While saving for retirement is the number one priority for most Americans, how we all go about it is as individuals is unique. But there is one rule that is true for everyone when it comes to saving and taxes: Uncle Sam always gets paid.
What you get to decide is WHEN the government gets your money – and that’s a big deal. Yes, the government offers many incentivized pre-tax vehicles, but that means we end up paying our taxes on their terms – not our own.
Most people’s investable assets are usually tied up in pre-tax individual retirement accounts (Traditional IRAs, 401k’s, etc.): Every month, you or your employer add untaxed savings into your retirement accounts, which is then invested and grows larger. The problem is, when you finally do retire, the taxes kick in.
But there’s an alternative solution: Roth IRA conversions help ensure that you’re being strategic about paying the government AND may help you spend less on taxes; as a result, you hold onto as many precious dollars as possible. It’s important to remember that without the income from a steady job, our expenses need to be covered by social security and whatever we have stored away, making it even more important to stretch every dollar as far as possible. The issue in retirement comes from the taxes paid on all the distributions we take from our traditional, pre-tax retirement accounts. Even if you don’t need income from your traditional retirement accounts, the government will make you take required minimum distributions (RMD’s) once you reach age 72.
How Roth Conversions Help You Save on Taxes
Most people save for retirement using a traditional 401(k), 403(b), or something similar. The money you invest is treated in a tax-advantaged manner that creates a powerful discount to your bottom line. Money that’s saved in pre-tax retirement accounts bypass any current taxation.
Assuming you’re in the 30% tax bracket, this equates to receiving 100 cents of every dollar vs. receiving 70 cents of every dollar if the government gets their cut. This pool of money is compounded over many years and is not taxed until you pull it out in retirement. But as you celebrate a long career and head off into retirement, the tax bill comes due. The government takes their cut on required distributions (RMDs) which are taxed and treated as ordinary income. Your retirement tax bill becomes higher the more you pull from these buckets just as you’d pay more income tax if you made $100,000 at your job versus someone who made $50,000.
In other words, the more your savings are invested into these sorts of pre-tax retirement vehicles, the more the government will take in taxes upon your retirement. This is where Roth IRA’s and Roth conversions come into play.
The main difference with Roth retirement accounts is that you are investing money that has already been taxed. Using the same example of being in the 30% tax bracket would mean you are only contributing 70 cents of every dollar to these post-tax vehicles. But what if you were only in the 5% tax bracket? You could then be saving 95 cents on every dollar compared to 70 cents.
While most people relate income tax to wealth, they’re very different. If someone had $5M but didn’t work at all that year, their income tax bracket is still 0%. Jeff Bezos, the richest man in the world, only has a salary of $81,000 per year! Because of this, Roth conversions work best for people with pre-tax assets who show little to no income such as:
- Retirees before taking Required Minimum Distributions (RMDs) or social security
- People changing careers
- People going back to school
While this article is mainly directed toward retirees under age 70, the principles apply just as well to those other groups. (Just a reminder: Pre-tax investments are a great idea when you’re younger and in a high tax bracket. It’s not that Roths are good and pre-tax is bad; it’s all about understanding when the right time is to have either or both of these savings vehicles based off of where you are in your lifecycle.)
Using the case study of a married couple retiring at age 55 with large savings, the question becomes how to effectively invest for retirement now while managing tax liabilities in the future. There are many factors that go into analyzing if a Roth conversion is right for you but the question you need to ask is this: How many years can you live off of cash reserves/ taxable investment accounts while you take the tax hit on converting your pre-tax IRA’s?
The longer you can live off of your reserves the higher potential that a Roth conversion might be a good idea. By paying the government in artificially low years of income you’ve saved yourself from recognizing large tax hits later in life when you potentially need the money the most.
Estate Planning Opportunities with Roth Conversions
While the benefit of lower taxes helps stretch your dollar further in the present, Roth conversions are also a great estate planning technique as well. Under the 2020 SECURE Act, beneficiaries must now disburse traditional retirement accounts over a 10-year period. If your children are in their working years, these disbursements will be taxed at high rates and potentially push them into higher income tax brackets.
Roth IRAs do not have this same tax impact on beneficiaries because it’s tax-free money! By converting in your golden years, more of your assets can be used by your beneficiaries rather than by the government. Understanding the tax on income and when to “recognize” taxable events can be incredibly beneficial for your bottom line. Your beneficiaries will thank you when they receive tax-free money rather than assets that will cause large tax bills for them.
When considering your Roth conversion options at Denver Private Wealth Management, we consider tax impacts throughout your lifetime, as well as your heirs. Roth conversions can be a significant tax planning strategy to help grow and protect your wealth.
Denver Private Wealth Management is an independent fee-based financial planning practice with 50+ years of experience in the financial industry. DWPM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at firstname.lastname@example.org.
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