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)