When Mike and Liz retired at age 63, they were looking forward to finally having an easy tax return. No more working meant no more worrying whether their company withheld enough taxes on their incentive plan payouts and stock vesting.
They’d hit their “retirement number” and had almost $2 million saved, much of it within traditional IRAs and 401(k)s. Required minimum distributions (RMDs) from these accounts were still more than a decade away.
Their initial plan was to live off their savings as well as withdrawals from their brokerage accounts until they took their Social Security benefits at the maximum amount at age 70.
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So, when Mike and Liz came into my office for our quarterly meeting, they were quite surprised when I suggested that they make a sizable, taxable Roth conversion from their traditional IRA.
Liz asked, “Why would we voluntarily pay more taxes right now when our income is finally so low?”
I answered, “Because this may be the lowest tax rate you see for the rest of your retirement. It could be a once-in-a-lifetime planning opportunity.”
Mike and Liz are in their “golden tax planning window” — the time between when you retire and when your RMDs start at 73 (or 75).
This is when the tax planning focus should shift from, “How do I enjoy a low tax rate today?” to, “How do I use this low-tax-year opportunity to create a strategy that could lower my lifetime taxes?’
What is the golden tax planning window?
The golden tax planning window is usually the period between when you stop receiving a paycheck and when you start receiving significant taxable retirement income.
For many retirees, this starts the year they retire and ends when they start taking Social Security, collecting a pension, or reach RMD age.
Not everyone has the same window, and you can’t time it around your age alone. Some retirees might only have one or two years before a taxable income source kicks in. Others might have five to 10 years.
And if you have a large pension, deferred compensation payouts, passive income from owning a business or renting a property, or significant capital gains, you might not get a golden window at all.
Why Roth conversions are often recommended
While they were working, Mike and Liz were focused on lowering their current year’s taxes through contributions to traditional IRAs and 401(k)s.
Entering retirement, they heard of Roth conversions but initially dismissed them because of two thoughts they had that many of their fellow retirees share:
- “I can’t Roth convert. I don’t have any income.”
- “My account balances are so large. The conversion tax bill would be huge.”
Yes, once you stop working, you may no longer have the taxable compensation needed to make a regular Roth IRA contribution. But you can still convert traditional IRA money to a Roth IRA, without earned income or contribution limits.
And Roth conversions don’t involve the entire account. You can choose the amount you’d like to convert — from one penny up to the maximum amount within the account that’s eligible to convert.
Which is why I believe the golden rule of Roth conversions is:
Choose the right year and the right amount of Roth conversions.
Roth conversions are often recommended when the tax rate you expect to pay on a conversion today is lower than the projected tax rate on traditional retirement account withdrawals in the future.
Your golden window helps you identify the right years to make the conversion and the right amount to convert in each of those years.
How to identify your golden tax planning window
Once you stop working, your monthly paycheck disappears. Your annual bonuses or stock compensation goes away.
That drop in income often creates an opening in the lower tax brackets to convert money from your traditional retirement accounts into a Roth IRA at a low tax rate.
You have the opportunity to report income from your traditional retirement accounts, during this time frame, at a current rate that may be lower than your projected future withdrawal tax rates.
This opportunity doesn’t last forever. As your expected retirement income sources like pensions and Social Security start, your tax planning window starts to close.
If you’re still in a relatively low tax bracket when you reach RMD age, this often signals the end of your golden tax planning window. The added taxable income from RMDs can often make more of your Social Security taxable, creating a higher tax cost than expected.
Another life transition that often signals the end of the golden tax planning window is the death of a spouse.
When the first person dies, the surviving spouse moves from the wider “married filing jointly” tax brackets to the much narrower “single filer” tax brackets. But the household’s annual taxable income doesn’t usually get cut in half like the brackets and standard deductions do.
Within the narrower single filer category, the widow’s income can more easily reach the higher tax brackets, creating a tax hit called the “widow’s penalty.” While unpleasant to think about, this change in tax situation should be a key piece of proactive planning.
Finding the right Roth conversion amount
Once I’d explained to Mike and Liz the scale of the opportunity in front of them, they agreed that they should take advantage of their golden window.
“Let’s do it! Should we convert our whole nest egg right now?” asked Mike.
“Not yet,” I told them. “We need to look at each part of your retirement planning first, not just your tax picture.”
Taxes are an important part of your retirement planning — but they are just a part of the whole picture. You need to coordinate your decisions on how much to spend in retirement, how to take Social Security and pensions, how to plan your taxes, how to invest and how to set up your estate plan.
I call the process of coordinating your retirement decisions your Retirement Master Plan. I share how to follow this process in five simple steps in my book Retire Today.
For Mike and Liz, we decided together when each of them would take Social Security. Then we mapped out their future tax situations in each year of their expected 30-year retirement.
Once they could see their projected tax rates each year, they could find the years when their tax rates were expected to be higher and lower.
For them, their marginal tax rates were projected to increase when they started their RMDs. They saw the rates projecting lower in the years before they were both claiming Social Security.
They were then able to determine how much to target for Roth conversions, when to do them and how best to pay the tax withholding for each year.
How to take advantage of your golden tax planning window
Mike and Liz spent decades planning how much they could put into their retirement accounts every month.
When they hit retirement, they thought the hard work had ended.
Thankfully, they discovered in time that the beginning of retirement is often the beginning of a golden tax planning window.
It’s the time to think ahead and decide how you can intentionally pay taxes, through Roth conversions, to potentially manage your projected lifetime tax liability.
When you hit retirement, don’t just push off your tax decisions until RMD time.
Project your taxes now and at each big change in your financial situation, such as starting Social Security, starting a pension and starting your RMDs.
Find out whether your golden tax planning window is open, how long it may stay open and how much of it you could use for Roth conversions each year — before that opportunity closes.