One of the costliest and least addressed issues in retirement is taxes. Everyone’s focus is on saving enough to retire, but few look at how taxes will affect their income over 20 to 30 years of unemployment.
And it’s a big problem.
Most people have their money in three places:
- After-tax accounts, like savings and money markets
- Taxable investment accounts
- And tax-deferred accounts, like IRAs/401(k)s.
The fourth, and the one that could save you a bundle, is the Roth IRA. It’s funded with after-tax dollars, your money grows tax-deferred and the distributions are tax-free.
Now that’s a deal, if you earn less than $191,000 a year. That’s the cutoff to qualify for one.
But anyone can convert a conventional IRA to a Roth, if you can afford the tax bill that will result. The amount converted is fully taxable at your current tax rate. That can get expensive at any tax bracket above 15%.
But, and here’s where it gets good, if you convert it after you retire, you will most likely be in a much lower tax bracket. So you get a lower conversion tax bill.
And, don’t kid yourself, you will pay the taxes one way or another; either as after-tax money at your current rate going into a Roth or as taxable distributions when it comes out of your IRA.
And, with a Roth, there are no yearly RMDs (required minimum distributions) starting at 70 1/2. And these RMDs are becoming a big problem for the well-funded retirement. You literally lose control over how much you withdraw each year and that can cost a bundle in taxes and bump you into an unplanned higher tax bracket, too.
So, the ideal situation is to convert to the Roth in the first few years of retirement when you are likely to be in a lower tax bracket. Pay a much lower tax bill than you would if you were either contributing after-tax dollars to a Roth or converting at a higher tax bracket, have no RMDs and get tax-free income in retirement.
But here’s where you have to plan around one Roth regulation. You must leave the money in a Roth for five years after a conversion before you can get the tax-free benefit.
This is workable for most people, because most planners will tell you to draw down taxable accounts, savings, CDs and investments outside of IRAs before touching the tax-free or even tax-deferred money.
If you can get five years out that money, this Roth idea can be a good deal.
Talk to your tax advisor about converting your IRAs to a Roth after retirement, ideally in the lowest tax bracket. And stop giving your money to the Washington bureaucrats. They got enough when you were working.