Saving for retirement over the course of your career may have left you with investments in various types of accounts.
By the time you retire, you can have a 401 (k) from work, an IRA for additional retirement savings and a taxable brokerage account on top of that.
Savvy investors will take the opportunity in the early years of retirement to convert as much of their savings as possible into a Roth IRA. Here are three reasons.
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1. You can better control your taxes
While you want your retirement savings to grow as much as possible, you want to minimize withdrawals from traditional retirement accounts. Since you will pay income tax on any amount withdrawn from these accounts, it is a good idea to make these withdrawals when it is most advantageous for your tax obligation.
If you are in a position to postpone receiving Social Security benefits, the first years of retirement may be an ideal time to make these withdrawals. Since you probably will have no other source of income, you can fill the lower tax ranges with withdrawals from the IRA.
But you don’t want to miss out on the tax-free growth opportunity you will get by converting traditional IRA funds into Roth IRA. This allows you to pay your low tax liability now, but you will not be paying any tax on the IRA money again, no matter how much your Roth account grows.
If you manage to live off long-term capital gains from a taxable account in the early years of retirement and convert an amount in the lower tax ranges of your IRA to a Roth each year, you will end up with an exceptionally low effective tax rate in retirement.
2. There are no mandatory minimum distributions at the beginning of retirement
One thing that can hinder your retirement tax planning is the mandatory minimum distributions (RMDs). After turning 72, the IRS forces you to withdraw from your retirement accounts. If you have a lot of money in these accounts, you may be asked to withdraw more than you need. In many cases, it will not be the most tax-efficient way to defray your retirement annually.
The Roth IRA is exempt from the required minimum distributions. Therefore, converting as much as possible to a Roth before the age of 72 can avoid many hassles with tax planning. Not only will you not be concerned about the tax obligations on Roth’s withdrawals, but you will also minimize the minimum distribution required. Fortunately, you can keep it at a very manageable level.
If you end up with an RMD that exceeds your retirement spending requirements, you cannot transfer those funds to a Roth IRA.
3. You can have more Social Security benefits later
Perhaps the greatest benefit of retiring primarily from a Roth IRA at the end of retirement is that it will not affect how much of your Social Security benefits will be taxed. Social Security benefit tax is based on combined income, which is the sum of half of your Social Security benefits, your adjusted gross income and non-taxable interest.
See the table below to find out how your combined income affects Social Security taxation.
|
Taxable percentage of Social Security |
Combined income if you are reporting as an individual |
Combined income if filed together |
|---|---|---|
|
0% |
Less than $ 25,000 |
Less than $ 32,000 |
|
50% |
$ 25,000 to $ 34,000 |
$ 32,000 to $ 44,000 |
|
85% |
More than $ 34,000 |
More than $ 44,000 |
Table source: Author. Data source: SSA.gov
Roth IRA distributions do not count towards your combined revenue, but traditional IRA distributions do.
Converting traditional IRA funds into Roth IRA before you start receiving Social Security benefits can provide double tax benefits. First, you pay a low tax rate on conversion and then a low tax rate on your Social Security benefits.
It’s all about taxes
Ultimately, Roth’s conversions (and direct contributions, by the way) are about controlling his tax rate. And the best opportunity to control your tax rate is when you have complete control over your revenue. These are the first years of retirement.
Take the opportunity if you can, but it is not necessarily the best option for everyone. Some people cannot afford to delay Social Security and others are not particularly concerned about the effect of the required minimum distributions. A Roth IRA is just a tool to help you control your tax rate on retirement.