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You may think that your income will drop in retirement since you’re no longer in the workforce, However, the combination of required minimum distributions (RMDs) from retirement accounts, Social Security, investments, and a pension could keep you in a higher tax bracket.
As a result, you may be looking for ways to optimize your taxes in retirement so that you have access to more of your funds. This is why we wanted to explore why you should consider a Roth IRA conversion early in retirement.Here are five reasons to do so.
Your Current Tax Rate Will Be Lower Than Your Future One
When you first retire, you’ll likely be paying less in taxes since your income has dropped. You should want to optimize your tax planning so that you can spread out your tax liability.
“Generally speaking, the primary reason to do a Roth conversion would be if you suspect your current income tax rate will be lower than your future tax rate,” said Keith Spencer, founder of Spencer Financial Planning. “Those in the early years of retirement often find themselves in much lower tax brackets than during their working years, and possibly lower than their future tax brackets as well.”
Effective tax planning in your retirement can get fairly complex, so you’ll want to ensure that you’re taking the right steps to preserve your funds.Spencer added, “You’re essentially choosing to pay the tax now, at a relatively low tax rate, so that you won’t have to pay tax later at a higher tax rate.”
This leads us to the next point…
You Can Control Your Taxes at Your Own Pace
“If you expect that your required minimum distributions at 73 are likely to be more than you need to withdraw for income, then starting to slowly convert money from tax-deferred Traditional IRA or 401(k) accounts to a tax-free Roth will be a solid financial strategy,” saidStephen Kates, CFP and principal financial analyst at Annuity.org.
This move lets you control your tax liability at your own pace, and you can preserve your assets for later in life.Kates added, “Roth assets are one of the best types of accounts to pass on to your heirs because they can use the money tax-free.”
You Avoid RMDs From Other Retirement Accounts
“If you have pre-tax retirement accounts, such as Traditional/Rollover IRAs and 401(k)s, the day will come when you’ll be forced to take distributions from them in the form of RMDs (required minimum distributions),” warned Spencer.
If your retirement account balancers are fairly large, your future RMDs will also likely be larger, which could drive you into a higher tax bracket in the future. You don’t want to be stuck dealing with higher taxes when you want to be enjoying your funds after a lifetime of work.
“To avoid having to take an RMD from a tax-deferred account at age 72 (73 if you reach 72 after December 31, 2022), beneficiaries can receive funds via a Roth IRA, which can be withdrawn tax-free,” shared Jay Joseph, a CRPC and founder of Jay’s Money Secrets.
If you convert your Roth early in retirement, you’ll reduce the size of those pre-tax accounts and your future RMDs. This is why it’s crucial that you work with a financial professional for every stage of your life.
You Need To Hold a Roth IRA for 5 Years
“A Roth IRA must be held for five years or longer for all gains to be withdrawn tax-free,” remarked Joseph. “Converting can take place before employer plans are converted to an IRA, which saves taxation on the conversion.”
The earlier you make the conversion, the better off you’ll be since you want to satisfy the 5-year aging requirement on the Roth IRA.
Kates expanded, “This rule stipulates that after 59.5 years old, you can withdraw any conversion or growth within the account without any taxes as long as the account has been open for five or more years.”
This early conversion will allow you to use your Roth IRA funds to cover your expenses if necessary in the future.
It’s Difficult To Predict Tax Laws
Kates noted that if you believe your tax bracket will increase compared to your pre-retirement rate, then a Roth will let you get taxed now so that you can save on taxes in the future.
Kates said, “It’s hard to predict what the tax laws will be in 5+ years, but this is one way to hedge your risk. One thing we do know is that without congressional action, the tax cuts implemented in the 2017 Tax Cuts and Jobs Act will expire at the end of 2025. This is likely to raise taxes for all Americans across the income spectrum.”
While you can only control what you can based on available information, it’s essential that you consult with a trusted financial advisor to see what financial moves will make sense for you in retirement.
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