Taking Advantage of Pre-Retirement Tax Brackets for the Early-Retiree
In Retirement Tax Tips-Part 1 I recommended fully funding your 401(k) account before retiring from your job (and making contributions to an IRA if you qualify). In this post, I will talk about how to save retirement tax dollars by converting traditional IRAs into Roth IRAs.
If you are retiring before "normal" retirement age (I'll call that 59 1/2, when you can begin withdrawing assets from retirement accounts without penalty) and are not going to be tapping into your retirement assets for several years, you may well be in the situation that I find myself in, a low tax bracket! While I was working, my income level was too high to take advantage of the IRA contribution provisions. After I reach retirement age and start collecting (hopefully) Social Security and begin taking distributions from my traditional IRA, my taxable income will once again be higher than it is now, in my early-retirement-post-working years. My income tax bracket will go up right along with it.
I have 15 years to go before I will begin taking distributions from my retirement accounts, so will be living off of my non-retirement portfolio until that time. Since the only taxable income I will be receiving will be the earnings on these accounts (which will go down each year as we spend down these accounts during our early retirement years), our federal tax bracket will be zero after taking into account our itemized deductions.
During this period of time, we can take advantage of our low (or zero) marginal tax rate and convert a portion of our traditional IRAs to Roth IRAs. When you convert a portion of a traditional IRA into a Roth, you must include the portion converted in your current year's taxable income. If your income is low enough (and/or your deductions are high enough), you can manage the year-to-year conversion amount to be just enough to keep you out of tax (or just enough to keep you in a lower tax bracket than you project to be in during your "normal" retirement years.)
Why would you want to do this? Because withdrawals from a Roth IRA are completely tax-free when you follow the appropriate distribution rules. Conversely, distributions from a traditional IRA will be fully taxable since those dollars provided you a tax deduction in the year you contributed them (which Roth IRA contributions do not). You can read a very good article about this distinction here.
For tax years 2008 and 2009, you must have "modified AGI" below $100,000 to take advantage of these conversion provisions. As the tax law stands right now, however, this income limitation goes away for tax years beginning in 2010.
With the current political climate, and an almost certain change in our tax laws on the horizon, it is likely tax rates will go up. So even if your expectation is not to have a far greater income in your retirement years, it is certainly possible your tax rate will be higher anyway.
(Next post in this series: Tax Tips for Retirees-Part 3-Taking advantage of low capital gains rates)
Converting my 401k (or IRA as it may be) into a roth is what I plan to do as well. However, do you know/think/guess if this opportunity for conversion will exist in say 10 years. I have gotten the impression that it was temporary?
Posted by: Early Retirement Extreme | March 18, 2008 at 10:58 AM
To sort of answer your question: First, the tax law that allows you to convert your traditional IRA to a Roth is not "temporary", i.e. it's not a law that is scheduled to "sunset".
As to whether it will be around in another 10 years, well now, that's another story. In the alternative world that is tax law, that is a very long time--with very likely political changes, that could always be legislated away.
However in all the areas I hear rumblings of change, (most notably estate tax, capital gains rates, and ordinary income rates), I have not heard rumblings of this area being a target.
Posted by: Retired Syd | March 18, 2008 at 09:17 PM
For someone my age who plans to retire at around the same time, I am thinking it probably makes the most sense to keep my traditional IRA until I do retire, at which point I should convert to a Roth piece-by-piece until 59 1/2, like you're doing. Would you agree?
(This is, of course, assuming that tax laws and retirement plans look at all the same in another 20 years).
Posted by: Lise | March 20, 2008 at 11:50 AM
Assuming that you are in a higher tax bracket right now (while you are working) than when you retire, that's right. Otherwise you would be picking up the conversion income at higher rates than you would have experienced anyway by just keeping it in a traditional IRA.
Keep in mind that if your pre 59 1/2 bracket isn't any lower than your post 59 1/2 bracket it may not make sense to do it at all. It usually only makes economic sense if you can pick up the conversion income while in a lower tax bracket than the one you would have when drawing the distributions when retired, if that makes sense. (And yes, 20 years is even a longer time in tax world, not sure the rules will even resemble those that are on the books right now!)
Posted by: Retired Syd | March 20, 2008 at 01:07 PM