Traditional IRAs and 401(k) retirement savings accounts build up over time with tax deferred contributions. That makes them attractive options while your clients are still working, but the tax bill for that income will become due when they start taking distributions. The taxes are inevitable. Roth conversions can be used to change the timing on when they’re paid.
A Roth conversion classifies as a tax-efficient distribution strategy. Income is always taxed, even in retirement. Tax liabilities are based on income brackets. While employed, income brackets are higher. That’s why deferring a portion of that income to be taxed later is appealing. In retirement, income brackets are typically lower, at least in the first few years.
With proper planning, there can be a small window of time between retirement and required minimum distributions (RMDs) from a retirement account. Clients also can delay receiving social security benefits. Tax brackets are lowest between retirement and those additional sources of income. Let’s examine some of the possible scenarios of this.
Delayed Social Security and an Early Roth Conversion
Clients can file for social security benefits as early as age 62. There are instances when that might be financially necessary. Filing at age 67 or a delayed filing at age 70 will produce a higher lifetime social security income. The lower income in early retirement resulting from that opens a window for a Roth conversion with a smaller tax liability.
Another variable to consider is Medicare premiums. They are based on modified adjusted gross income (MAGI) and there’s a two-year look-back period. Roth conversions increase taxable income during the conversion year, so the timing needs to be precise if clients want to keep their Medicare premiums low. Age 63 is an ideal time to do a Roth conversion.
The RMD age for both tax-deferred retirement accounts and Roth IRAs is 72. Combined with delayed social security benefits, that’s the point when retirement income and the tax bracket clients are in will be at their highest. Paying taxes on retirement savings funds early by converting them to a Roth IRA will lower the tax bracket on social security income.
Timing Roth Conversions Based on Market Conditions
The IRS charges penalties and early withdrawal fees if a Roth conversion is done less than five years before clients access the money. That’s a good reason to do it early. An even better time is when markets are down and the values of the equities in the retirement savings portfolio are at their lowest. That reduces the amount clients are paying taxes on.
It’s important to explain to clients that a “conversion” is not a “sale” of their holdings while we’re in a down market. There will still be time for their portfolio to recover. A Roth conversion extends the window for that growth because tax free distributions are the last ones they’ll want to take in their retirement. Taxable income comes out first.
On the advisor side, converting to a Roth IRA could be an opportunity to actively trade clients out of declining positions. It’s a good time to examine the retirement portfolio and make sure that it’s been adjusted to account for changing economic circumstances, new technology, and growth opportunities that may not have been there when the account was set up.
Using RightCapital to Explain this to Your Clients
Explaining the intricacies of financial planning to clients is simpler when you have the right visuals. Roth conversions aren’t a complicated topic for advisors. Clients don’t have the same level of knowledge. It’s best to assume they need a detailed explanation. Visuals like the graphics and charts we’ve shown in this article can help with that.
Roth conversions are only one part of the conversation about retirement income. The issue of reduced social security benefits starting in 2034 should be discussed with clients. There may also be a change in the full retirement age from 67 to 70. Keep checking in to this blog and share it with others to stay informed about these issues as they evolve.