This is the third installment of our three-part series on tax efficient retirement planning. Please consider reading parts one and two.
By far, the largest wealth eroding factor we face over the course of our working lives are taxes. Minimizing taxes can have a significant impact in the short term. However, the difference that maximizing and optimizing our tax planning can have over the course of our retirements can be profound.
Today, I will discuss the third of the three most crucial tax strategies for a successful retirement. Depending on factors such as the amount of wealth we have accumulated, the types of assets we own and how long we live, getting these strategies right can mean tens of thousands, hundreds of thousands, or even millions of dollars in additional net spendable income over our lives.
Keep in mind that this is true at today's tax rates. If taxes rise in the future, as I believe they shall, these strategies will become even more valuable.
The overwhelming majority of retirees whose plans I have evaluated, regardless of wealth or education level, get these strategies wrong. I would like to change that for you.
Roth Conversion Strategy
A Roth IRAs is a terrific way to save. With traditional IRAs and 401(k)s, your contributions are not taxed but all withdrawals are taxed as earned income. Of course, if those withdrawals take place prior to the age of 59.5, there will also be a 10% penalty.
Conversely, as most of you know, money that goes into a Roth IRA is taxed in the year we earn it. However, all cumulative contributions and future gains can be withdrawn, with a small number of exceptions, tax free. This tax-free effect can be especially powerful as returns compound over time.
Owing to this, many people with IRA/401(k) balances should consider converting some of those funds to Roths. An important thing to remember is that the money being converted, that is moved from a traditional IRA to a Roth IRA, will be taxed in the year of the conversion. That makes Roth conversions less attractive to some and may, depending on several factors, make converting a mistake.
Another thing to consider is the Required Minimum Distribution (RMD). Depending on your birth year, the RMD requires that owners of tax deferred savings plans must begin taking distributions from their accounts between the ages of 73 and 75. The exact amount will vary based on factors such as account balance and life expectancy.
For higher income households with significant tax-deferred account balances or simply folks who do not need to withdraw funds from their tax deferred plans, that can mean significant additional taxes. Roth conversions, particularly those that begin far in advance of the RMD, can serve to flatten out those account balances and reduce the required distributions when they begin. All while the assets that have been converted are growing and can be accessed tax-free.
Some of the important questions to answer to determine if Roth conversions are right for you:
- What amount should be converted annually? There is a tax bracket sweet spot that can change from case to case.
- Will conversions retain their value when considering IRMAA surcharges?
- How will long-term capital gain tax brackets factor into your strategy?
- What will your terminal tax rate be? This could affect your beneficiaries significantly.
- For how long should you convert to optimize this strategy? There can be too little and too much of a good thing.
Be in no doubt, the three strategies for a tax efficient retirement, Asset Location, Withdrawal Sequence and Roth Conversion strategy can indeed save people tens of thousands or even hundreds of thousands of dollars or more in retirement. However, implementing these strategies is complex and coordinating them perhaps more so.
If you like, consider working with a financial planner who is knowledgeable and whom you trust to determine if these strategies will work for you. If you like, call me at (732) 844-3000. I am here to help.
Scott R. McGimpsey March 18, 2025
Certified Financial Fiduciary®
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