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Tax Planning During the ‘Gap Years’ in Retirement
An IRS incentive for workers to contribute to their employers’ plans and for that money to grow tax-deferred has been so great that people have socked money away in these retirement plans like wildfire.
As of the second quarter of this year, the total balance of defined contribution plans and individual retirement accounts in the U.S. reached an estimated $20 trillion. To put this in perspective, the entire U.S. economic gross domestic product as of the end of 2019 was nearly $21.5 trillion.
The problem for retirees is that the U.S. government is deeply indebted, and that debt burden will continue to grow because of the fiscal stimulus measures enacted to combat the health crisis. The bottom line is that taxes for some retirees could very well go up in retirement as the government looks to the $20 trillion in retirement accounts that have yet to be taxed.
For those retirees who have not yet reached the required beginning age of 72, where they have to take minimum distributions from their retirement accounts and pay taxes on those distributions, planning could be of the utmost importance to minimize the inevitable tax burden. The “gap years” are defined as the years after a person retires but before they start claiming Social Security and before required minimum distributions kick in at age 72.
Enter Roth Conversions
While there are many strategies available, Roth conversions are an indispensable tool available to any retiree that has a 401(k), IRA, or 403(b). A Roth IRA conversion occurs when you transfer money from an IRA to a Roth IRA and pay income taxes on the amount converted. In other words, you are paying tax voluntarily before you are required to in exchange for that money growing tax-free indefinitely.
Taxable incomes for many retirees are exceptionally low because they are not yet receiving Social Security and do not have to tap money from their retirement accounts. As a result of this low-taxable income during these gap years, retirees can convert money from an IRA to a Roth IRA and potentially pay zero in federal income taxes.
An example of how this works: A married couple jointly filing their taxes will not pay taxes at the 22% rate until their taxable income exceeds $80,250. Assuming a couple takes the standard deduction of $24,800 in 2020, their adjusted gross income could be $105,050, and they would still be in the 12% marginal federal rate.
In determining whether a Roth conversion makes sense, it is critical to project your estimated income once Social Security and required minimum distributions begin. For some, once those income sources kick in, their taxable income will rise, sometimes significantly, pushing them into higher tax brackets like 22%, or even higher.
With the 2020 election on the horizon and debt piling up, tax rates might also increase.
To complicate matters, retirees’ Medicare Part B and Part D premium (Income Related Monthly Adjusted Amount or IRMAA for short) is determined based on your income level. The higher the income level, the higher the premium will be. The premium difference can be thousands of dollars per year for a married couple.
Have a Retirement Plan
Putting a plan together could help manage the tax bill and leave more money to one’s family and less to the IRS. Keep in mind, if a retiree has six years before they plan to take Social Security and eight years before their required minimum distributions (RMD) begin, they can convert money from an IRA to a Roth IRA each year and convert a different amount each year if desired. There is no set amount required.
Let us take a couple who are both age 65, with $1 million in their IRA accounts. They plan to take Social Security at age 70 and are targeting five years of Roth IRA conversion before Social Security begins. Let us also assume that this couple has enough money in savings accounts and taxable brokerage accounts to live on during this time. Given a low taxable income, this couple might very well be able to convert $80,000 per year from their IRA to a Roth IRA and pay a marginal rate of 12%.
After five years, they would have $400,000 in a Roth IRA, assuming no growth and $600,000 in their IRAs (assuming no growth). Any growth in the Roth IRA monies will not be taxed when it is withdrawn, and there are no required minimum distributions from Roth IRAs.
Takeaway
The RMDs that will come out of the IRA are based on the IRA balance, which could be substantially lower than if no conversion took place.
Big picture: If no conversions took place, a $1 million IRA, assuming a tax rate of 24%, would equal an after-tax amount of $760,000.
With the conversions, the taxpayer realizes $48,000 in tax savings (because of paying taxes at the 12% rate versus 24% rate) from doing some intelligent planning.
Furthermore, the compound interest earned in the Roth IRA would continue to grow tax-free relative to money in the IRA where compound growth would be taxed. If tax rates are higher in the future (higher than the 24% estimated here), the tax savings is that much greater.
When it comes to taxes in retirement, understanding the rules around IRAs/Roth IRAs and planning can make a big difference in your bottom line.
