Tired of taxes? Can’t blame you. But sometimes it pays to start thinking ahead about successful strategies we can discuss before year-end to save you on your future tax bill, and help you beef up retirement assets you can access totally tax-free for years to come.
What we’re talking about is getting more money into a Roth IRA account for you.
A tax-free nest egg in retirement
Funds in a Roth IRA are (under most circumstances) totally tax-free. You can access the funds without paying tax, and ongoing growth in the account is also tax-free. And guess what? Your heirs gain access to the assets … totally tax-free.
But getting more money into a Roth IRA is a struggle for many people, who make too much money to qualify for annual Roth contributions.
A back-door Roth
So one back-door way to beef up your Roth is to convert taxable retirement assets (like those in your IRA or 401k) to a Roth IRA. We like clients to do small, partial transfers over multiple years, so each year we have the client convert a modest portion of their IRA and pay a correspondingly manageable amount of tax.
Of course, doing a Roth conversion involves paying tax now rather than later. Normally, that’s not a good idea, but we’ve found this can be a smart strategy for certain clients whose tax bill will likely increase in future years due to hefty taxable income from Social Security, pensions and IRA required withdrawals. These are often people blessed with sizable IRA and 401(k) balances, which are unfortunately fully taxable upon withdrawal.
By withdrawing funds now, while they are in a relatively lower tax bracket, clients can often save money. Once they start taking Social Security and required IRA withdrawals at age 70½, their taxable income – and tax bracket – can go sky high. So while it normally is better to defer taxes, this is a case when it makes sense to do the opposite.
Timing is everything
The right timing is everything. These Roth conversions ideally take place when the clients are in their 60’s – no longer earning a salary, but not yet receiving Required Minimum Withdrawals or full Social Security benefits.
We were pleased to see financial planner Jonathan Guyton mention this strategy in a recent Wall Street Journal column on “When the Conventional Wisdom About Taxes in Retirement Is Wrong.”
While any Roth conversion results in immediate taxes, using this strategy for select, early-retiree clients can leverage temporarily lower tax brackets and save on long-term tax bills, especially for clients who anticipate receiving higher taxable income down the road. Not only will that push them into higher tax brackets as they age, but it leaves them vulnerable and exposed if tax brackets should creep up in the future, as they are likely to do as the U.S. struggles with the growing financial burden of entitlement programs and government debt.
The Takeaway: As we did last year, we’ll be talking to clients later in the year to discuss whether a Roth conversion strategy can put them ahead of the game for retirement and cut their future tax bills. If this sounds like something you may be interested in, feel free to give us a call or reach out to us at your convenience.