Nothing is certain except taxes and more taxes, particularly if clients have large traditional retirement accounts. Many clients do not realize that stashing hard-earned money in traditional retirement accounts creates a ticking tax time bomb upon retirement!
One key way to prevent this is through harnessing the power of distribution planning, including using Roth conversions.
Once investors retire or start heading into lower-income years, there is a great opportunity to do the advanced tax planning that will save money in the future. We call this time the “income valley.”
Read below for the five reasons why we love Roth accounts, some obvious and some not so obvious.
1. Roth accounts decrease a client’s pre-tax balance and decreases future RMD bills
We should all be wary of required minimum distributions, or RMDs.
RMDs grow based on the IRA account size and they also increase as your clients age. So, at age 73 the RMD may be only about 4% of the account value (let’s say $2 million), but that annual distribution grows to 6.25% of the account value at age 85, which could easily be $4 million (assuming net growth of 5.5% per year). On a $4 million account, that RMD has grown from $80,000 to $250,000. But, that’s not all! That RMD now needs to be added to Social Security for two people, and your couple has taxable income of over $300,000 in many instances.
In this case, additional retirement contributions to traditional retirement accounts hurt, not help. Clients essentially compound the tax problem with additional contributions to their traditional retirement accounts. To minimize taxes, it is essential to create a tax minimization plan as part of the client’s accumulation plan.
Pro tip: It is important to note that although we want to build tax-free assets, we do not want to completely deplete tax-deferred and taxable accounts as the diversification of the account types helps to maintain tax efficiency throughout retirement as the portfolio is drawn down.
2. Roth accounts are available through employer retirement plans, increasing the opportunity to invest
This means looking into Roth contributions, backdoor Roth conversions, and Roth conversions alongside a thorough review of after-tax account opportunities available through the employer, especially when tax rates are favorable.
For example, some employers offer after-tax accounts that can be funded up to $69,000, plus catch-up contributions for a total of $76,500 in potential employer retirement plan contributions (for 2024), much of which could be Roth or after-tax accounts.
Roths come with no upfront deduction because you fund these accounts with money you’ve already paid taxes on. But once you turn 59½, provided you’ve held the account for five years or more, clients can withdraw all of their money, including investment gains, tax-free. And you’re allowed to withdraw up to the amount you’ve contributed at any time without penalty.
Pro tip: As a result of SECURE Act 2.0, there are a couple of new provisions that could help you build your Roth accounts further. First, the annual catch-up contribution limit for IRAs (traditional and Roth) will increase to $10,000 starting in 2025 (for those age 60, 61, 62, and 62 in the calendar year). In addition, your employer can now offer Roth matching contributions within your employer-sponsored retirement plan so you could have the option to choose how you want your employer match allocated—pre-tax (traditional) or Roth.
3. Roth accounts increase other AGI-dependent deductions and decrease Medicare IRMAA surcharges
Having a Roth account will help to keep income down, which decreases Medicare Income-Related Monthly Adjustment Amount (IRMAA) surcharges and increases other Adjusted Gross Income (AGI) dependent deductions, among other benefits.
Income in retirement can significantly impact the IRMAA surcharge because it is partially dependent on your Modified Adjusted Gross Income (MAGI) from two years prior. So when you withdraw money from a tax-deferred retirement account (IRA or 401k), the withdrawal counts as taxable income and increases your MAGI. Conversely, withdrawals from a Roth account (Roth IRA or Roth 401k) are tax-free and don’t affect your MAGI. By reducing your MAGI through tax-free Roth withdrawals, you may fall into a lower IRMAA bracket and pay less for your Medicare premiums.
Another major benefit of a Roth account are no RMDs, which means your money can sit in the account and continue to grow tax-free, which makes early Roth conversions a good protection against higher tax rates in retirement.
