Convincing investors to make financial moves that will increase their tax burden in the short term can be incredibly challenging. However, when a financial adviser and a CPA collaborate, the potential for lifetime tax savings can be substantial, and overall portfolio growth can be significant. Additionally, these strategies can serve as valuable estate planning tools.
One such strategy involves retirees making Roth conversions before they reach the age at which required minimum distributions (RMDs) begin. We often highlight the “sweet spot” between retirement and the start of RMDs when investors typically face their lowest tax rates, a period when many retirees rely on after-tax savings and taxable brokerage accounts to supplement their cash flow.
At age 73 or 75, depending on birth year, investors must begin taking RMDs, which are calculated based on their account balances as of December 31 of the previous year, divided by a life expectancy factor to determine the required withdrawal amount. As investors age, this factor decreases, leading to larger withdrawals and, consequently, higher income taxes. While we haven’t discovered a way to make investors younger, we have found a way to strategically manage their account balances.
One approach is withdrawing funds from tax-deferred IRAs and converting them into Roth IRAs. Once in a Roth IRA, these assets continue to grow tax-free for the remainder of the investor’s life and potentially for up to 10 years after being inherited.
But does it make sense to incur taxes today by making these conversions? As with most financial decisions, the answer depends on the investor’s spending needs. When RMDs begin, some investors may be forced to withdraw more than they need for living expenses. These withdrawals are taxed as ordinary income. If they reinvest the excess funds into a brokerage account, any subsequent interest, dividends, or growth are taxed again—creating multiple layers of tax inefficiency.
A common strategy is to make Roth conversions gradually over several years leading up to RMD age, converting just enough each year to keep the investor within a favorable marginal tax bracket. For example, consider a couple, both 69 years old, with approximately $5.3 million in tax-deferred accounts. If they take no action, we estimated that by age 92, their portfolio could grow to $16.2 million, with a total tax bill of $4.5 million. However, if they systematically convert $1.4 million to a Roth IRA over the next four years—while remaining in the 24% tax bracket—their estimated cumulative taxes paid would drop to $3 million, and their total portfolio could grow to nearly $20 million. Of that, an estimated $8.5 million would be in a Roth IRA, which would pass to their heirs tax-free.
Of course, every investor’s situation is unique, depending on their spending needs, current income, expected retirement income, and anticipated RMDs. Roth conversions are not a one-size-fits-all solution. It’s not always easy to tell investors they should pay taxes now. However, if you believe the stock market is efficient and will go up over time, the most premium conversion to tax-free growth is the present conversion.
If you have questions on whether a Roth conversion is appropriate for your situation, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the February 22, 2025 “Henssler Money Talks” episode.