A financial planner's guide to Roth conversions: a tool for recent retirees

As a financial planner who’s spent almost a decade helping families plan for retirement, I’m familiar with what’s top of mind for many retirees. Whether it’s going on that vacation you’ve been dreaming of, working on your golf game, spending more time with loved ones, or optimizing the tax efficiency of their retirement withdrawal strategy – everyone wants to make the best decisions for their nest egg. While I can’t plan a trip for you, I can help you better understand a tool that many recent retirees overlook: the Roth Conversion.

When used properly, Roth conversions can become a tool that recent retirees can use to optimize their retirement savings, reduce future tax burdens, and create a tax-efficient legacy for their high-earning children. In this piece, we will explore the option of potential benefits of Roth conversions, with a focus on minimizing Required Minimum Distributions (RMDs), constructing a tax-free bucket for future expenses, and establishing an efficient wealth transfer plan. Please know that it is recommended that you consult your CPA or a tax professional to assess the impact and benefits of a Roth IRA as well as your specific situation prior to implementing a conversion strategy.

mITIGATING rmdS: aVOIDING THE "tAX tORPEDO"

Some people spend their whole working lives stashing as much money as they can in their 401ks to build a nest egg that will last their whole retirement. They get a break on the taxes up front and push the tax burden off to another day far in the future. One aspect that many overlook is the Required Minimum Distribution. Uncle Sam doesn’t want you to defer taxes on those accounts forever, so at age 75 you are required to start taking withdrawals which are all taxable. If you were a diligent saver and have a retirement account balance above $1m, your RMDs can be well into the six figures. That’s six figures of taxable income on top of any pensions, Social Security, or other forms of income you might have. This dilemma of being forced to take these costly withdrawals in retirement is often called the “Tax Torpedo”.

So how do we steer this ship to avoid the dreaded Tax Torpedo? Enter the Roth Conversion! The amount that you convert to a Roth is taxable in the year you move it, however, Roth IRAs are not subject to RMDs. By converting small amounts of your 401k to a Roth IRA in the early years of your retirement, you can control the amount you pay in taxes upfront and reduce the amount that will be subject to RMDs later. You can calculate how much you can convert each year to keep you in the lower brackets while you chip away at the (hopefully) growing pile in your Pre-Tax 401k or IRA. This effectively allows you to choose your tax rate on large portions of your 401k and minimize, if not completely avoid the Tax Torpedo.

Building A TAX-FREE bUCKET: eMPOWERING YOUR FINANCIAL FLEXIBILITY

Anyone who’s tried to stick to a budget can tell you that surprise expenses are always around the corner. This fact of life doesn’t go away now that you’re retired. You’ll have home repairs, cars that need replacing, family that needs help, and increasingly expensive medical emergencies. Too often I see people need to take funds from their retirement accounts and the only source of funding they have is their Pretax 401ks or IRAs. So not only do you have a big expense to pay, but you have a tax bill to cover as well.

Another factor to plan for is Long Term Care. The cost of Long Term Care is a major burden for most retirees with in-home care costing as much as $30/hour and skilled nursing costing as much as $9,000/month. The U.S. Census Bureau estimates that the number of Americans aged 65 and older will continue to increase steadily over the next decade and the demand for Long Term Care is expected to grow as a result. These large expenses usually come later in life when RMDs have already started and the withdrawals only add to the tax burden.

ESTABLISHING A TAX-EFFICIENT WEALTH TRANSFER PLAN: A GIFT TO THE NEXT GENERATION

If you’re fortunate enough to have dodged the Tax Torpedo and weathered all of the surprises that retirement has thrown at you with a good-sized nest egg left over, you’re probably thinking about the legacy you’ll leave to the next generation. However, if you have successful, high-earning heirs, they will inherit your retirement accounts and have to pay taxes on top of their already high incomes. Current law dictates that any amount in an inherited IRA has to be distributed over 10 years which can create eye-popping tax bills and erode away the legacy that you worked so hard for. Inherited Roth IRAs still have to be distributed in the same 10-year time frame, but aren’t subject to any income tax when they are distributed.

By strategically implementing Roth Conversions early on in your retirement, you can plant the seeds of a tax-efficient wealth transfer plan. Converting retirement funds to Roth when you’re in lower tax brackets can help leave a tax-efficient legacy for your family to enjoy.

An additional benefit is that if you worked with your financial team and determine early on that you have enough saved to think about leaving a legacy, you can invest these Roth funds more aggressively than you would with funds that you need for your own expenses. Because this bucket is earmarked for the next generation, you can invest it without worrying as much about short-term volatility and focus on growing it for the long term.

cAVEATS AND CONCLUSIONS

Now that you understand some of the benefits of this tool, it’s time to throw on a cold splash of reality. Engineering a tax plan can be dangerous waters and there are a few pitfalls I want to make sure people avoid.

The first is paying the tax bill generated by converting funds to Roth. This strategy works best if you have post-tax funds to draw from to pay the tax bill. Accounts like checking, savings, and taxable brokerage accounts are perfect for these purposes. You can withhold funds from the conversion to pay the taxes, but then less is going into the Roth which makes this a little less efficient.

Another common mistake is converting too much and creating side effects that can increase your Medicare Premiums. Medicare has a threshold for reduced premiums called the Income Related Monthly Adjustment Amount or IRMAA. As of 2023, a single person with income over $97k or a married couple with income over $194k is eligible for this reduced amount. However, going over it can cause a significant increase in your Part B and Part D Premiums. You might determine that the increase in premiums is worth it to help build your tax-free bucket, but it’s something to be aware of.

While Roth conversions require careful planning and consideration of individual circumstances, the potential long-term benefits make them an underused gem in the world of retirement planning. Recent retirees who are willing to explore this strategic approach can find themselves well-prepared to navigate the uncertainties of retirement, enjoy tax-free growth, and pass on a more substantial and efficient legacy to their loved ones.

While understanding and working through these issues can be complex— working with a financial advisor puts you in the driver’s seat, so you can be proactive and make informed decisions. Contact EP Wealth Advisors to get the conversation started today.