This also means that lower AGI could help you take larger deductions. For example, you can only deduct medical and dental expenses on your federal tax return if the expenses exceed 7.5% of your AGI. In addition, some states also have a separate medical expense deduction that is dependent on AGI. Therefore, a lower AGI can make it easier to qualify for a medical expense deduction.
Pro tip: Of course, a Roth account is favorable in retirement as all withdrawals will be tax-free. But it is also important to consider the other residual benefits that could come with building tax-free assets such as decreasing Medicare IRMAA surcharges or allowing for greater tax deductions. These benefits may not be obvious but can be impactful.
4. Roth conversions help decrease the impact of the ‘widow’s penalty’
The “widow’s penalty” is becoming more and more costly as women live longer and their wealth grows larger. Since many couples file as “Married Filing Jointly,” an advantaged status for every tax bracket except the highest one.
However, once a spouse dies, then the surviving spouse is filing as “Single,” which uses tax rates at roughly half of the taxable income of the Married Filing Joint tax bracket. Her standard deduction is cut in half, along with the key income thresholds, thereby pushing the surviving partner into a higher tax bracket.
This shift in tax rates can amount to about an extra 10% a year in a tax rate increase for the surviving spouse, plus additional Medicare premiums.
However, the surviving spouse will typically have about 90% of the income, as the IRAs will go to her, and she can step into the higher Social Security benefits, which are often the deceased spouse’s (thus giving up her lower amount which is typically not too significant).
For example, we had a married couple in their early 70s (pre-RMD age) who had a total tax-deferred balance of about $2 million and was in the 10% bracket. We showed them that they were able to do a $115,000 Roth conversion and stay in the 22% bracket, but the point that pushed them to do the Roth conversion was that our projections showed when the first spouse passed, the survivor would likely be in the 32% bracket or higher (and that assumes the current tax rates stay the same).
This is a main reason why most people will pay tax rates that are higher in retirement than immediately before retirement—is there will be a sole survivor and she will be filing Single.
Pro tip: Make sure to consider tax rates if your client’s spouse passes. If the rate in retirement is higher, you want to engage in tax planning now. With this, most husbands do not want their wives to have a significant tax bill when they are gone and are typically inclined to take action now. You always want to compare your client’s current tax rate to three potential future tax rates in retirement: once RMDs start, the filing Single rate, and the tax rate of the heirs if they are inheriting a large IRA.
5. Roth conversions can help drive down taxes during your client’s lifetime and also position assets for the next generation
Roth conversions can help diversify your client’s accounts from a tax perspective which can then help to drive down their lifetime tax bill. In addition, building the Roth assets now can act as an estate planning tool as Roth IRAs that have been passed to an heir have already had the income tax prepaid.
Because an inherited Roth IRA doesn’t trigger RMDs, your heirs can wait the full 10 years, letting the money grow and withdraw a lump sum at the end of the 10the year, tax-free. However, tax-free distribution of earnings are subject to certain Roth limitations, such as a five-year holding period from the time of the original account opening. When comparing today’s rate with the beneficiary’s tax rate, advisors may find that their heirs’ future tax rate is higher. If so, doing a Roth conversion today would essentially pre-fund their inheritance by paying taxes upfront and also driving down the value of the estate.
Pro tip: The goal here is tax diversification to drive down taxes, which can be achieved by having the following three accounts: taxable accounts (that get taxed at a capital gains rate which is generally lower than your ordinary income tax rate), tax-deferred accounts (ex. IRA, 401k, 457(b)) and tax-free accounts (Roth IRA, 529, HSA), with the emphasis on the latter types of tax-free accounts. The tax-free accounts also act as a great estate-planning tool to allow your clients’ heirs to keep more money in their pockets (instead of the government’s pockets).
In conclusion…
Roth conversions can help reduce a client’s overall tax burden, ultimately saving them thousands of dollars (or millions). Focusing on tax-saving strategies such as this will help to minimize lifetime taxes and maximize lifetime wealth for all your clients and their heirs.