Maximizing Tax Efficiency in Retirement: A Guide to Roth Conversions and Proactive Planning

By Andrew J. Tapparo, MSF, RICP®

Taxes could be your largest expense in retirement! Therefore, planning for taxes in retirement is not just important; it's crucial. It can help you maximize your retirement income and ensure that your hard-earned savings are used to fund the retirement you envisioned and not unnecessarily paid to the IRS.

Introduction to Roth Conversions

As you approach retirement, it's crucial to have a well-thought-out plan in place to minimize your tax burden and ensure your hard-earned savings last as long as possible. One effective strategy to consider is Roth conversions. A Roth conversion involves transferring funds from a traditional IRA or 401(k) to a Roth IRA. By doing so, you can potentially reduce your taxes in retirement and set yourself up for greater financial security in your golden years.

When you contribute to a traditional IRA or 401(k), you typically do so with pre-tax dollars, meaning you get a tax break upfront but will owe taxes on the money when you withdraw it in retirement. In contrast, Roth IRA contributions are made with after-tax dollars, so you don't get an immediate tax break, but your withdrawals in retirement are tax-free. By converting some of your traditional retirement account funds to a Roth IRA, you pay taxes on the converted amount now, but those funds will then grow tax-free and can be withdrawn tax-free in retirement.

The key benefit of a Roth conversion is that it allows you to take control of your tax situation in retirement. By strategically converting a portion of your traditional retirement account funds to a Roth IRA each year, you can manage your taxable income and potentially stay in a lower tax bracket. This can result in significant tax savings over the course of your retirement, leaving more money in your pocket to enjoy during retirement.

Additionally, Roth conversions can help you create a more diversified retirement portfolio from a tax perspective. Having a mix of traditional and Roth accounts gives you the flexibility to choose which account to withdraw from each year based on your tax situation. This "tax optionality" can be a powerful tool in minimizing your overall tax burden and ensuring your retirement savings last as long as possible.

Avoiding IRMAA Surcharges

Another significant benefit of Roth conversions is their potential to help retirees avoid unnecessary Income-Related Monthly Adjustment Amount (IRMAA) surcharges on their Medicare premiums. IRMAA is an additional fee that high-income Medicare beneficiaries must pay on top of their standard Medicare Part B and Part D premiums. The surcharges are based on your modified adjusted gross income (MAGI) from two years prior, and the thresholds are adjusted annually for inflation.

For example, in 2024, if your Modified Adjusted Gross Income (MAGI) in 2022 exceeded $103,000 for single filers or $206,000 for married couples filing jointly, you would be subject to IRMAA surcharges ranging from $69.90 to $419.30 per month for Part B and $12.90 to $81.00 per month for Part D. These additional costs can add up quickly and significantly impact your retirement budget.

This is where Roth conversions can be particularly helpful. By strategically converting a portion of your traditional IRA funds to a Roth IRA each year, you can manage your taxable income and potentially keep it below the IRMAA thresholds. The key is to spread the conversions out over several years, converting just enough to stay within the desired tax bracket and avoid triggering the IRMAA surcharges.

For instance, let's say you're a single filer with a MAGI of $95,000 in 2024, which is below the lowest IRMAA threshold of $103,000. If you anticipate needing to withdraw an additional $20,000 from your traditional IRA in 2026 to cover expenses, that extra income could push you over the IRMAA threshold and trigger the surcharges. However, if you convert $10,000 from your traditional IRA to a Roth IRA in both 2024 and 2025, you can spread the tax impact over two years and potentially avoid crossing the IRMAA threshold in 2026.

IRMAA surcharges can unintentionally be triggered by Required Minimum Distributions (RMDs) from traditional IRAs. Unlike traditional IRAs, Roth IRAs are not subject to RMDs during the account owner's lifetime. Also, since distributions from Roth IRAs are not taxable nor included in your MAGI, they will not push you into a higher tax bracket or trigger IRMAA surcharges.

Tax Optionality in Retirement

One of the most powerful aspects of Roth conversions is their contribution to tax optionality in retirement. Tax optionality refers to the flexibility to choose which retirement account to withdraw from each year based on your tax situation. By having a mix of traditional and Roth accounts, retirees can adapt their withdrawal strategy annually to minimize their tax liability and maximize the longevity of their retirement savings.

Here's how it works: Traditional IRA and 401(k) withdrawals are taxed as ordinary income, while Roth IRA withdrawals are tax-free (assuming you meet the requirements). In years when your taxable income is lower, you might choose to withdraw more from your traditional IRAs, filling up the lower tax brackets. Conversely, in years when your taxable income is higher, perhaps due to large capital gains or other sources, you could rely more on tax-free Roth withdrawals to avoid being pushed into a higher tax bracket.

