Avoiding Higher Tax Brackets in Retirement with Partial Roth Conversions

As a retiree, it’s important to know and understand the basics when it comes to withdrawal order of your nest egg. Generally, conventional wisdom states that its best to spend down your cash and after-tax funds, while allowing your tax-advantaged investments to grow. But is this always the case, or can there be a such thing as “too much” tax deferral?

When accounting for all factors – including taxes, RMDs, and sources of retirement income – the answer often becomes more complicated.

Consider this example:

Mr. and Mrs. Smith, both aged 62, are recent retirees. Their combined income after deductions is $55,000, putting them squarely in the 15% tax bracket. They can live off this income, despite it being substantially lower than their working years, by tapping into their savings of $200k when needed. They are each eligible for social security income of $2,500 a month at full retirement age, and have managed to save $1.25M in their IRAs. Mrs. Smith will also begin receiving a private pension of $15,000 annually beginning at age 65.

In the case of Mr. and Mrs. Smith, continuing the tax deferral of their tax-advantaged accounts is likely not the best solution, and the couple should take advantage of their tax situation in their early 60’s. To do this without withdrawing the tax-advantaged funds, they can utilize a Partial Roth Conversion. In doing so, Mr. and Mrs. Smith can “fill up” the lower tax brackets by paying taxes on the IRA funds they convert to a Roth IRA. Mr. and Mrs. Smith will have access to tax free withdrawals in their later years, and will reduce their RMDs in the process.

Source: IRS.GOV

*If your nest egg is primarily tax-deferred investments, do your best to “fill up” the tax brackets in green in your early years of retirement

Reducing their RMDs, as well as having access to a stream of tax free funds in their later years, will be vital when their other sources of income kick in. Given that Mrs. Smith’s pension and 85% of the couple’s social security will be subject to tax, the Smith’s marginal tax rate will very easily jump to the higher, undesirable tax brackets. This will be doubly worse if the Smiths are forced to take RMDs that they don’t necessarily need to support their yearly expenses.

This example is a very common situation for recent retirees today, given that the primary source of retirement savings is through tax-deferred, employee sponsored 401k plans. Sometimes it’s important to challenge conventional wisdom when planning for retirement, and to recognize that seemingly crazy ideas, like paying tax now instead of later, may be something you should consider.


*This information is not intended as authoritative guidance or tax advice. You should consult with your tax advisor for guidance on your specific situation.