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Taxes in Retirement Part 3:  Tax Planning with Roth IRAs Thumbnail

Taxes in Retirement Part 3: Tax Planning with Roth IRAs

Estate Planning Tax Planning Retirement Planning Financial Planning

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?

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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. 

For a couple filing a joint return the first $22,000 of their taxable income is taxed at 10%.  The amount between $22,001 and $89,450 is taxed at 12%.  This progresses until you reach the maximum level.  While getting to your taxable income is far more complicated, you can get a rough estimate by subtracting the standard deduction from your gross income.  

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...

Bill and Janet before Roth Conversions

Any additional income Bill and Janet receive will be taxed until the reach the orange line.  They can receive approximately $44,000 of additional income and still stay in the 12% tax bracket.

Visualizing Roth Conversions

If they were to convert roughly $44,000 per year over the next 7 years, they would only pay taxes at 12-15% (there is a potential change coming in 2025) on the amounts they convert.

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.

Bill and Janet's Lifetime Tax Bill

Our software projects a lifetime tax bill for Bill and Janet of $77,884.  The amount they pass on to their daughter is just under $600,000.  But in the chart to the right, you can see what Barbie and her husband will pay in taxes over the next 10 years.

Barbie's Inheritance

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

The Tax Bill for Roth Conversions

The cost to Bill and Janet to convert the IRA's to Roth IRA's is $52,720.  That might be a tough pill to swallow until you look at the net impact to their daughter.  Barbie and Ken pay NOTHING in taxes compared to $170,000, and the after-tax value of their Roth IRA is nearly $30,000 more!

Barbie's Inheritance

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

Nikki Lude, CFP®

Nikki is a financial advisor in Woodsfield, Ohio

Evan Brockmeier

Evan is a financial advisor in Marietta, Ohio

Neal Watson, CFP® 

Neal is a financial advisor in Marietta, Ohio.