Taxes in Retirement Part 3: Tax Planning with Roth IRAs

Today it is Part 3 of our series taxes in retirement.  In this episode we look at the planning opportunity our couple, Bill and Janet have to impact both themselves and their daughter.  We dig into the potential impact of Roth IRA conversions.  

Watch Now:  Tax Planning with Roth IRAs?

Taxes in Retirement Series Watch Part 1:  How are my retirement accounts taxed? Watch Part 2: How are retirement accounts taxed when I die?

Please Subscribe to our YouTube Channel

For the Basic Details of Bill and Janet, please click here.

Please note:  This is for illustrative purposes only, Bill, Janet, and Barbie are not real people, this is a hypothetical situation.

The "silent" partner

If you saved for retirement on a pre-tax basis—meaning you and your employer deducted the contributions to their retirement plan—you have a partner.  It is the federal and state governments.  At some point, the balances in those accounts will be taxed and a portion will go to the government.  When you take distributions from these accounts, they are taxed as ordinary income.  When your children inherit them, they will also pay taxes on distributions from those accounts.  And, they are essentially forced to liquidate them over a 10-year period.  

One of the ways we approach this is to try and minimize the share of your retirement accounts the government receives.

Filling up tax brackets...

The concept of "tax brackets" is difficult, and is often misunderstood.  But, this is a key factor in the Roth conversion conversation.  If your income is such that you are in the 22% tax bracket, it doesn't mean all of your income is taxed at that level. 

This is one of the things we, as planners, will evaluate when looking at your situation.  Can you create more income that will be taxed at 12% or 22%?  It is also why we ask questions about your family.  Your children may find themselves in a situation where the distributions they are required to take are taxed at a higher level as they are pushed into the next tax bracket.

Looking at Bill and Janet's Situation...

Why this makes sense...

As we discussed in our previous episode, their daughter Barbie and her husband are a successful couple with high earnings.  When Barbie and Ken inherit the money, the additional income they received from the required distributions would be taxed at 24%.

Illustrating the Impact

As a baseline situation, we assume Bill and Janet do not do the Roth conversion and just leave things as they are.  This is what is possible.

Here is what happens if Bill and Janet fill up the 12/15% tax bracket by converting their IRAs to Roth IRAs each year.

Important Factors to Consider... 

Making the decision to do this is not easy.  There are many other things to consider before you proceed with this strategy.  Here are some of them...

• Who has more income? If your beneficiaries pay taxes at a lower rate than you do, the math changes and should be evaluated more closely. 
• Use the "sweet spot." The best opportunity to do this is between your retirement date and the year you start taking required minimum distributions.  You cannot convert your RMD. 
• Who is your beneficiary?  If a charity is your beneficiary, you may not want to incur the extra tax liability.  The charity won't pay taxes on the inherited funds. 
• Married or Single?  As you can see above, the tax brackets for a single person switch a lot faster than those of a married couple.  Also be aware of filing separate returns, you may run into difficulties with the conversion.

There are other things to consider too, and that is where working with a financial advisor can help.  If you would like to connect with us, please fill out the form below.

In this video