If you’ve become a 401(k) millionaire or amassed large sums in other tax-deferred retirement accounts, you can potentially reduce your lifetime taxes by hundreds of thousands of dollars by converting some of it. ci in a Roth IRA before you start collecting Social Security. But figuring out how much to convert and when is tricky.
In a Roth conversion, you transfer money from a tax-deferred pre-tax account like a traditional IRA to the tax-free after-tax account. Every dollar you convert is taxed as ordinary income on the day it moves. Essentially, you’re choosing to prepay taxes that wouldn’t normally be due for years.
Conversions generally make sense if your current marginal tax rate is lower than the marginal tax rate you expect when you take the money out of the tax-deferred account. People in early retirement who have not yet started collecting Social Security are often in a low tax bracket for a few years and have a window to make conversions. But conversions can also make sense for young workers who are not yet earning big salaries or even high earners who are between jobs and temporarily in a low tax bracket. Conversions are more beneficial if you have enough money outside your tax-deferred account to pay the taxes.
Before recommending a Roth conversion, Mike Piper, a St. Louis CPA, says he compares clients’ current tax rate with their expected marginal tax rate after they turn 72. This is currently the age at which they must begin taking the required minimum distributions. from tax-deferred accounts, and they’ve already started collecting Social Security by then. (Recent pension legislation has proposed raising the age of RMDs to 75 in stages over the next decade.)
“The analysis is what is the tax rate we would pay now, and how does that compare to the tax rate we would pay later,” Piper says. “If it’s lower now, we keep converting until it doesn’t make sense anymore.”
How to estimate your future tax rate
It sounds simple. The catch is that determining your future tax rate is more complicated than you might think. For middle-income retirees in a certain income bracket, every additional dollar you withdraw from your tax-deferred account results in the taxation of an additional 85 cents of Social Security income. This means you can be in the 22% tax bracket and have a marginal tax rate of 40.7% (22% times 1.85).
For higher income retirees, meanwhile, the big RMDs push you into much higher brackets for federal taxes of all kinds and Medicare Part B Premiums, which are actually another tax. If you are single and have an income of $91,000 or less, the current Medicare premium is $170.10 per month. But it goes up quickly after that. A single person with an income above $142,000 is in the third highest bracket and pays $442.30 per month. Higher-income retirees also pay higher premiums for Medicare Part D drug coverage.
The solution to avoiding Social Security taxation and higher Medicare premiums is the same: reduce tax-deferred account balances through Roth conversions before RMDs begin.
How to optimize conversions
Piper and other advisers use expensive software that helps calculate the optimal amount of money to convert. But if you’re patient, Piper says you can get the hang of it with mainstream programs like TurboTax.
To use a program like TurboTax for this fiscal year, run one return with your income at age 72, including RMD, and another return excluding RMD. If your RMD is $50,000 and this causes you to pay $15,000 in additional taxes, your tax rate for the entire RMD is 30%. Since this tax rate may be higher for part of your RMD and lower for another part, Piper suggests slicing your RMD and running multiple returns to get a better idea of the optimal Roth conversion amount. .
“If you’re in that window where you’re retired, and it’s going to be a few years before Social Security and RMDs kick in, you should at least look into that,” Piper says.
The tax savings from Roth conversions can be significant. William Reichenstein, head of research for Social Security Solutions, performed an analysis on a newly retired couple where the husband is 65 and the wife is 62 and found the potential savings of nearly $400,000. They have $1.2 million in tax-deferred accounts and $300,000 in after-tax savings in bank or brokerage accounts.
Reichenstein ran two scenarios: In the first, the couple immediately begins collecting Social Security. In the second, the husband waits to collect Social Security at age 70 and the wife waits until age 69 and one month, and they make a total of $341,500 in Roth conversions in the first four years of retirement; because they largely lived on after-tax money, Roth conversions were made at tax rates of 12% or less.
Less taxes, more savings
The combination of the Social Security deferral and Roth conversions gave them $392,000 in extra after-tax retirement money. And they were able to stay in the 15% or lower bracket for most of their retirement.
Without the Roth conversions and delayed Social Security, they would have faced marginal federal tax rates as high as 46.25%, as their RMDs from tax-deferred accounts forced more of their benefits from social security to be taxed.
“The logic is simple,” says Reichenstein. “Let’s do the Roth conversions at 0%, 10% and 12% tax brackets, and it will allow you to avoid additional withdrawals from the tax-deferred account that would have been taxed at 46.25%.”
Laurence Kotlikoff, a professor at Boston University and author of the recent book “Money Magic: An Economist’s Secrets to More Money, Less Risk, and a Better Life,” did a math for a friend who is retiring at age 62 with 1, $6 million in deferred taxes. accounts and $3 million in after-tax accounts. He advises the friend to make Roth conversions of $120,000 a year for eight years and defer the Social Security levy until age 70.
The friend will save $170,000 by doing so. This includes $102,000 in tax cuts and $68,000 in reduced health insurance premiums.
If the government raises taxes in the future, the savings from Roth conversions would be even greater. If federal and local taxes go up 20% in the future, Kotlikoff calculates his friend will save nearly $250,000 by doing Roth conversions now.
Roth’s conversions don’t make sense to everyone, Kotlikoff notes. If you’re going to be in a high bracket when you retire, you can actually increase your taxes for life by converting, he says. In particular, he noted that Roth conversions may make less sense for people who are already collecting Social Security.
“For some households, wealth conversions can be a huge boon,” he says. “For others, they can actually cost you. It depends a lot on the circumstances. »