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INSPIRED BY THE TV series The Queen’s Gambit, many people suddenly want to master the game of chess. But I’m more interested in mastering the practical world of retirement gambits—and that means matching wits with Congress and the IRS.
During my working career, I saved money in taxable brokerage accounts, IRAs and 401(k)s, but never focused on Roth accounts. At age 55, having left my last employer, I had two things that compelled me to begin—time and reduced income. As an experienced investor but a Roth novice, I wanted initially to take it slowly.
The first thing I learned is that you should start a Roth IRA by age 55, so you can withdraw all amounts—contributions and earnings—tax-free beginning at age 59½. For your earnings to be entirely free of taxes and penalties, there’s a five-year waiting period, plus you need to reach the magical retirement age of 59½. If I didn’t open my Roth until age 58, I’d have had to wait until age 63 to access everything tax-free.
Aware of this rule, I opened a Roth IRA at age 55 by transferring $1,000 from my traditional IRA. This was my first Roth conversion. I made the transfer in December, but that was enough to claim that year as the first year toward meeting the five-year rule. The reason: Under the tax regulations, what matters is the year you start, not the actual month.
Next, I had to analyze if there were any other uses for my traditional IRA that should limit how much I convert to a Roth. I came up with three.
The first reason for not converting too much: I wanted to use my IRA to buy deferred income annuities and, under the rules that govern so-called qualified longevity annuity contracts (QLACs), I could only do so with up to 25% of that account. If I shrank my traditional IRA too much, I wouldn’t be able make the maximum allowable QLAC investment, which is currently set at $135,000. I’ve now purchased three QLACs to create a guaranteed income stream to help pay for my later retirement years.
Another reason not to shrink my traditional IRA too much: I wanted to use the account as a financial bridge to cover my costs between ages 62 and 70, while I delay Social Security to get the maximum monthly benefit. To that end, I used my traditional IRA to purchase a period certain annuity that’ll pay me a monthly amount roughly equal to what I would be entitled to receive from Social Security during that eight-year stretch.
I could, of course, have used Roth money to purchase the period certain annuity—but I’m looking to spend down my traditional IRA, not my Roth. Indeed, by using my traditional IRA, I’ve ensured I’ll have enough taxable income during these years to “take advantage” of the lower tax brackets. At age 70, the period certain annuity will stop paying and, in its place, I’ll have my maximum monthly Social Security benefit.
A third reason to keep at least some money in a traditional IRA: tax diversification. A future Congress might permit traditional IRA withdrawals to be tax-free if they’re used for certain activities, such as purchasing long-term-care insurance. Even without a change in the law, an IRA can be a great way to give to charity once you’re in your 70s, thanks to so-called qualified charitable distributions, or QCDs. By using a traditional IRA to give directly to charity, seniors can reduce the tax hit that accompanies required minimum distributions.
With these three reasons in mind, I faced the hard decision: How much did I want to convert from my traditional IRA to a Roth—and hence how much of my traditional IRA’s tax bill did I want to prepay? Paying taxes today to create the Roth is delayed gratification. I’ve ended up converting 10% to 20% of my traditional IRA every year, aware that there’s a risk that a future Congress could try to tax the Roth.
There are two other major timing issues with Roth conversions. The first regards Obamacare. Early retirees, who aren’t yet age 65 and hence eligible for Medicare, may receive a tax credit toward the purchase of health insurance. But if they make large Roth conversions, they could lose part or all of that tax credit, since the conversion amount will be included in their taxable income. I was fortunate to have retiree medical insurance from my old employer, so this wasn’t a concern for me.
The other issue is IRMAA, short for income-related monthly adjustment amount. IRMAA is the Medicare premium surcharge that hits higher-income recipients. Roth conversions can trip you up by generating income and putting you into a higher IRMAA bracket. Keep in mind that IRMAA considers your income from two years earlier. This means that, if you do a Roth conversion at age 63, Medicare will use that added income to calculate your potential IRMAA penalty at age 65. Result? Instead of slowly increasing my Roth conversions, I accelerated them, so most of my conversions will be done before age 63.
I’ve noticed I now have a different attitude toward my traditional and Roth IRAs. I’m much happier when my Roth account grows and less happy when my traditional IRA increases, because the latter means I’ll have to pay more in taxes.
Intrigued by my Roth Gambit? If you like the idea of sacrificing your traditional IRA pawn to create a Roth Queen, consider these three steps:
James McGlynn, CFA, RICP, is chief executive of Next Quarter Century LLC in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of Retirement Planning Tips for Baby Boomers. His previous articles include He Gets, She Gets, The Taxman Cometh and Back When.
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Dave
Thanks. As you know the tax rates would be worse if you were single.
James
I don’t have a Roth, so I have dumb question: does each contribution to a Roth have its own 5 year starting period, or is the first contribution the only important one to consider in establishing the 5 year holding period?
Contribution is different from conversion. If you contribute to a Roth you can acccess the principal immediately-tax-free and penalty- free. If you convert from an IRA you can’t access the Roth penalty-free(the 10% before age 59.5) for 5 years UNLESS you are over age 59.5. I wouldn’t worry too much about the 5 year issues if your goal is to build the Roth account. My only advice is to open a Roth IRA by age 55 so that at age 59.5 everything in it will be tax-free.
