Avert a Tax Surprise in Retirement: Get Ready With a Roth

If you’re like a lot of people I’ve met with over the years, your focus is probably on saving enough so you can feel confident and free to do the things you want to do.

What folks tend not to think much about is what their tax bills might look like in the future and how that could affect their plans. I’m usually the bad guy who has to explain that, despite what they may have heard, their taxes won’t necessarily be lower in retirement.

I understand how they may have gotten that idea — especially if they’ve paid off the mortgage, the kids are out of the house, and they’ll no longer have work-related expenses (commuting, wardrobe, etc.). Because they expect to have fewer necessary costs in retirement, they don’t think they’ll need as much income.

But most of the people I talk to really don’t want to cut back in retirement — they want to maintain or even improve their lifestyle, which means their income requirements may not be much lower than when they were working. Meanwhile, they may have lost some important tax breaks — if they no longer have dependents to claim, for example, or a mortgage interest deduction.

And if they’ve been diligently socking away money for years in a 401(k) or similar tax-deferred plan, they’ll also have to deal with a looming tax bill when they withdraw those funds in retirement.

Add to that the real concern that tax rates could be much higher in the future (they’re at an all-time low right now), and you can understand why building tax efficiency into a retirement plan can be so important.

Should you consider a Roth conversion?

There are several strategies that can help you protect your nest egg from taxes, and I encourage you to discuss them all with a trusted financial professional. But you may want to start by taking a serious look at what moving (or “converting”) all or some of your tax-deferred savings to a Roth account could do for you, including:

• Reducing or eliminating required minimum distributions (RMDs) at age 73. Unlike a tax-deferred retirement plan, a Roth is RMD-free. Original account holders can keep all their money in their Roth IRA for as long as they like, and their investments can keep growing tax-free.
• Reducing or eliminating taxes on your Social Security benefits. Many people are unaware that they could end up paying taxes on up to 85% of their Social Security benefits. (That’s another surprise I frequently get to share.) But Roth IRA distributions aren’t considered taxable income, which can help retirees stay under the IRS income threshold and avoid triggering this tax. A Roth also can help you avoid paying the income-related adjustment amount (IRMAA) surcharge on top of your Medicare premiums.
• Reducing your capital gains tax rate. Long-term capital gains tax rates are also based on income level. With tax-free income coming from a Roth, you may be able to receive a more favorable rate when selling an asset in retirement.
• Keeping taxes lower for your heirs. Contributions from an inherited Roth IRA can be withdrawn tax-free at any time. And as long as the account has been open for at least five years when the account holder dies, earnings from the inherited Roth can be tax-free.
• Avoiding the “widow tax.” If you become widowed or divorced in retirement and move into the single-filer tax status, you could find yourself paying more in income taxes. Withdrawing funds from a Roth can help keep your taxable income lower and reduce what you might otherwise owe. (To read more about this, see the article Don’t Let the ‘Widow’s Penalty’ Blindside You: How to Prepare.)

How does a Roth conversion work?

When you do a Roth conversion, you’re moving money from a traditional pre-tax retirement account into a Roth account. To do this, you can:

• Transfer money from a traditional IRA to a Roth IRA
• Roll over a 401(k), or similar plan, to a Roth IRA
• Move money from a traditional 401(k) account to a Roth 401(k) account (if your workplace plan offers this option)
• Use a strategy called a backdoor Roth IRA

Your financial adviser can help you understand which method is right for you, but it should be made clear: When you do a Roth conversion, you’re making a decision to pay taxes now rather than later. If the contributions you made to your retirement account were taken out of your paycheck pre-tax, or deducted when you filed your taxes, you’ll owe income tax on every dollar you convert to a Roth. And you’ll have to pay those taxes in the year that you withdraw the funds. So you’ll want to be cautious about how much money you move and what it might do to your tax bracket.

I like to compare preparing for the taxes from a Roth conversion to planning for an impending snowstorm.

Anyone who’s ever had to shovel several feet of snow at one time knows how difficult it can be. But if you go out and shovel a couple of inches at a time, it can make the task more bearable. It’s the same idea with a Roth conversion. You don’t have to move your money all at once; instead, you can do it over a period of years. You could convert just enough each year, for example, to keep your income within a manageable tax bracket.

Using an online Roth conversion calculator can help you determine how much to move, and when to move it, to minimize the tax impact. Some things to keep in mind as you do the math might include:

• If you’re no longer working but don’t plan to file for your Social Security benefits right away, you may want to take advantage of this income “valley” to complete your conversion at a lower tax rate. Then, when you turn on your benefits, you won’t have to worry about triggering extra taxes.
• If you’re 65 or over and on Medicare, you also might choose to manage your conversion amount each year to avoid the IRMAA surcharge.
• You’ll also want to take the “five-year rule” and the early-withdrawal penalty into consideration as you plan the timing of your conversion. Once Roth IRA funds have been held for five years and the Roth owner is 59½ years old, all distributions, including earnings, can be received tax- and penalty-free forever.

Don’t let taxes blur your retirement vision

If you’ve overlooked or underestimated the impact taxes could have in retirement, it’s not too late to make some changes. By converting to a Roth account, you might even be able to eliminate income taxes altogether in retirement.

But minimizing your tax bill while you complete your Roth conversion can take time and proactive planning. And the lower tax rates we’re currently enjoying won’t last forever. Delaying could mean a bigger bill.

A financial adviser can help you decide whether a Roth conversion is the best move for you and can provide advice on how to make the move in the most tax-efficient manner.

Kim Franke-Folstad contributed to this article.

The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

Kurt Supe, John Culpepper and Brian Quick offer securities through cfd Investments, Inc., Registered Broker/Dealer, Member FINRA & SIPC, 2704 South Goyer Road, Kokomo, IN 46902, 765-453-9600. Kurt Supe, Andrew Drufke and Brian Quick offer advisory services through Creative Financial Designs, Inc., Registered Investment Adviser. Creative Financial Group is a separate and unaffiliated company. The CFD Companies do not provide legal or tax advice.