This flexibility allows you to fine-tune your retirement income strategy each year based on your unique circumstances. By being strategic about which accounts you tap and when, you can potentially lower your taxes over your lifetime and stretch your retirement savings further.

For example, let's say you retire with $500,000 in a traditional IRA and $500,000 in a Roth IRA. In a given year, you need to withdraw $50,000 to cover your living expenses. If you have other taxable income that year, such as from part-time work or investments, you might choose to withdraw the full $50,000 from your Roth IRA to avoid increasing your tax burden. However, if you have minimal other income that year, you could withdraw a portion from your traditional IRA, paying taxes at a lower rate, and the remainder from your Roth IRA tax-free.

By having both traditional and Roth accounts to draw from, you give yourself the flexibility to adapt your withdrawal strategy based on your changing tax situation in retirement. This tax optionality, made possible in part by strategic Roth conversions, is a powerful tool for minimizing the impact of taxes on your retirement lifestyle.

Roth Conversion Strategy Example

Let's look at a simple, hypothetical example to illustrate how a Roth conversion strategy could be implemented in the years leading up to retirement. Meet John and Sarah, a married couple in their late 50s. They have $1 million saved in traditional IRAs and 401(k)s, and they plan to retire in about five years. Their current taxable income is $150,000 per year, putting them in the 22% tax bracket.

To minimize their tax burden in retirement and create tax optionality, John and Sarah decide to implement a Roth conversion strategy. They plan to convert $50,000 from their traditional IRAs to Roth IRAs each year for the next five years. By spreading the conversions out over several years, they can manage the tax impact and avoid being pushed into a higher tax bracket.

Each year, John and Sarah will pay taxes on the $50,000 they convert at their current 22% tax rate. This means they'll owe an additional $11,000 in taxes annually for the next five years. However, by paying these taxes now, they're effectively prepaying their retirement taxes at a known rate. The converted funds will then grow tax-free in their Roth IRAs, and they can withdraw them tax-free in retirement.

After five years, John and Sarah will have converted $250,000 from their traditional IRAs to Roth IRAs. In retirement, they can withdraw this money and any associated growth tax-free, giving them a significant source of tax-free income to supplement their other retirement income sources.

By implementing this Roth conversion strategy, John and Sarah have not only created tax optionality in retirement but also potentially saved thousands of dollars in taxes over the long run. They'll have the flexibility to choose between tax-free Roth withdrawals and taxable traditional IRA withdrawals each year, depending on their tax situation. This approach can help them minimize their overall tax burden, avoid unnecessary IRMAA surcharges, and ensure their retirement savings last as long as possible.

Importance of Planning and Consulting

While Roth conversions can be a powerful tool for reducing taxes in retirement and creating a more flexible withdrawal strategy, it's essential to approach this strategy with careful planning and guidance from a financial professional. The decision to convert funds from a traditional IRA to a Roth IRA depends on various factors, including your current tax bracket, expected future tax rates, retirement timeline, and overall financial goals.

At Tapparo Capital Management, we can help you assess your unique situation and determine whether Roth conversions make sense for your retirement plan. We can work with you to develop a personalized conversion strategy that minimizes your tax liability, avoids unnecessary IRMAA surcharges, and ensures your retirement savings are optimized for your specific needs. If you are worried that you might outlive your retirement assets, give us a call at 978-887-1121. We can help you take control of your tax situation, minimize your tax burden, and create a more diversified retirement income stream. All this will provide you with greater peace of mind and financial security as you navigate your golden years.

About Andy

Andrew Tapparo is a fee-only financial advisor at Tapparo Capital Management, a financial planning firm in Topsfield, MA, helping clients turn their savings into a retirement income that lasts. Inspired by the quote, “Choose a job you love, and you will never work a day in your life”, Andy founded Tapparo Capital Management in 1997 with a passion for helping clients enjoy a truly worry-free and fulfilling retirement and experience financial freedom. As a Retirement Income Certified Professional (RICP®), he designs retirement strategies along with sound money management to help clients retire with confidence.

Andy holds a Bachelor of Science in Industrial Engineering from Rochester Institute of Technology in Rochester, New York, and a Master of Science in Finance from Bentley University in Waltham, Massachusetts. Specializing in retirement income planning, Andy completed a comprehensive financial industry education program at The American College of Financial Services and was awarded the Retirement Income Certified Professional® designation. He is frequently quoted in the media as a financial expert.

Andy and his wife, Susan, live in Topsfield, Massachusetts, and have two beautiful daughters. Outside of work, he is an automobile enthusiast, enjoys taking road trips, and loves the Outer Banks of North Carolina. In his spare time, he volunteers with the local high school varsity girl’s basketball team as the team statistician and runs the team’s website. He is passionate about supporting charities that serve our veterans and their families. To learn more about Andy, connect with him on LinkedIn.