PSSST, Want to Save $60,390 In Taxes?
Let me preface this post by saying that if you think what I am proposing could possibly work for your situation, you've got to run it by your accountant.
Abnormal Returns included this link in it's Wednesday post from Vanguard about when to start planning for required minimum distributions, RMDs. As a quick reminder, at 70 1/2 you have to begin to take money out of your "non-Roth IRA," that amount is an actuarial determination that is often in the range of 4-5% to start. There is more nuance to it but the big idea is that it is a way for the government to get its money as RMDs are taxed as income.
If you look for content on this subject you will find articles that suggest converting that "non-Roth," usually a traditional IRA, into a Roth. The downside is that you have to pay income tax on the amount of the conversion, the upside is that hopefully the account continues to grow and you don't have to pay tax when you then withdraw from the now Roth IRA. Like everything related to this topic, there are more moving parts but these are the basics.
I don't really write about Roth conversions because I am not a big fan of having to pay the tax. In converting $100,000 a married person might owe $22,000 in taxes or $24,000. This strikes me as a big setback. If you're entire retirement accumulation is $300,000-$400,000 do you really want to give $22,000 away and hope you come out ahead? Obviously the concept resonates with a lot of people and my general lack of interest shouldn't dissuade you from it.
However I had a small realization about conversions that makes it more compelling. I might be late to the party on this but in case I am not the last to think of it there is at least one circumstance where you can covert tax free. I ran this by my accountant, I am not an accountant and like anyone my accountant could be wrong (that is my disclaimer). If you think there is any way this could work for you, check with your accountant. Did I mention you should check with your accountant?
The standard deduction is currently $24,000. With no other taxable income you could convert $24,000 of your traditional IRA, that $24,000 is taxed as income, it is offset by the $24,000 standard reduction resulting in no tax owed. Taking it further, if you can contribute to a Health Savings Account for which there is no income requirement (this ends at age 65), you could increase the $24,000 to $30,900.
(a quick correction, above 55 years old, HSA contributions are allowed an additional $1000 catch up so instead of $6900 you'd could max out at $7900, I did not adjust all the math in the post but an important point).
A scenario where this could work is for a couple that retires at 60. Over the course of ten years with no income (more on that below) they could convert $30,900 until age 65 and then from 65 to 70 they could convert $24,000 per year. The $60,390 in the title assumes paying 22% on a total of $274,500 worth of converted IRA money. How much is in your traditional IRA? What percentage of your IRA is $274,500 that you might now be able to access without tax?
How would this couple live with no taxable income? They would need a decent amount of money in a taxable account, invested in a combination of tax free municipal bonds and a tax free money market. They might owe state income tax on interest from their holdings but that won't get in the way of this strategy. For that matter if they already had money in their Roth (so not the dollars just converted) they could take that money to live on, remember Roth withdrawals are not taxable. Stressing for emphasis, you have to wait for five years to access converted Roth money.
Muni bond funds could work in this scenario but capital gains paid by the funds could get in the way of this strategy, reducing the amount you could convert.
A couple of weeks ago I wrote about depleting a taxable account during the early years of retirement while allowing Social Security and tax deferred accounts to keep on growing. As a follow up I then did a study with an aggressively constructed, taxable account to hopefully stretch out the time it would take to deplete that account. What we're talking about today ties right in. The taxable account could very well deplete, the closer to 70 the better, as Social Security continues to grow and the IRAs continue to grow. Taking Social Security would reduce the amount that could be converted as that income can be taxable. I may not have mentioned it but you should work with your accountant on this.
A slightly more practical application of this might be early on in your retirement and you're fortunate enough to have a taxable account to draw from without needing Social Security and you get toward the end of a year and you realize that for whatever reason you had little to no taxable income. In that circumstance you could convert enough such that your small taxable income plus the amount converted equals exactly $24,000 or maybe $30,900 if you're eligible for an HSA that year.
This clearly calls for a lot pencil sharpening and something I haven't mentioned yet, you should work closely with your accountant on this.