If you were saving for retirement during your career, you may have left investments in different types of accounts.
By the time you retire, you could have a 401 (k) of the job, an IRA for additional retirement savings and a taxable brokerage account.
The smartest investors will take the opportunity in their earliest retirement years to convert as much of their savings as possible to a Roth IRA. Here are three reasons why.
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1. You can take better control of your taxes
While you want your retirement nest egg to grow as large as possible, you want to limit your withdrawals from traditional retirement accounts. Since you pay income tax on any amount you withdraw from the accounts, you will want to make the withdrawals if it has the best benefits for your tax liability.
If you can delay the benefits of social security, the first few years of retirement may be an ideal time to make the withdrawals. Since you are unlikely to have any other income, you can fill in the bottom tax brackets with IRA withdrawals.
But you do not want to lose the opportunity for tax-free growth if you convert traditional IRA funds to a Roth IRA. This allows you to pay your low tax liability now, but you will not be paying tax on the IRA money again, no matter how much your Roth account grows.
If you manage to live long-term capital gains from a taxable account in the first few years of retirement, and convert an amount in your lower IRA to a Roth each year, you will have an extraordinarily low effective tax rate at retirement.
2. There are no required minimum benefits early in retirement
One thing that can confuse your tax planning during retirement is the minimum distributions (RMDs). Once you turn 72, the IRS forces you to withdraw your retirement accounts. If you have a lot of money in these accounts, you may be asked to draw more than you need. In many cases, this is not the most tax-efficient way to finance your retirement annually.
The Roth IRA is exempt from required minimum distributions. Converting as much as possible into a Roth before the age of 72 can save you a lot of effort with tax planning. Not only do you have to worry about the tax liability on Roth withdrawals, but you will also reduce the required minimum distribution. Hopefully you can keep it at a very manageable level.
If you receive an RMD that exceeds your retirement expense requirement, you will not be able to transfer these funds into a Roth IRA.
3. You may like more of your social security benefits later
Perhaps the biggest benefit of retiring primarily from a Roth IRA is that it will not affect how much of your social security benefits are taxed. Social security benefits tax is based on joint income, which is the sum of half of your social security benefits, your adjusted gross income and non-taxable interest.
See the table below for the effect on your joint income on the social security tax.
|
Taxable percentage of social security |
Joint income if you as an individual |
Joint income if submitted jointly |
|---|---|---|
|
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 benefits do not count towards your joint income, but traditional IRA benefits do.
Converting traditional IRA funds to a Roth IRA before you start using Social Security benefits can offer double tax benefits. First, you pay a low tax rate on the conversion, then you pay a low tax rate on your social security benefits.
It’s all about taxes
Ultimately, Roth conversions (and direct contributions, for that matter) are about controlling your tax rate. And the best opportunity to control your tax rate is when you have full control over your income. These are the early years of retirement.
Use the opportunity if you can, but it is not necessarily the best option for everyone. Some people do not have the luxury of delaying social security, and others are not exactly worried about the effect of the required minimum benefits. A Roth IRA is just one tool to control your tax rate during your retirement.