For many retirees there is a “sweet spot” generally between the age when they retire and the age when they must take required minimum distributions. This can be when their income taxes are at their lowest, providing an opportunity to move tax-deferred retirement assets into a tax-free retirement account.
When investors retire, we generally recommend spending after-tax brokerage account savings first, as the tax due on distributions should only be capital gains, which generally have some of the lowest tax rates. Next, we recommend using tax-deferred savings, such as a 401(k) or Traditional IRA, and then finally, any Roth IRA savings. The goal is to let tax-free savings grow for as long as possible.
Investors usually begin Social Security benefits once they retire and no longer have any earned income. Roughly 40% of those receiving Social Security benefits end up owing federal income taxes on their benefits, which most often happens when there is other substantial income such as wages, earnings from self-employment, interest, dividends, and other taxable income that must be reported on a tax return. However, it is adjusted gross income, which includes investment earnings, that determines how much income tax an investor will pay on benefits.
Newly retired investors who supplement their cash flow with their after-tax savings or brokerage accounts are usually in a much lower income tax bracket. Furthermore, if earned income is low enough, their long-term capital gains may be taxed at 0% for individuals earning up to $47,025 or $94,050 for married filing jointly in 2024. While an investor may not owe long-term capital gains tax on their investment earnings, their adjusted gross income could still push them above the threshold, making their Social Security benefits taxable.
However, with taxable income at a low point compared to their earning years, new retirees may want to consider Roth conversions for their Traditional IRA assets. With a Roth IRA, provided the account has been open for at least five years, withdrawals are tax-free. Assets in a Roth IRA also grow tax-free, and Roth IRAs are not subject to RMD requirements. Conversions also lower the balance of an IRA, potentially reducing future required minimum distributions.
With help from a financial adviser or CPA, an investor can convert an amount from their IRA that will max out their current tax bracket. Furthermore, investors can choose to convert specific stocks in their IRA that are at depressed prices, which may allow them to convert more shares into a Roth account. Remember, regular income tax will be due on the assets converted. We highly recommend being able to pay the tax due from another account, like a brokerage or savings account. Paying the tax due from the converted funds could reduce the value of the assets receiving the tax-free growth.
If an investor knows that they may never tap their Roth assets for spending, the Roth account still passes to heirs tax-free. Non-spouse heirs will still need to distribute all retirement accounts within 10 years, but there would be no tax on the distributions from a Roth versus the Traditional IRA, which would be taxed. Most often, heirs are adult children who are in their highest earning years.
Contact our experts if you have questions on whether you could benefit from a Roth conversion during your early retirement years.
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Listen to the December 16, 2023 “Henssler Money Talks” episode.