By Neal Templin
Barron’s Retirement recently explored which accounts you should tap first in retirement in order to minimize taxes. The conventional wisdom of always drawing down taxable brokerage accounts or bank account first is often wrong. It all depends on whether you’re in a high or low tax bracket early in retirement.
Following on that article, we dug into readers’ questions on Roth IRA conversions and other maneuvers to reduce your taxes in retirement:
How does the five-year rule affect Roth IRA conversions?
Let’s take step back first. In a Roth conversion, you take money out of a tax-deferred account, pay income taxes on it, and put it in a tax-free Roth IRA account.
If you’re at least 59½ years old, you can always withdraw the money converted without paying taxes or penalties. However, you need to wait five years from Jan. 1 of the year you first opened a Roth IRA before you can withdraw earnings tax-free, according to Mike Piper, a St. Louis certified public accountant.
Whether it is smart to pull money from a Roth so quickly is a different matter. Because Roth accounts are so tax-efficient, they are often—but not always—the last accounts you should tap in retirement.
“If you have a compelling reason in a particular year to keep your income as low as you can, then spending from a Roth account can make sense,” Piper says.
Do I need earned income to do a Roth conversion?
No. It’s true that direct contributions to a Roth account must come from earned income. However, when you do a Roth conversion, the money comes from a tax-deferred account, and there’s no income requirement.
“You can be retired and do a Roth conversion,” says economist
of Boston University who sells software on smoothing retirement income. “You can be unemployed and do a Roth conversion. It’s not really connected to earnings.”
Is there an income limit for Roth conversions?
No. There is a limit for direct Roth contributions, but not for conversions. “If you make $3 million a year, you can’t contribute to a Roth,” says Scott Bishop, a CPA and financial advisor at Avidian Wealth Solutions in Houston. “But you can convert to a Roth.”
I’m worried that tax rates are going up? Is a Roth conversion a good idea?
Fear of rising taxes is one of the best reasons to do a Roth conversion. In general, it makes sense to do these conversions when your future tax rates will be higher than your current ones. That could be because you will have higher taxable income in the future than you do currently. But it could also be because tax rates are heading up, and you’re trying to lock in today’s lower rates with a Roth conversion.
Greg Will, a financial advisor and CPA in Frederick, Md., has been advising clients to do Roth conversions for exactly that reason. “Tax rates are at an all-time low for most types of income,” he says. “Just looking at the deficit, it seems pretty unlikely that tax rates will come down in the future, and relatively likely they will go up—at least for certain people.”
How much should I care about triggering higher Medicare premiums in retirement?
A lot. These premium bumps can be expensive. Your monthly Medicare premium is based on your modified adjusted gross income two years earlier. A married couple could earn up to $176,000 in 2019 and still each pay the minimum Medicare Part B premium of $148.50 a month in 2021. But if their income gets above that levels, premiums start rising rapidly. (Here is the Medicare rate table.) A couple who had earned $277,000 in 2019 would each pay a monthly premium of $386.10 this year. They will owe premiums for supplemental Medicare coverage or drug coverage on top of that.
One of the best ways to lower future Medicare premiums is do Roth conversions while you’re in low tax bracket early in retirement before you start drawing Social Security.
Even if you don’t have enough income to trigger a higher Medicare premium as a couple, you may get with one after a spouse dies and the survivor is taxed as a single person. A single filer pays a higher Medicare premium this year if he or she had income in excess of $88,000 in 2019.
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