Have you ever thought that saving too much money for retirement could be a problem? In reality, saving too much money is never a problem; however, when you have a lot of money, you often have to pay a lot in taxes—which can be a problem for some investors.
Many investors do an excellent job of saving substantial amounts in pre-tax vehicles like 401(k)s and IRAs. Once they reach retirement and need to start withdrawing the money, these withdrawals are taxable as ordinary income. The investor is taxed on every dollar taken out; therefore, they might need to withdraw $120,000 to $130,000 for every $100,000 they want to spend.
The tax situation worsens once investors reach the age when they’re subject to required minimum distributions (RMDs), which may force them to take out more than they need based on the balance of their tax-deferred accounts. Large withdrawals increase modified adjusted gross income, which can reduce available tax deductions and affect the cost of Medicare in terms of income-related monthly adjustment amounts (IRMAA).
Between retirement ages of 65-67 and RMD ages of 73-75, investors have a window to lower their IRA balances. They can do this through withdrawals to spend down the balance or consider Roth IRA conversions.
Many investors shy away from Roth conversions because the amounts converted are taxable in the year of conversion. While the Roth IRA will grow tax-free for many years, it is unlikely the investor will spend from the Roth. Only their heirs will benefit from a tax-free inheritance. While this is a great estate planning vehicle, it remains one of the last buckets of money investors would pull from, meaning they would pay the taxes on the money without benefiting themselves.
However, if you change your thought process from focusing on the tax-free growth of the Roth IRA to utilizing the Roth to generate income for the investor, you could lower your IRA balance through conversions and, in the future, withdraw less from the IRA for expenses. Dividend-paying stocks, some fixed-income investments, and even alternative investments may yield 4% to 12% in income for spending.
Let’s say the investor has reduced their IRA balance through spending and Roth conversions. Once they reach RMD age, the required distribution is $75,000, but the investor spends $100,000 annually. Instead of withdrawing $25,000 more than the RMD from the IRA, the Roth IRA may be able to generate the income to offset the spending need. The investor no longer needs to withdraw more than necessary, which may result in income tax savings and possibly avoid other tax consequences like IRMAA.
While this income generation could come from taxable accounts, the investor will still end up paying taxes on capital gains, dividends, and interest, which could also affect the cost of Medicare.
This strategy requires considerable planning and cash flow projections to determine how much income the recently retired investor can absorb for the Roth conversion without presently generating severe tax consequences. However, the eventual tax savings may be worth the long-term payoff.
If you have questions on how a Roth IRA conversion can generate income for you, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the May 18, 2024 “Henssler Money Talks” episode.
This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
