2. Minimizing Today’s Tax Bill Isn’t Always The Best Strategy

Steve and Jennifer had high taxable income during their working years. A year ago at age 65, they both retired as they became eligible for Medicare. Jennifer is now receiving Social Security spousal benefits based on Steve’s record. Once Steve is 70, he will claim his maximum Social Security benefit. They have sufficient assets for lifestyle needs, with substantial assets in both tax-deferred IRA accounts and taxable accounts. They also have small Roth IRA accounts.

Their cash flow for spending is coming from Jennifer’s Social Security benefits and funds from the taxable accounts. They bragged about not paying any income tax the first year after retirement. They did not understand they were wasting the low tax brackets and their tax deductions. By deferring taking taxable income now, they were building a tax-trap for later. Indeed, starting at age 70½, they will be required to take greater minimum distributions (RMDs) from tax-deferred accounts, such as traditional IRAs, and pay higher taxes than they would now. Each year, the amount they must withdraw, and report as taxable income, will be based on the value of their account at the beginning of the calendar year and the distribution period per the IRS Distribution Table.

Working with an advisor, they were able to see the tax advantage of converting $1 million of their IRAs to Roth IRAs over the next five years. This causes $200,000 of taxable income each year, using up the lower tax brackets and enabling them to utilize their deductions. This strategy also has the important benefit of reducing the traditional IRA account value. This provides the important benefit of reducing future RMDs at a time when Steve must begin taking his Social Security benefits. With the graduated tax brackets, less income will be taxed at the higher tax brackets in all future years.

Another benefit is that their money will remain in a tax-advantaged account, but all future growth of the Roth IRA accounts will be tax-free as they plan to leave the Roth conversion accounts untouched for many years. On the other hand, allowing the traditional IRA accounts to continue to grow creates higher taxable income in future years. (Note that because Steve and Jennifer are over age 59½, the five-year rule for penalty-free distributions of converted funds won’t apply. But, the five-year rule for tax-free distribution of earnings should be considered.)

By bringing taxable income into the years of the black-out phase, and using up lower tax brackets, Steve and Jennifer have reduced the total amount of taxes they will pay over their lifetimes. The old adage of never paying taxes now that you can defer until later can lead to paying more in taxes over your lifetime.

Our next example is similar in that it also takes advantage of a Roth conversion. However, it has a few other nuances, including: doing a small Roth conversion to start an important clock ticking; doing an IRA withdrawal at year end for tax withholding purposes; and using some of the withdrawals for spending purposes.

3. Roth Conversions To Fill Up Lower Tax Brackets

Jim and Rhonda retired last year with pension income that provides for approximately half of their spending needs. The majority of their retirement funds are in tax-deferred accounts. They will be in the highest tax bracket once they are taking RMDs after age 70½. They are waiting until age 70 to claim Social Security to obtain the largest benefit. At that time, their taxable income will include their pensions, Social Security, and the RMDs.

By letting their investments continue to grow inside the traditional IRAs, their future RMDs also increase. Projections were done to estimate how much they should withdraw from their IRAs annually until they are 70½ to reduce the tax bracket in future years and the total tax over their lifetime. Since they need cash now to support their lifestyle, part of the IRA withdrawal was kept for spending and part was converted to a Roth IRA.

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