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.