Do you pay too much in taxes? Are you concerned about required minimum distributions pushing you into a high tax bracket in retirement? If so, you might consider a Roth IRA conversion.
What is a Roth Conversion?
A Roth conversion is when an IRA, SEP IRA, SIMPLE or 401k owner converts pre-tax money to a post tax Roth IRA. They pay taxes on the conversion so that they can withdraw income from the Roth tax free after 5 years. Why would someone want to pay more in taxes now? Simply put, they may not need the money. And when they reach a certain age, they are required to take minimum distributions (RMDs) on the account. Think of this as the government’s way of saying, we’ve let you grow your retirement savings tax free over the years, now we want some tax money.
You might be wondering why someone would pay taxes now instead of waiting until you HAVE to take RMDs? Simply put, you’re in a lower tax bracket.
An example
Let’s say you have a $2 million dollar nest egg. $1 million is in a joint account or trust account. Joint accounts are taxed as capital gain income. The rest is in IRAs. IRAs are taxed as ordinary income. You live off $80,000 annually and retire at age 60. You need 10 years of income at $80,000 to get you to age 70, when you’ll both collect social security worth approximately $45,000 each or $90,000 total.
If you take out $80,000 out of your IRA, you have to pay taxes. So you don’t actually get $80,000, you get closer to $75,000 after taxes. You would have to take out around $87,000 to get $80,000 in income. Your tax is $6,585. So you can withdraw $870,000 out of your IRA over the next 10 years and pay $65,850 in taxes or $870,000 from your joint account and pay zero in taxes depending on your gains. Note that capital gains are taxed at zero percent if your taxable income is less than $83,350 in 2023.
So you withdraw your income form your joint account at the suggestion of your financial advisor and pay zero in tax. Your $1 million IRA grows to $3 million by the time you have to take required minimum distributions at age 75. At 75, your $3 million IRA RMD would be approximately $122,448. Couple that with your social security payments, which are probably closer to $50,000 each, and your adjusted gross income is $222,448. Your taxable income is $178,748 and you’re in the 24% tax bracket.
What could you have done to lower your future taxes?
Annual Short Term Planning
The answer is annual short term Roth conversions planning. If you convert some of your $1 million IRAs each year over the course of 15 years, when you reach age 75, your RMDs will be significantly less. The key is to convert up to the 12% or 22% bracket, depending on our IRA size, so that when you have RMDs at 75, you are not forced into a higher bracket.
Lifetime Projections
Here is an example of a client that is pushed into the 24% bracket if they don’t do any tax planning. As you can see, in 2030 they are pushed into the 24% tax bracket. This is whey they’ll collect the light blue social security AND have the green RMDs kick in. They end up paying an estimated $1,144,259 in taxes over the course of their lifetime.
Let’s take a look at what their scenario looks like if they convert from now until 2030 up to the 12% bracket. As you can see from the circled area, the client converts up to the 12% bracket and saves an estimated lifetime amount of $150,000 in taxes. 
For this client, the savings is even greater if they convert up to the 22% bracket because they have $4.5 million.
Takeaway
Roth conversions just might be the best tax planning tool we have at our disposal to lower your taxes. Ironically, you do it by paying more in taxes now, so that you can pay less in taxes in the future. The key is to do a tax projection each year to determine how much space you have to convert before hitting the 12% or 22% bracket. In the original scenario, the $80,000 income client taking income from their trust could convert $89,000 before they hit the next bracket. Over the course of 10 years, they could convert $89,000 of their IRA to Roth and have next to no RMDs at age 75. But this requires meticulous annual and lifetime tax planning.
