Window of Opportunity, Part 1: The Retirement Tax Planning Window
Retirement can create an unusual tax-planning opportunity, one that may last only a few years.
For many people, taxable income changes significantly when they retire. A salary that has filled much of their tax brackets for decades disappears, while other sources of retirement income may not have begun yet. Social Security benefits may be delayed, and required minimum distributions (RMDs) from retirement accounts may still be years away.
The period between those events can create what we call a window of opportunity.
Why lower-income years matter
During your working years, contributing to a traditional IRA or employer-sponsored retirement plan can provide valuable tax benefits. Those contributions generally allow you to defer income tax until the money is withdrawn.
But tax deferral doesn’t necessarily mean tax elimination.
Eventually, distributions from tax-deferred retirement accounts generally become taxable income, whether that is taxable to you or your heirs if you do not deplete the account. And once RMDs begin, you may have less control over how much taxable income those accounts generate each year.
That makes the years before RMDs begin particularly important.
If your taxable income drops after retirement, you may have room remaining in lower income tax brackets. Rather than simply allowing that capacity to go unused, there may be opportunities to recognize some income strategically while your tax rate is relatively favorable.
Where Roth conversions come in
One strategy to consider during this period is a Roth conversion.
A Roth conversion generally involves moving money from a tax-deferred retirement account into a Roth IRA. The amount converted is generally taxable in the year of the conversion, meaning the strategy intentionally creates taxable income today in exchange for potential tax advantages later.
That may sound counterintuitive. Why voluntarily pay tax sooner than necessary?
Because the more important question isn’t simply when you pay the tax. It’s what tax rate may apply when you do.
For someone experiencing relatively low taxable income after retirement, a carefully planned conversion may allow part of a traditional retirement account to be taxed at a lower rate today rather than potentially being taxed at a higher rate later.
The strategy can also reduce the amount remaining in tax-deferred retirement accounts that will eventually be subject to RMDs.
The opportunity is highly individual
A Roth conversion isn’t automatically beneficial, and determining how much to convert, if anything, isn’t as simple as looking at your current tax bracket.
Other income, deductions, investment gains, Social Security, Medicare considerations, state taxes and your longer-term retirement plans can all affect the calculation. A conversion that makes sense for one retiree could be unnecessarily expensive for another.
That’s why this period is best viewed as an opportunity for planning, rather than simply an opportunity to convert.
The years immediately after retirement may offer a level of control over taxable income that won’t always be available later. Identifying that window and deciding how best to use it can be an important part of a long-term retirement tax strategy.
Are you approaching retirement or already in the years between retirement and RMDs? Our team of tax professionals and Certified Financial Planners® can help you evaluate whether your current tax picture presents a planning opportunity and how a Roth conversion might fit into your broader retirement strategy.
