By Tami Noll Russo, CPA, CFP, CLU
When making a retirement plan, I encourage my clients to identify their needs and then we work together to develop a plan that will pay for those needs with guaranteed retirement income. Sources of guaranteed income include defined benefit pension plan payments, annuity payments, and Social Security. In my last blog, I focused on creating an income-tax free retirement plan for a couple. Now, I’d like to explore a way to keep taxes low on retirement income by permanently reducing your marginal income tax bracket during retirement.
One method of doing so is by implementing a partial systematic Roth IRA conversion. A Roth IRA is a retirement account that uses after-tax dollars, but the investments grow tax-free as long as you follow the rules. If planned properly, you pay the tax before you invest in the Roth IRA and then when you make a withdrawal, you do not pay tax. The benefits of implementing a partial systematic Roth IRA conversion include the following:
- Taking control of how and when you pay your federal income tax bill
- Reducing future required minimum distributions (RMDs)
- Potentially reducing the percentage of Social Security subject to federal income tax
Implementing a partial systematic Roth conversion strategy while deferring Social Security works extremely well for more conservative clients and for those who desire more guaranteed income. Remember, you can earn up to 8 percent each year in delayed retirement credits by deferring Social Security payments beyond your full Social Security amount. In addition, Social Security payments continue to be indexed for inflation throughout your life. A Roth conversion strategy can be implemented without deferring Social Security, but it’s much more effective when the two strategies can be combined.
A husband and wife came to me within one month of retirement. The husband was age 65, and the wife was age 57. They had close to $1 million in the husband’s 401(k) and a healthy $300,000 in bank assets. Their income was going to consist of a defined benefit pension of $8,500 and part-time income of $22,000. They had no need for additional income as they lived well below their means.
The first planning decision was to convince them to defer Social Security to age 70. Many psychological hurdles needed to be overcome: they hadn’t heard of this strategy; their friends aren’t doing it; there was concern over dying young; they feared the government will run out of money. After I addressed their concerns, they agreed to follow my advice. What helped to convince them was the expected longevity of the wife, no need for the additional income, and the 8 percent delayed retirement credits.
Next on the agenda was to implement a complete 180-degree turn on their 45-year habit of tax deferral. You can imagine the looks of horror! I had calculated that over the next five years they could systematically convert about $365,000 of IRA money to Roth money by filling up only their 10 percent and 15 percent marginal income tax brackets. The IRS requires that you complete IRA-to-Roth conversions by Dec. 31 of each tax year. However, mistakes happen. If you convert too much money, the IRS gives you until you file your tax return to fix the mistake through a recharacterization (putting the money back into the IRA).
This particular husband and wife, by their extremely conservative nature, would have been fine by not implementing any planning strategy, but at age 70 ½ they would have always and forever been stuck in the 25 percent tax bracket due to RMD rules. Years of paying taxes in the 10 percent and 15 percent brackets would have been lost.
This plan won’t work for all, though. The following situations would preclude a client from implementing the conversion strategy:
- If the conversion puts them in a higher tax bracket than they otherwise would be in during retirement
- If they need to keep income low to qualify for a health care subsidy
- When they don’t have the money in the bank to cover the tax bill the conversion will generate
I should note that I have never had a client come to me and request that I implement a partial systematic Roth conversion strategy or talk about filling up lower tax brackets. But it is our job as CPAs to point out these great planning opportunities to our clients. In the end, this particular husband and wife still don’t fully understand the why’s of the strategy. They do see, however, how happy it makes me and trust that my heart and head stay in the right place.
Tami Noll Russo, CPA, CFP, CLU is a consultant at Noll Financial Services in Middletown, Pa. She is a PICPA member who serves on PICPA’s CPA Image Enhancement Committee, is co-chair of its South Central Chapter’s Personal Financial Planning Committee, and is a Trustee of the PICPA’s Scholarship Fund. She also is a past president of the PICPA South Central Chapter.