Roth IRAs and Living Chapter 2

In the Grab a Cool $100K with a Roth IRA, I looked into the benefits of using a Blended Approach for saving money in Traditional and Roth retirement accounts over time. The discussion mostly pertained to maximizing your outcome while you are Living Chapter 1, i.e. while you are still working. Now I go into strategies to maximize your outcome when you are retired, or as we say, LivingChapter2.

Disclaimer

I am not a tax professional. Please consult one before taking any action on the ideas presented below.

What is a Roth Conversion?

Simply put, a Roth conversion is when you move funds from a Traditional IRA to a Roth IRA. You are moving funds from a tax-deferred account (the Traditional IRA) to a tax-free account (the Roth).

The great news with a Roth IRA is that you can withdraw the funds and any investment gain tax-free in the future. Hooray! This can provide a lot of money going forward. Later in this article, I discuss how Roth IRA money can also provide a lot of flexibility and how to best access that money.

Unfortunately, for a Traditional IRA Uncle Sam Requires you to take a Minimum Distribution (a.k.a. RMD) yearly starting at age 72. Any distribution from your Traditional IRA is counted as taxable income the year you make the transaction. The RMD amount starts at about 4% of your account value and the percentage grows a little every year thereafter. Depending on how much you choose to withdraw and what other income you have, those taxes can really add up.

Why is there an RMD, you ask? The taxman wants his slice of your pie. The government doesn’t want you to put off paying taxes forever. They use the RMD to force you to pay the tax on your retirement savings over your expected lifetime.

Why You Would Do a Roth Conversion

Since you don’t have to start taking RMDs until you are 72, you could let the money just keep growing in your tax-deferred Traditional IRA. But, if you have been a diligent saver (like me), those RMDs in later years can get so big that you are forced into a high tax bracket. You may not pay much tax now, but you may pay a lot more later.

Another key point: Remember that you and your spouse take RMDs independently, according to your individual ages. When you consider both of your RMD counts for your taxable income, the money you have to pay tax on can really add up.

Doing a Roth Conversion sooner than later may allow you to manage your tax bracket exposure. In years when you don’t have much other income, like from Social Security, or in early retirement you can convert some funds while staying in a low tax bracket so you won’t be required to remove as much money later when you are in a high bracket.

Here is a chart showing your taxes paid over the years if you have a $2M Traditional IRA, with 8% growth and you only take out your RMD starting at age 72:

On the other hand, if you withdrew enough to stay barely within the 24% bracket (i.e. pay a little more tax now) instead of just your RMD in the early years, you would save about $60K in taxes over 20 years.

Better yet, if you do a Roth conversion on the extra money you took out, your Roth IRA could really shine at the same 8% growth:

Why Do a Roth Conversion for Your Heirs

When you opened your IRA (either kind), you were asked who would inherit it when you pass. Under current law, if it goes to your spouse, he/she can treat it the same as their own IRA in terms of RMDs, i.e. over their remaining life.

However, because of recent changes in the tax law, if the IRA goes to someone other than your spouse, they must remove all of the funds within 10 years. Thinking back to the issue with normal RMDs, your heirs may be forced to recognize big income and pay taxes at a high rate at a time when they already have income from their jobs.

If you convert some funds to a Roth IRA while you are alive, there will be less money in your traditional IRA when you pass and less money than your heirs are forced to withdraw and pay tax on. The funds and the gain in your Roth IRA are tax-free for them, too. So, they can use the money when convenient without any worry about how it will impact their taxes. What a great legacy to leave them!

Minimize State Taxes by Moving

Another aspect of Living Chapter 2 (certainly for us) is that we moved out of a state with a high-income tax rate, i.e. California. If you think about your own chapter 2, will you be moving someplace with higher or lower taxes?

If you live in a state with a lower tax rate now, it may be better to convert funds now, even if it pushes you into a higher tax bracket today. Otherwise, you may be forced to remove funds later when you are subject to a lower federal tax rate but a higher state tax rate, making things worse overall.

For example, for 2020, the 22% bracket goes to $171,050 of taxable income and the next bracket is 24%. If you plan to move somewhere where your state tax increases by more than 2%, it may make sense to convert some funds now while you enjoy a lower state income tax rate and enjoy the gains later.

A Couple of “Gotchas” to Conversion

You can run afoul of the tax rules if you have your Traditional IRA service provider simply send you the money for conversion. Your provider should be able to help you understand the best ways to accomplish the transfer without risking a big tax booboo. This is similar to when you move money from a 401(k) to a Rollover IRA. It is important that you do not touch the funds.

Also, once you have done the conversion, it cannot be undone. So be sure it is the right time to do it.

When do you think Roth Conversion will make sense for you?