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Many Americans contribute to a tax deferred retirement plan like a 401k, SEP IRA or traditional IRA, because it is a tax efficient way to save for retirement. The term tax deferred means that while the contribution you make to these accounts today gives you a current tax deduction (and grows tax free over time), when the money is eventually withdrawn from the retirement account, it will be taxable to you as ordinary income, just like regular wages would be. This is an effective strategy to pay less tax, but only if you anticipate being in a lower tax bracket during your retirement years than you are today. What if you are in a higher tax bracket during retirement? Several factors could impact your future tax bracket, such as, working longer than originally planned, inheriting a taxable retirement account, a change in tax filing status from joint to single, or a decline in tax deductions from paying off your mortgage. One of the biggest increases to your retirement tax rate can come from a place you didn’t expect, your RMD (Required Minimum Distribution).
RMD is the amount the government requires you to withdraw each year from your tax deferred accounts once you reach a certain age, and with the passage of SECURE Act 2.0 in 2022, the RMD age got pushed back for many. Currently, age 59 ½ to the year you turn 73 (or 75 if born after 1959) is a distinct window of time where you are allowed to take penalty-free withdrawals from your tax deferred retirement accounts, but not yet required to take withdrawals. In fact, according to a 2021 study by the Investment Company Institute, 78% of IRA owners delay taking money from their IRAs until age 70. Delaying withdrawals can have an enormous impact on the growth of the account, which is a good thing, but this can also result in larger than expected RMDs when the time comes. This distribution could “creep” you into a much higher tax bracket and leave you with a startling tax bill you didn’t plan for. This is the surprising trend known as “RMD Creep”.
There are a few ways to combat “RMD Creep”, but the most powerful is through a series of deliberate Roth conversions. Simply put, a Roth conversion is the process of taking money from an IRA or other tax deferred account and converting it to an after-tax Roth retirement account. The taxpayer is required to pay tax on the amount converted today, but the beauty of the Roth IRA is that money will continue to grow tax free and will never be taxed again or subject to required minimum distributions. It effectively insulates those funds from any potential tax increases for you and your beneficiaries, reducing your lifelong tax expense and increasing your net worth. It’s particularly effective when done during the retirement phase prior to your RMD age when income is typically lower.
Let’s use an example to illustrate the difference a carefully planned Roth conversion strategy can make.
Nicole is a 66-year-old, retired physician. Her annual income is $170,000 thanks to her pension and social security income and is sufficient to cover her living expenses. She is in the 24% tax bracket. Nicole has been a good retirement saver and has a traditional IRA account worth $1,000,000. She will begin taking RMDs in seven years at age 73. Nicole could do nothing and continue to let her IRA account grow until she is required to take RMDs at age 73. Or she could convert about $40,000 each year from her IRA to a Roth IRA while preserving her 24% tax bracket until she turns 73 and then starts taking required distributions. These incremental conversions would result in her paying $100,000 less in cumulative lifetime income tax and her total portfolio assets would be $500,000 more at age 90. In addition, she will have a sizeable tax-free asset in the form of a Roth IRA to pass onto her heirs.
The idea of emptying the same tax-deferred bucket that you just spent the last 20 to 30 years or more filling up may seem counterintuitive, but the tax laws and RMD rules are unavoidable. While we have no way of knowing for sure if tax rates will go up in our later years, it is reasonable to expect that they will as a way to deal with our country’s ongoing budget deficits and staggering debt. In addition, the Tax Cut and Jobs Act of 2017 is set to expire after 2025. If Congress doesn’t act, tax rates will jump back to their pre-2018 levels. This makes tax planning a crucial part of overall wealth management and is the reason we ask for a copy of our clients’ tax return each year. Knowing which tax bracket a client falls into helps us create a plan to minimize tax liability and maximize net worth.