I see a lot of questions and comments about the five-year rule. If you’re confused, I’d encourage you to read this section of HumbleDollar’s money guide:
https://humbledollar.com/money-guide/roths-five-year-rule/
QCDs are a great way to donate to charities while you are still living. If you also expect to leave money to charities when you die, the best way is to make them beneficiaries of your traditional IRA. Since the charity will get no tax benefit from a Roth IRA, you would have paid taxes needlessly on the conversion from a traditional IRA.
Great article Jim,
Very well rounded with pros and cons. I liked that you mentioned keeping things flexible just in case some rules change. Just followed you on twitter so I know when you do more and I am going to look at your book.
I am 57 and have 7 figure (barely) 401K, no IRA and no Roth yet, I am doing one with Vanguard this week for 2020 and 2021.
I also plan to use my 401K as a bridge from say 60-70 whilst I wait for soc security and still do what I can to convert just to have a balanced tap into bucket of funds I can use if and when taking out of my 401K would boost me into an area tax wise I don’t want to be in. Any articles to read or things to be careful about at my juncture age wise.
Thanks,
Ray
Ray my book addresses many of these topics. As I wrote it from a 55 year old’s perspective planning for retirement.
Nice write-up James, I too have become both a student and a fan of the Roth. If I may, I’d like to offer a few of my own hints and tips for those trying to master the intricacies of this fine art:
1) While it’s true that once you hit 59 1/2 you are pretty much done with the 10% penalty tax, keep in mind that the 5-year clock still applies to Roth conversions; or, more specifically, to the earnings of Roth conversions. These are still subject to ordinary income tax if held less than 5 years. However, due to the ordering rules of how distributions go in and come out of your account, for most people this is of little practical concern (unless you substantially drain the account within a few years, in which case you shouldn’t be fooling with conversions in the first place).
2) Also consider the impact of state taxes on your conversions. I live in a state that is relatively tax friendly for many pension/IRA/Social Security withdrawals, to the point that much of your income could be state-tax free if taken at the proper time in the proper order. This could mean that doing Roth conversions might subject you to state income tax, whereas standard withdrawals from traditional accounts might not. This isn’t necessarily a deal-breaker for conversions, but should be taken under consideration for sure.
On point #1 I agree it is mostly a moot point the taxation on earnings. However I believe that once you have held the Roth 5+ years and are over age 59.5 that all distributions are tax-free-regardless of ongoing conversions. (The way the IRS words it is not too clear.) The intent of the 5 year start on conversions is to prevent dodging the 10% under age 59.5 penalty.
“However I believe that once you have held the Roth 5+ years and are over age 59.5 that all distributions are tax-free-regardless of ongoing
conversions.”
Sadly, this does not seem to be the case. Pub 590B, page 28 has a reasonable (at least, for the IRS) explanation of the differences in 5-year clocks for conversions, and further clarifies that each conversion has its own 5-year clock.
Here’s a great article by Michael Kitces that I think you will find relevant:
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/
Mike Piper and Ed Slott are also in agreement on this, and I consider them to be my final-word, go-to gurus on most anything related to Roths. I’ve also discussed this subject at length with a local tax-advisor who says he’s seen actual cases of the IRS hitting seventy-some odd aged people with income taxes on the earnings of his converted Roths, because they didn’t hold them long enough after conversion. Not the early-withdrawl penalty tax, mind you, but ordinary income tax.
Edited to add: Of course, earnings on contributions ARE tax- and penalty- free after 59.5, so long as the account has been held at least 5 tax years.
Nice – we allow users to model the long term tax and other impacts of Roth conversions to their plan. We also rolled out a Roth Explorer (Beta) that will suggest potential conversions over time that may help you.
Would love to know if it would have helped with your plan. (It’s in the Plus version but there is a free trial so you could run it and then cancel.)
https://www.newretirement.com/
Steve it might have helped but unless the Plus version knows where tax rates are in the future I am not sure how much. I just know that every $ I put in a Roth has paid taxes already and the answer to conversion usually is- “as much as you can afford”. btw just heard your podcast with Christine Benz!
Thanks James – small world – it was an honor to go on The Long View.
Yes – we use current IRS tax tables. Lots of folks use our platform to create a “second opinion” to their own home built plans or what their financial advisor provides. If you try it – I’d love your feedback either way – we learn a ton from our community and try to share that knowledge through the platform.
This is good information I hope to add to my retirement planning thought process. Thank you!
Thanks for this article! One other option to consider in order to take some of the tax bite out of Roth conversions is to set up a Donor Advised Fund (DAF), making a large donation towards it, in the year you do the conversion. It can help offset the tax burden for the year from your Roth conversion, especially if you fund the DAF with a large amount that you normally would have spread out over several years with smaller individual charitable donations. Or as you mention, if you still plan to have some Traditional IRA money left at age 72 when the RMDs are required, consider the QCDs instead (as a sort of delayed charitable gift you are planning for in the future). Keep up the great articles Humble Dollar!