If you want to succeed at chess, you need a plan for evaluating positions and setting short- and long-term goals. This includes being willing to strategically sacrifice pawns, knights, bishops, and even rooks in order to achieve the object of the game, i.e., checkmating your opponent’s king.
Just like chess, when planning for retirement you need to keep the ultimate goal in mind if you want to win — optimizing the longevity of your assets. With retirement, your opponent is the IRS as well as your state tax agency if you’re subject to state income tax. Similar to chess, you need to be willing to sacrifice pieces to achieve success. The pieces in the game of retirement planning come in the form of strategic income tax prepayments.
If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs to which you’re contributing, why wait until 70-1/2 when the value of your plans have potentially doubled and tax rates are potentially higher to pay income tax on your distributions? Wouldn’t you rather use prudent retirement income planning strategies today to pay less tax for the rest of your life and have more funds available when you need them the most – during your retirement years?
One underutilized strategy for accomplishing this is with a staged, or multi-year, Roth IRA conversion plan. The length of the plan needs to be flexible with the number of years dependent upon many variables, a discussion of which is beyond the scope of this post. The following are seven reasons to start this type of plan today.
1. Eliminate taxation on the future growth of converted assets.
Assuming that you will be subject to taxation during your retirement years, eliminating taxation on the future growth of converted assets is the most important reason for implementing a staged Roth IRA conversion plan before you retire. 100% of the value of Roth IRA assets, including appreciation, will be permanently exempt from taxation.
Appreciation is typically responsible for the majority of the value of retirement plan assets over time. Suppose that you did a $60,000 partial Roth IRA conversion using a moderately aggressive equity portfolio in the beginning of March, 2009 when the Dow Jones Industrial Average was 7,000. Let’s further assume that you paid income tax at a rate of 25%, or $15,000, attributable to your conversion. Assuming that you retained your portfolio, it could potentially be worth $240,000 today.
To keep the example simple, let’s further assume no additional growth and a current tax rate of 25%. If you didn’t do the Roth IRA conversion in 2009, you would have net assets of $240,000 less income tax of $60,000, or $180,000. As a result of doing the Roth IRA conversion, you have $225,000 ($240,000 less income tax liability of $15,000 paid in 2009) or an additional $45,000 available for your retirement needs.
2. Take advantage of low federal tax rates scheduled to expire after 2025.
While there have been numerous changes in the federal tax law over the last 35 years making for a difficult comparison, the income tax rates that took effect in 2018 are historically on the low side. This is especially true when you also consider the widening of the various tax brackets. A bonus for business owners was the reduction of the Subchapter “C” corporate tax rate to 21% and addition of a qualified business income (QBI) deduction of up to 20% for other business entities. The latter change reduced the effective tax rate for affected individuals.
With federal tax rates scheduled to expire after 2025 and higher rates likely thereafter, there’s a window of opportunity for Roth IRA conversions. You can potentially benefit from paying taxes on conversions at a low rate for up to seven years if you implement a multi-year staged Roth IRA conversion plan in 2019.
3. Reduce required minimum distributions beginning at age 70-1/2.
Minimum distributions, or RMDs, are required to be taken from non-Roth retirement plans beginning at age 70-1/2 based on the value of your accounts using an IRS table life expectancy factor. The income tax liability attributable to RMDs can be significant, reducing spendable income in retirement.
Why let your opponent, i.e., IRS, control your retirement income plan? A staged Roth IRA conversion plan can go a long way toward minimizing the value of taxable retirement plan accounts subject to RMDs while growing your nontaxable Roth IRA accounts.
4. Potentially reduce Medicare Part B premiums.
Reducing RMDs has a domino effect. One example is Medicare Part B premiums which are determined using modified adjusted gross income (MAGI) from two years prior to the current year. Medicare Part B annual premiums currently range from $1,626 to $5,526 depending upon income. Couples pay double this amount, or $3,252 to $11,052.
To the extent that you successfully execute a staged Roth IRA conversion plan and reduce your taxable retirement plans and RMDs, you can also reduce your MAGI. This can result in significant Medicare Part B premium savings over the course of one’s retirement.
Income tax planning, which is always recommended when considering Roth IRA conversions, is especially important beginning at age 63 since the amount of your conversions in a particular year can potentially increase your Medicare Part B premiums that you would otherwise pay beginning at age 65.
5. Reduce widow or widower’s income tax liability.
A second example of the domino effect of reducing RMDs is the ability to reduce the negative effects of the widow or widower’s income tax penalties. Surviving spouses who don’t remarry are subject to higher income taxes. An example of this was illustrated in Is Your Widow(er) Included in Your Income Tax Plan?.
A staged Roth IRA conversion plan executed while both spouses are alive can reduce the survivor’s ongoing income tax liability. If you’re married, own non-Roth retirement accounts, and you recognize that there’s a realistic possibility that one of you may outlive the other for several years, a staged Roth IRA conversion plan makes sense.
6. Reduce dependency on taxable assets in retirement.
In addition to reducing or potentially eliminating RMDs, a Roth IRA conversion plan reduces your dependency on taxable assets in retirement. The easiest way to illustrate this is with an example.
Let’s suppose that you’re retired and you want to do some major home improvements that you’ve been putting off, the cost is $100,000, you have $600,000 in traditional IRA accounts, and you’re in a combined 35% federal and state income tax bracket. You would need to withdraw $154,000 from your traditional IRA accounts in order to net $100,000 after tax.
If you instead had Roth IRA accounts, you could withdraw $100,000, or $54,000 less, since income tax liability wouldn’t be an issue. To the extent that you can reduce your dependency on taxable assets in retirement, you will optimize the longevity of all of your retirement assets.
7. Stay focused on retirement income planning.
The seventh reason for starting a staged Roth IRA conversion plan today, while not obvious, is very important. Given the multi-year nature of this type of plan, you’re forced to get in the habit of focusing on retirement income tax planning as long as you continue to own non-Roth retirement assets.
Whenever you visit your staged Roth IRA conversion plan, it’s an opportunity to examine and implement other retirement income planning and protection strategies that can also optimize the longevity of your assets. Given the fact that it’s difficult at best to do this yourself and a single mistake can be costly, an investment in a qualified team of income tax, investment, insurance, and legal professionals who specialize in retirement income planning is prudent.
Retirement income planning, much like chess, requires a great deal of patience and focus to be successful. If executed well, you can optimize the longevity of your assets while accomplishing another goal — stalemate IRS!
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.