time to grow tax-free.
One way to help manage this is through so-called staggered conversions. This means you exchange small amounts of money in stages rather than large amounts all at once.
The main advantage of a staggered conversion is that it helps you stay in a lower tax bracket. The more money you convert, the higher your taxable income and the higher your final tax bracket. This means that you will pay higher taxes per dollar you exchange than if you exchange fewer dollars at once. By converting your funds into smaller, staggered amounts, you can lower your tax bracket.
Take our place as an example. If you converted the entire $900,000 at once, your taxable income would be 37%, for an overall effective tax rate of 32.02% (not taking into account ordinary income for the year). On the other hand, if you only converted $90,000, you would only be in the 22% tax bracket and have an effective tax rate of 13.40%.
Again, regardless of your income, every $90,000 of conversion will trigger $12,061 in income taxes. Over 10 years, that’s $120,610, less than half the $307,197 in conversion taxes you’d pay to make this move once.
So, should you exchange your money? It depends on your goals. If you’re approaching retirement, you may spend more on conversion taxes than you save on income taxes and RMD requirements. However, if you wish to maximize the value of your estate, you can usually preserve the most wealth for your heirs by allowing them to inherit a tax-free Roth IRA.
To understand this, let’s look at your $900,000 401(k). For ease of use, we will assume that both inflation and portfolio growth are ignored, although in real life neither is a trivial issue.
Let’s say your median annual income is roughly $75,000. If you converted $90,000 per year, this would bring your annual taxable income to $165,000. Your tax bracket will rise slightly from 22% to 24%, and you’ll pay approximately $20,915 per year in conversion tax (total tax of $29,676 – income tax of $8,761 on income of $75,000).
Over 10 years, the total conversion tax would be $209,150, leaving you with $690,850 in your Roth IRA at age 72.
We further assume that you use a standard 4% withdrawal strategy, which means that you withdraw 4% from the portfolio each year for 25 years. With our converted Roth IRA, you will receive approximately $27,634 in after-tax income per year ($690,850 * 0.04). With a traditional IRA, your annual after-tax income is expected to be $33,652 ($900,000 * 0.04 = $36,000 – $2,438 in taxes).
So in this case, you earn more by retaining the money, and that’s before taking into account the lost growth and opportunity cost due to the conversion tax. However, these examples are simplified and do not take into account dynamics such as portfolio growth, inflation, and your own income levels and retirement needs. For tailored help, consider speaking with a vetted fiduciary advisor.
There are many ways to look at it, but in most cases the result is the same. By the time you reach 60, your retirement accounts are large enough to trigger very high conversion taxes. At the same time, the new Roth portfolio has little, if any, time to enjoy tax-free growth that would offset those taxes. As a result, tax savings through late-career transitions are rare, but for the right person it can be a huge boon.
A Roth IRA can certainly help you manage taxes and RMD withdrawals in retirement, eliminating them entirely. However, as you approach retirement, make sure your long-term savings will actually exceed your upfront conversion tax, otherwise you could end up paying high premiums for this peace of mind.
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Roth IRAs are a great financial tool, but they can be especially useful if you time them right. Perhaps more than any other retirement account, these accounts are most valuable to you early in your life, when you can maximize the tax benefits.
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