Many investors may be surprised to learn just how much tax they will owe during their retirement years. Roth conversions can help reduce the tax bills.
Knowledge is Power
Most retirees expect the bulk of their retirement income to come from retirement savings accumulated in various tax-deferred accounts, such as IRAs and 401ks. Any withdrawals from these accounts (unless they are Roth versions) will be subject to income tax at ordinary income rates, which are currently much higher than rates on long-term capital gains or qualified dividends. You received a tax break when you put the money into the account because that money was not counted in your income at the time. In exchange, you will have to pay ordinary income taxes not only on the amount originally contributed, but also on the increase in value from investment returns accumulated over the years. Ouch!
If you are thinking that you can avoid the income taxes by not withdrawing any money, sorry, but the IRS requires you to withdraw a certain percentage of your account, called a required minimum distribution (RMD), each year, starting at age 72. (The age used to be 70 ½, but the age was pushed back to 72 under the Secure Act for anyone born after July 1, 1949. And RMDs for 2020 have been completely suspended under the Cares Act.)
Ideally, what you would like to do is avoid having RMDs that are so large that they put you into a higher tax bracket than you would otherwise be in. Later, we’ll discuss strategies for lowering the tax burden for RMDs, but the first task is to figure out what the tax burden will be.
Calculate Your Future RMDs
It’s a fairly straightforward exercise to project your RMDs out into the future. The IRS publishes the “Uniform Lifetime Table” which tells you the percentage of your annual required minimum distributions (RMDs) based upon your age. (This table is updated once in a while, but not very often.) Your retirement savings will grow over time, of course, depending upon how it is invested, so you’ll want to factor in a rate of return. This should be a real (inflation-adjusted) rate of return because income tax rates are inflation-adjusted, and our objective is to figure out the constant-dollar taxes that will have to be paid on the RMDs.
What is a reasonable real rate of return? On the low end, a portfolio that is 100% in government bonds, such as in the iShares U.S. Treasury Bond ETF (GOVT), currently yields only about 1.8%, which is likely to be less than the long-term inflation rate. On the high end, a portfolio that is 100% in stocks has historically (since 1926) returned about 9.8% before adjusting for inflation. After inflation, the return has been about 6.7%. However, that is not a realistic rate to assume going forward, since price/earnings ratios have inflated so much since 1926. A more realistic bottom-up forecast would add the current dividend yield of 2.1% to a long-term dividend growth rate, which since 1990 has been about 6.1%. This would result in a total expected nominal return for stocks of about 8.2%.
A simple 50/50 combination of the 1.8% government bond return and 8.2% stock return would net an expected nominal return of 5%. From that, you would have to subtract expected long-term inflation. One market-based measure of inflationary expectations is the yield spread between the 10-Year Treasury Bond and the 10-Year TIPS (Treasury Inflation Protected Securities) Bond. Most researchers would add to that some margin to account for the illiquidity risk in the TIPS compared to Treasurys. The 10-Year Breakeven Rate (Treasury-TIPS) has been running about 1.5%, and if we add an illiquidity premium of .5% to that, we get long-term expected inflation of about 2%. Thus, the long-term real return on a 50/50 stocks/bonds portfolio would be about 3%.
Mind the Gap Years
The graph below illustrates the RMDs for a traditional IRA account of $2 million at age 60 and a 3% real return. By age 72, the IRA would have grown to a constant-dollar value of $2.85 million. The first RMD is about 4% of the portfolio value and it goes up from there. At age 90, the RMD rate is 8.8%. The increased RMD rate, along with the accumulated real earnings, push the inflation-adjusted value of the RMDs up close to $160,000 per year by age 90.
The current federal income tax brackets for married taxpayers filing jointly (MFJ) jumps from 12% to 22% (an 83% increase) at incomes over $80,250. However, if you add the standard deduction of $12,400 for MFJ taxpayers to that figure, the jump doesn’t occur until an income of $92,650. Therefore, steps that will help keep taxable RMDs below that figure will help keep taxes low.
One excellent strategy for reducing the tax burden of RMDs is to smooth out the income from an IRA by converting some of the money from traditional to Roth IRA during the “gap years” between retirement (here assumed at age 60) and the start of RMDs at age 72. Any money that is distributed out of a traditional IRA, even if it is then contributed to a Roth IRA, becomes income that is taxed at ordinary rates. However, once money is "converted" from a traditional IRA to a Roth IRA, it is never taxed again. That is a tremendous benefit that is widely underappreciated.
An optimal approach to Roth conversions is often bracketed between two alternative strategies, which we will call the “minimum” approach and the “maximum” approach. The minimum strategy merely seeks to “fill up” the 12% tax bracket with yearly Roth conversions. For example, if you expect income of only $50,000 in a gap year, you would move $42,650 of your traditional IRA into your Roth IRA. Because the amount moved is taxable, this will fill up your 12% tax bracket with a total income of $92,650.
By the way, if you think you have a good handle on your taxable income for the year, you will want to do your Roth conversion toward the early part of the year, which will give you longer to accumulate investment returns tax-free and also maximize the delay in paying the taxes on the converted amount, which will be April 15 of the following year.
