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When should you use a Roth IRA to manage your taxes?
As you hit your 60s, it’s common to shift retirement planning from general wealth accumulation to practical details like taxes and required minimum distributions (RMDs). Getting this right matters, because how you manage these tax requirements will help determine how much spending power you have in your retirement.
The challenge for many households is that, by the time you’re in your 60s, the cake is very often baked. While you can certainly change your tax and RMD situation, it’s often hard to do so in a cost-effective manner. In most cases, with most options, you’ll spend more in taxes than you stand to save.
For example, say that you’re 61 years old with $890,000 in a traditional IRA. Should you convert this, 10% at a time, in order to avoid taxes and RMDs in retirement? The answer is, maybe. Depending on how you structure it, this approach might save you some money on taxes, but the benefits will depend a lot on your approach and overall income.
If you need help determining which option is best for you and your financial situation, consider working with a financial advisor.
Some major tradeoff elements to consider when planning a Roth IRA conversion are your current year’s tax liability and your tax liability in retirement. Ultimately, the value of each will depend on your income and assets, and the type of accounts your retirement savings are in. Qualifying Roth IRA withdrawals in retirement are not taxable, while those from a traditional IRA are. And Roth IRAs are not subject to required minimum distributions (RMDs). But any money converted from a traditional IRA to a Roth IRA is taxed in the year it is converted, potentially creating a large tax bill.
For the purposes of this example, we have an $890,000 IRA at 61 years old. Let’s assume that you earn $100,000 per year and intend to retire at age 67. Say, also, that you make 10% retirement account contributions and your portfolio grows at the mixed-asset average of 8%. Under these assumptions, by the time you turn 67, your portfolio might be worth around $1.48 million.
Now, say that you leave this money alone to continue growing until age 73. You are retired, so you no longer make contributions, but it keeps growing at an 8% average return. By the time RMDs begin, you might have around $2.35 million in this account.
Your RMD on this portfolio at age 73 would be $88,965, which would trigger an estimated $11,413 in federal income taxes. While your RMD would change modestly each year, as your portfolio value and age change, say that you continued that $88,965 withdrawal for 20 years from age 73 to age 93. You would pay $228,260 in income taxes on those withdrawals.
