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When should you use a Roth IRA to manage your taxes?
As you hit your 60s, it’s common to shift retirement planning from general wealth accumulation to practical details like taxes and required minimum distributions (RMDs). Getting this right matters, because how you manage these tax requirements will help determine how much spending power you have in your retirement.
The challenge for many households is that, by the time you’re in your 60s, the cake is very often baked. While you can certainly change your tax and RMD situation, it’s often hard to do so in a cost-effective manner. In most cases, with most options, you’ll spend more in taxes than you stand to save.
For example, say that you’re 61 years old with $890,000 in a traditional IRA. Should you convert this, 10% at a time, in order to avoid taxes and RMDs in retirement? The answer is, maybe. Depending on how you structure it, this approach might save you some money on taxes, but the benefits will depend a lot on your approach and overall income.
If you need help determining which option is best for you and your financial situation, consider working with a financial advisor.
Should You Convert This Money?
Some major tradeoff elements to consider when planning a Roth IRA conversion are your current year’s tax liability and your tax liability in retirement. Ultimately, the value of each will depend on your income and assets, and the type of accounts your retirement savings are in. Qualifying Roth IRA withdrawals in retirement are not taxable, while those from a traditional IRA are. And Roth IRAs are not subject to required minimum distributions (RMDs). But any money converted from a traditional IRA to a Roth IRA is taxed in the year it is converted, potentially creating a large tax bill.
For the purposes of this example, we have an $890,000 IRA at 61 years old. Let’s assume that you earn $100,000 per year and intend to retire at age 67. Say, also, that you make 10% retirement account contributions and your portfolio grows at the mixed-asset average of 8%. Under these assumptions, by the time you turn 67, your portfolio might be worth around $1.48 million.
Now, say that you leave this money alone to continue growing until age 73. You are retired, so you no longer make contributions, but it keeps growing at an 8% average return. By the time RMDs begin, you might have around $2.35 million in this account.
Your RMD on this portfolio at age 73 would be $88,965, which would trigger an estimated $11,413 in federal income taxes. While your RMD would change modestly each year, as your portfolio value and age change, say that you continued that $88,965 withdrawal for 20 years from age 73 to age 93. You would pay $228,260 in income taxes on those withdrawals.
On the other hand, say that you convert your portfolio to a Roth IRA. There are two ways to approach this. One option is to convert your portfolio entirely. To do this, you would need to move both your base 10% each year ($89,000) plus that year’s portfolio growth. At an 8% rate of return, you should expect to pay more than $250,000 in cumulative taxes on this transfer over time. This is more than you would pay in long-term income taxes due to RMDs.
You could also decide to convert just a portion of your portfolio to a Roth IRA. Under this strategy, you move 10% of the existing portfolio ($89,000) each year while leaving the IRA’s returns in place. This approach is more complicated, but could potentially save you some money. An $89,000 transfer would, on its own, generate a minimum $11,421 in transfer taxes. So over 10 years, you would pay about $110,421 in taxes on this conversion, and you would convert about $77,579 per year after taxes.
Setting aside additional contributions for ease of example, but assuming an 8% rate of returns, this could leave you with about $1.12 million in your Roth IRA at the end of 10 years. You would also have $721,139 still in your traditional IRA, due to the portfolio’s assumed growth over those 10 years. Given two more years’ growth, when you’re 73, the Roth IRA might hold about $1.3 million and the traditional IRA might hold about $841,137. But remember, you should always account for market volatility in your plan.
The traditional IRA would be subject to taxes and RMD rules. At 73, you would need to take about $31,741 from this portfolio in required minimum withdrawals, which would on its own generate about $1,825 in federal income taxes.
If we estimate steady withdrawals over 20 years, that might come to about $36,500 in total taxes. This, combined with your conversion taxes, would come to about $146,921 in total taxes on your IRA, a meaningful savings over the RMD-related taxes if you had left this money in place.
So, the answer to the question is, per this example, maybe yes. In this case, converting a portion of your IRA to a Roth IRA might save you some real money on your taxes. The big question will be your specific income and tax situation. Our numbers have been generated in a vacuum. Your specific income each year will impact the tax brackets for both income and conversion taxes, which in turn could increase these taxes. It may be worth considering consulting with a financial advisor and see what they think.
Bottom Line
As you prepare for retirement, it’s common to consider whether a Roth conversion could save you money on your income taxes and RMD requirements. As you do so, make sure to consider a partial Roth conversion. Moving only some of your money over can help lower the applicable taxes on all of your funds, saving you in the long run.
Tips on Retirement Roth Conversions
- There are a lot of reasons to consider a Roth conversion near or even in retirement, including both tax and estate planning. So here’s how you might want to think about moving your money around, even long after you don’t have any earned income.
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.