The maximum approach is to convert 1/N of your traditional IRA in each of your gap years, where N is the number of gap years. The result is that you convert the same amount each year, and at the end of the gap years, you have converted 100% of your traditional IRA into a Roth IRA.
Even if you do not necessarily expect your RMDs to push you into a higher tax bracket, there are still two very good reasons to consider Roth conversions: 1) the tax burden of compounded investment returns on RMD money that you then put into a taxable account (but would otherwise be in the tax-free Roth) and 2) the fact that tax rates are likely to increase in the years ahead. Let’s consider each of these in turn.
Taxes Upon Taxes
The highest federal income tax rates apply to “ordinary income,” such as
- Wages, tips, and salary
- Short-term capital gains
- Interest income
- Non-qualified dividend income (from REITs and MLPs)
- Traditional IRA distributions
Fortunately, at least under the current tax code, long-term capital gains and “qualified dividends” (those paid by most corporations) qualify for preferential tax treatment at lower rates. For MFJ taxpayers, the first $80,000 in preferential investment income is tax-free. That’s right. It’s ZERO.
That’s works great if your portfolio is 100% in stocks either owned directly or through low-turnover index funds, since your dividend income will (most likely) be tax-free and you can control the timing of capital gains to make sure that you avoid short-term gains. However, most retirees do not want that high a level of market risk in their portfolios. Consequently, they are likely to have some interest income from their taxable accounts, which will be taxed at ordinary rates.
Interest income by itself will not push an MFJ taxpayer into a higher bracket until their bond portfolio grows to a fairly high level. For example, the current yield on the iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD), the largest corporate bond ETF, is about 3.2%. In order for interest income to exceed $92,650 (the maximum to stay in the 12% tax bracket), the investment in LQD would have to exceed $2.9 million.
However, we have already shown above that it may be difficult to keep RMDs from a traditional IRA below the $92,650 threshold. Even if only half of the taxable retirement portfolio is invested in bonds, the interest income, coupled with RMDs, is likely to exceed $92,650 for many retirees. In addition, many retirees find that they have other sources of taxable income. For example, income from part-time employment. Or short-term capital gains (most actively managed funds will have them). Or non-qualified dividend income. It all adds up quickly. For many, moving a substantial amount from traditional to Roth will help make it possible to stay in the 12% tax bracket.
Place Your Bets
But the most compelling reason to go ahead and pay taxes early to get money out of a traditional IRA and into a Roth IRA is the likelihood that tax rates will go up in the future. The RATE that you pay on your IRA distributions, whether now or in the future, is what matters.
This may come as a surprise. Most of us instinctively avoid paying sooner when we could pay later. However, the ending value of your portfolio will not be affected by when you pay the tax if the rate is the same, assuming that once you pay you are able to avoid paying any more taxes after that. (Such as would be the case with a Roth conversion.)
The table above illustrates this mathematical principle, which is called the “commutative” property of multiplication. You probably learned about it in elementary school and have long since forgotten. If “T” stands for the rate of taxation, and A, B and C stand for annual rates of return, then it doesn’t matter where you insert T into the chain of multiplication, the product will be the same. That is:
T x A x B x C = A x B x C x T
So, if your current marginal tax rate is 22% and you are SURE that it will be 22% in the future, then there is no benefit in paying early to convert to a Roth, but neither is there any penalty. However, if you have reason to believe that your marginal tax rate will be higher in the future, either because your income is higher or because tax rates have gone up, you are better off paying NOW at the lower rate to avoid paying the higher rate in the future.
What are the chances that tax rates will go up? Given the current political environment, especially with the level of federal, state, and local spending in the wake of the coronavirus pandemic, the odds seem to favor higher rates in the future. Federal tax rates went down with the Tax Cuts and Jobs Act of 2017, but those cuts are already set to expire in 2025. Most Democrats favor repealing the tax cuts sooner than that. And many of them favor setting rates higher than they were before. Many of them also favor eliminating preferential rates for long-term capital gains and corporate dividends. That’s just at the federal level. The same political winds are blowing in most states and municipalities.
There may never be a better time to convert IRA money from traditional to Roth. IRA account values are down because of the recent bear market, so the tax burden is less than it would have been before the downdraft. The floodgates of government spending have been opened wider than ever. Government intervention in the economy has never been higher. The mindset of the electorate seems to have shifted in favor of socialism and against capitalism. This is an election year. Change is in the air. Anything can happen, but the momentum seems to be building towards a bigger role for government. Higher taxes will be needed to pay for it.
The Bottom Line
- Current federal income tax brackets have a significant jump from 12% to 22%, an increase of 83%.
- Keeping your taxable income below the jump to the 22% rate (or at least minimizing the amount above it) will help keep your taxes low in retirement.
- Required minimum distributions (RMDs) and interest income tend to grow during retirement, pushing income up.
- Moving money from traditional IRAs to Roth IRAs, especially during the “gap years” after retirement and before RMDs, is an excellent strategy for maximizing lifetime after-tax income.
- IRA account values are down at present and it seems likely that tax rates will increase, making Roth conversions especially compelling right now.