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So you have a substantial IRA (or several IRAs), and you’ve retired. For the first time since you started your career, you’re in a low tax bracket. You’re not age 72 just yet, so you don’t need to concern yourself with Required Minimum Distributions (RMDs).
But then again, maybe you should concern yourself with those Required Minimum distributions…?
Think about it – you’re in a good place, tax-wise, and your IRA money is bound to continue to grow over time. You are getting along just fine with your pension, Social Security, and other investment income. This is the perfect time to strategically reduce your future tax bite.
Staging the Roth IRA Conversion
Let’s say for example that your taxable income puts you in one of the lowest tax brackets… say 22% or less. You have some “headroom” left in the bracket to spare, meaning that you could realize some additional income without bumping up to the next bracket. The amount you’re converting in any given year doesn’t seem like a lot, but since you’ve got a few years before you reach age 72, little by little you could be reducing (or eliminating) the amount of RMDs that you’ll be forced to take later on.
Each year you can convert an amount from your IRA to a Roth IRA that will bring you just up to the top of your tax bracket (but not over). By doing this, you’re controlling the flow of the money at a point when you can afford to, rather than having income forced on you when you don’t want it.
Then, when you reach age 72, you have either reduced your IRA down to an easily-manageable amount for RMDs, or completely eliminated the IRA altogether, and the RMDs with it! If that’s the case you don’t have to worry about taking RMDs from the funds that you’ve transferred (converted) to the Roth IRA – and if you want to take money out of the Roth IRA, you can do so tax free!
The funds in the Roth IRA can continue growing over time, and you don’t have to worry about paying tax on the growth at all. You paid tax at today’s (assumedly lower) rates and today’s value of the old IRA account before all of that future growth occurred.
If you don’t have a need for the funds in the Roth IRA, you will never be required to take the money out – and your heirs can stretch out the tax-deferral over many years. This can amount to some very substantial tax savings!
The Downsides
There are a few downsides to such a strategy, as you might have guessed. As you convert funds from your IRA to your Roth IRA, the increase in your taxable income in any given year has some additional impacts that you need to keep in mind. Increasing taxable income can increase the amount of your Social Security benefit that is taxed, for one thing.
Another is that, as your income increases, so does your Adjusted Gross Income (AGI), which controls a lot of your deductions, such as medical expenses. Your medical expense deduction is limited to the amount greater than 7.5% of your AGI. If you increase your AGI by converting IRA funds to a Roth IRA, you’ll effectively reduce the amount of your medical deduction by 7.5% of the amount you convert.
In addition, you need to come up with a source of money to pay the tax – either from your IRA (thus reducing the potential Roth IRA and its potential for growth), or from other investment accounts, which will reduce the available funds from there.
Medicare premiums could be impacted by a Roth conversion as well, but if you’re in the 22% tax bracket and you stay below that threshold, you shouldn’t have any issue with IRMAA increases to Medicare premiums.