You can reduce the impact that taxes have in retirement by converting pre-tax savings into Roth assets. Doing so not only unlocks future tax-free growth, but also helps you minimize or avoid required minimum distributions (RMDs).
However, converting a large IRA balance like $650,000 all at once would trigger a significant tax bill in the year of the conversion. Instead, you may be able to reduce the overall tax burden by gradually converting your IRA over several years. This won’t eliminate taxes, but it can give you some control over the timing and amount of taxes you pay. It can also be useful for estate planning, since your potential heirs would inherit tax-free assets. Consult a financial advisor to determine whether a Roth conversion strategy makes sense for you.
Anyone who saves for retirement using a traditional IRA, 401(k) or similar pre-tax account must begin withdrawing their money after they turn age 73 (75 for people who turn 74 after Dec. 31, 2032). While RMDs are mandatory for pre-tax accounts, some retirees would rather not take them if they don’t need the income. That’s because when the income from mandatory withdrawals is added to their other income, it can push them into a higher income tax bracket and increase their overall tax bill.
For example, say that you have $650,000 in a traditional IRA at age 64. If your account grew at an average rate of 7% per year, it would be worth approximately $1.37 million by the time you hit age 75. As a result, your first annual RMD would be around $95,000.
But if you have $75,000 in taxable income from other sources and your tax filing status is single, your $95,000 RMD could push you in from the 22% tax bracket to the 24% tax bracket and increase your income tax liability.
A financial advisor can help you plan for RMDs and explore other tax planning strategies for retirement.
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Since Roth accounts are not subject to RMD rules, converting a traditional IRA into a Roth account is one way of avoiding RMDs and the potentially burdensome taxes on unwanted income in retirement.
But a Roth conversion can also be expensive because the money you convert is treated as taxable IRA withdrawals in the year that the conversion is completed. For example, converting a $650,000 IRA to a Roth all at once would automatically increase a single filer’s tax rate to 37% – the highest marginal tax rate. Converting $650,000 alone would trigger an income tax bill of approximately $193,000, not including any other income tax you may pay.