Nov 29, 2024
Tax planning is an often overlooked aspect of retirement income planning, but it can help you get the most out of your savings. One tax strategy is to take advantage of the different tax treatments for traditional and Roth individual retirement accounts (IRAs) and, where suitable, do a Roth conversion. But when does this make sense — and what if you’re already close to retirement?
For example, Paul is 60 years old and, after years of diligent saving and successful investing, he’s amassed a large balance in his retirement accounts, including his traditional IRA. He plans to keep working for at least another five years, but at a much-reduced pace (which means a much lower income). Still, he expects to have a sizable income in retirement.
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His traditional IRA allows him to make tax-deductible contributions that grow tax-deferred. Any withdrawals he makes will be taxed at his income tax rate at the time of the withdrawal, and he’ll be forced to make required minimum distributions (RMDs) when he turns 73. His 401(k) is also subject to RMDs and taxes, and although he can also convert this account, he’s considering only a conversion from his IRA.
The benefits of a Roth conversion
Given that Paul will likely be in a high tax bracket in retirement, he’d like to minimize his taxes with some tax-free withdrawals. He’d also like some distributions that aren’t subject to RMDs, since the flexibility to take distributions when he chooses may allow him to keep his annual income lower and reduce his taxes in retirement. For this reason, he’d like to have some of his investment savings in a Roth IRA because, with some conditions, the withdrawals will be tax-free and the account won’t be subject to RMDs.
That means Paul will have to do a Roth conversion to move money into his Roth IRA. This can be done through a direct transfer from his traditional IRA either at the same financial institution, between different financial institutions or by receiving the distribution directly from his IRA and depositing it into his Roth account within 60 days. There’s no limit on the amount he can roll from a traditional IRA to a Roth IRA, but the amount he withdraws from his traditional account will be counted as income toward his income taxes.
Ideally, Paul will do a direct transfer. With a 60-day rollover, 10% of his money would be withheld for taxes, so he’d need to come up with another source of cash to deposit the full amount he was hoping to convert. With all transfers, he’ll need to make sure he has funds available from other sources to pay taxes — an amount which can be considerable (and is a potential downside to a conversion).
In Paul’s case, this conversion could make sense. He didn't retire early, so he isn’t subject to the 10% penalty that he would have faced for withdrawals from the Roth IRA before age 59.5, and he expects his retirement tax bracket to be higher than his tax bracket over the next five years. If he expected a lower tax bracket in retirement, it might make more sense for him to keep his funds in the traditional IRA, receiving the deduction for contributions at the higher rate now and being taxed on the distributions at a lower rate later.
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The importance of timing the conversion
Paul may want to consider initiating the conversion as soon as possible. Since he plans to continue working, he’s unlikely to need the funds (at least not much) in the near future, but he’ll need to wait five tax years after a conversion to access those funds penalty-free. If he was in a situation where he needed the funds sooner — as can be the case for 60-year-olds looking to retire — then he might reconsider doing the conversion.
Also, each year, he may want to roll over only a portion of the total he wants to convert to avoid pushing his annual income into a higher tax bracket. For instance, if his part-time income is $40,000, he may want to convert just enough so he doesn’t hit the next tax bracket, and therefore none of his conversion would be subject to a tax higher rate.
There can be significant tax advantages in retirement from a Roth conversion, but, as with most complex financial decisions, it may be a good idea to consult a financial adviser before determining the timing and amount of any conversion.
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Vawn Himmelsbach is a veteran journalist who has been covering tech, business, finance and travel for the past three decades. Her work has been featured in publications such as The Globe and Mail, Toronto Star, National Post, Metro News, Canadian Geographic, Zoomer, CAA Magazine, Travelweek, Explore Magazine, Flare and Consumer Reports, to name a few.
