Retirement is a time to relax and enjoy the fruits of your labor. However, financial issues are one of the primary stressors for many retirees. The fact is we’re living longer, and sometimes our lifespans outlast our savings.
One of your largest retirement expenses is your tax bill. But herein lies an opportunity. And that’s strategic Roth conversions during your retirement gap years. If executed correctly, this strategy can significantly reduce your tax bills over years or even decades. And that means increased odds of preserving your retirement savings for a longer period of time.
Let’s discuss gap year strategic Roth conversions. Because when it comes to making your money run as long as you do, it’s time well worth it.
First, What are the Retirement Gap Years?
Your retirement gap years are the time between the start of your retirement until you begin receiving your Social Security, pension benefits, or Required Minimum Distributions (RMDs).
The main point to understand here is that you’ll likely have a lower tax rate during your retirement gap years as compared to the periods before or after. And a lower tax rate is an opportunity to save money by executing a Roth conversion.
So, What’s a Strategic Roth Conversion?
A strategic Roth conversion is the act of transferring (converting) some of your traditional IRA or 401(k) funds into a Roth IRA during your retirement gap years. The goal is to pay taxes on the converted amount at your current - lower tax rate - rather than at a potentially higher rate in the future.
Here’s how to execute it:
- Calculate Your Expected Taxable Income: To determine how much you can convert without pushing yourself into a higher tax bracket, you’ll first need to estimate your taxable income for the year. Include all sources of income, such as rental properties or part-time work.
- Determine How Much You Can Convert: Once you know your expected taxable income, you can easily calculate the maximum you can convert without going into the next higher bracket.
- Convert the Funds: Initiate the conversion from your traditional IRA or 401(k) to your Roth IRA.
And it’s that simple. Remember, you’ll pay taxes on the converted amount, but it’s likely less than what you would pay after your gap years. And less money paid in taxes means more money to enjoy in retirement.
What are Some Additional Benefits of Strategic Roth Conversions?
Besides the main benefit of saving more money, here are some other key benefits of strategic Roth conversions:
- No Required Minimum Distributions: Unlike traditional IRAs and 401(k)s, Roth IRAs do not require RMDs. This means you can leave the funds in your account to grow tax-free for as long as you like. The IRS can no longer force you to take out large RMDs every year that result in big tax bills.
- Reduced Medicare Expenses: The higher your income, the more you pay in Medicare expenses. Unfortunately, Medicare’s income-related monthly adjustment amount can cause you to pay significantly more for your Medicare benefits. But by reducing your Adjusted Gross Income (AGI), you can reduce or eliminate this Medicare surcharge expense. This can result in thousands of dollars saved annually. That adds up over a thirty year retirement.
- Estate Planning Benefits: When you pass away, your beneficiaries will inherit your Roth IRA - tax-free - as long as the account has been open for at least five years. This means your loved ones can enjoy tax-free distributions over the following ten-year period after your death.
As you can see, correctly executing a strategic Roth conversion can result in substantial additional savings beyond the basic strategy.
What are the Main Considerations for a Strategic Roth Conversion?
While a Roth conversion can be extremely effective, here’s the important considerations to keep top-of-mind:
- Immediate Tax Implications: As stated previously, converting funds to a Roth IRA will require you to pay taxes on the converted amount. So make sure you understand the tax implications before you do it. It is also recommended to pay the taxes from a cash account rather than using your IRA funds to cover the conversion taxes.
- Future Tax Rates: A Roth conversion can save you money, and even more so if tax rates increase in the future. If you believe that tax rates are likely to increase, then executing a Roth conversion now makes even more sense.
- Future RMDs: Unfortunately, the IRS makes many of our clients take out large RMDs every year, which results in large tax bills that must be paid. The Roth conversion can help you reduce the tax bite in retirement.
- Other Sources of Income: If you have other sources of income during your gap years, such as rental properties or part-time work, you may want to consult with a financial advisor to determine the optimal amount to convert.
It’s pretty simple: a strategic Roth conversion during your retirement gap years can save you money. Pay the tax bill when you’re in a lower bracket and enjoy tax free distributions in the future.
But the benefits extend far beyond that. No RMDs give you more financial freedom. And reduced RMDs lower your AGI, which lowers your Medicare premiums. With all this money saved, not only is it more likely that your retirement funds will last as long as you do, but you can also pass your Roth IRA to your loved ones after you’re gone. And they’ll be able to enjoy tax-free distributions as well.
Want more on how to save money on taxes? Every Tuesday at 6:30 p.m. Pacific Time, we host our Saving Money On Taxes Webinar. Click here to register now.
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