One way retirees can make the best of their inevitable reckoning with the tax collector is by doing a series of Roth conversions before the start of required minimum distributions (RMDs) at age 70½. The big benefit is tax diversification. Vanguard’s research shows that IRA investors are doing just this, since we see Roth conversions increase as RMDs approach (a period we’re calling the Roth conversion “zone”). As the research further suggests, some retirees may be in the fortunate position of not needing RMDs for retirement spending, and we see a cohort reinvesting the net proceeds in a nonretirement account (hopefully in a tax-efficient manner, based on the guidance that their financial advisors are giving them!).

If you and your clients are thinking about Roths beyond retirement, here are a few tax-smart tactics to consider as part of your year-end planning conversations:

  • Pair conversions with charitable giving. One way to minimize the taxes due on a Roth conversion is to make a charitable donation as a way to help offset the income. Also, keep in mind that charitable contributions are capped—typically, contributions can be deducted up to 50% of adjusted gross income. Because a Roth conversion increases adjusted gross income, this can also allow for a higher deductible charitable contribution cap in the year of the conversion. This pairing can maximize charitable giving while reducing the tax impact resulting from the Roth conversion.
  • Use up any low marginal income tax bracket years. It’s fairly common for retirees to be in a relatively lower marginal income tax bracket when they’re in the “zone”—that is, the years before they start taking RMDs. In particular, those retirees deferring Social Security until age 70 may be in relatively lower marginal rates in their sixties. This is prime time for accelerating taxable income, for example, considering a series of Roth conversions to “fill up their brackets.” The dollars will be taxed at lower marginal rates, will create tax diversification for the future, and will ultimately lower future RMDs since the traditional IRA balances will be lower.
  • Use the alternative minimum tax (AMT) to your clients’ advantage. Those subject to AMT may actually be able to reduce the taxes they pay on a Roth conversion. The reason is that their AMT rate will likely be lower than the marginal income tax they would otherwise pay. Circumstances will certainly vary, but if a client is subject to AMT, you can help him or her strike the right balance between converting as much as possible while still remaining in the AMT envelope.

While these strategies can reduce the tax bite of a Roth conversion, there are a few wrinkles for retirees to consider. First, if a client is receiving Social Security benefits, be sure to factor in how the additional income from a Roth conversion could affect the taxation of benefits. Besides calculating whether the benefits will be taxable, consider the overall marginal rate that will result if the benefits are taxable.

Second, for those retirees enrolled in Medicare Part B, consider the impact on their monthly premium. One of the main factors affecting Medicare premiums is income, based on a client’s tax return filed two years previously. Premiums can be higher for individuals or households that exceed certain thresholds. So if your client is enrolled in Medicare,1 be mindful of how the additional income generated by a 2016 Roth conversion could affect his or her Medicare premium in 2018. (For example, the 2017 Medicare Part B premium is based on information from the tax return filed in 2016 for the 2015 tax year.)

Not quite sure that a Roth conversion is in a client’s best interest? Or you’re unclear as to how much your client can convert before bumping into a higher marginal bracket? Remember that you have the flexibility to recharacterize a client’s 2016 Roth conversion next year, on or before October 16, 2017. The ability to unwind all, or part, of the Roth conversion affords a unique opportunity to refine any unwanted tax circumstances into 2017.

 

1 For more detailed information on Social Security taxation and Medicare premiums, go to ssa.gov.

 

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All investing is subject to risk, including possible loss of principal.

Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made.)

We recommend that you consult a tax or financial advisor about your individual situation.