Early Retirement and Tax-Smart Roth Conversions

By Nathan Davis, CFP®, CFA

For many Americans, early retirement is an important financial goal. Getting more years to pursue interests and hobbies and spend more time with family and friends without having to deal with the 9-to-5 grind is certainly a worthwhile objective. Of course, early retirement requires careful planning, a commitment to saving and investing as much as possible during the working years, and employing tax-smart strategies to keep as much of your money as possible working for you instead of the government.

And speaking of tax-smart strategies… for those on track for or already enjoying early retirement who have significant balances in traditional retirement accounts—IRAs, 401(k)s, 403(b)s—it may be worthwhile to consider Roth conversion as a way to save on taxes and increase tax-free income in retirement.

Traditional vs. Roth

First, a few fundamentals. With a traditional account, you aren’t taxed on the money deposited in the account (you get a tax deduction for the deposits). Funds grow tax-deferred until retirement, at which time you pay taxes on withdrawals from the account at the same rate as your ordinary income. Many investors like to leave the funds in the account as long as possible, to take advantage of tax-deferred compounding and growth, but when you reach age 73(if born 1951-1959) or 75 (if born 1960 or later), you must begin taking required minimum distributions (RMDs) from the account.

A Roth account differs in several respects. First, you don’t get a tax break for depositing into the account. But once in the account, compounding and growth of the assets is tax-deferred, just as with a traditional account. And when you withdraw the funds in retirement, the entire distribution, principal and income, is tax-free. In addition, because of the passage of SECURE 2.0 in 2022, Roth accounts have no RMDs; the original owner can leave the money in the account as long as they want.

Roth Conversions and Taxes

Converting traditional accounts to Roth accounts can be especially advantageous for those who believe they will be in a higher tax bracket in retirement than they are presently. This makes sense for many soon-to-be retirees who own their own businesses, as many of the deductions presently available to them may go away when they retire. Paying taxes on the funds now and obtaining tax-free income later can be especially attractive if you anticipate a higher bracket in your future. And because Roth accounts have no RMDs, you also have the option to leave the funds alone entirely (though any non-spousal beneficiaries who receive the account as part of an inheritance must take distribution of the full account balance within ten years).

A key detail to note is the Roth five-year rule. Each Roth conversion starts its own five-year clock. If converted funds are withdrawn within five years and the account owner is under the age of 59½, a 10% early-withdrawal penalty may apply to the converted principal (though taxes have already been paid). For most retirees who do not need the funds immediately, this rule is not an issue, but it is an important consideration for those creating a Roth conversion ladder for early retirement income.

Timing Roth Conversions

From a timing perspective there are usually two different periods that most often recommend Roth conversions. First year of retirement until last year prior to filing for social security is when the capacity for conversions is generally highest, once social security starts opportunity is still there but to a lesser extent and that period lasts until RMDs start, so the year someone turns 72 or 74.

Weighing the Pros and Cons

To convert from a traditional to a Roth account, you must pay taxes on the amount of the exchange, in return for never having that money taxed again, either as the Roth account grows or when you take the money out in retirement. But the math requires some careful consideration. Should you pay taxes now, or should you wait until the money comes out in retirement? As mentioned above, if you believe your tax bracket in the future will be higher than it is today, then this move should save you money in taxes. If not, then it will cost you money. If the rates are the same, then the Roth conversion is basically a wash, as far as taxes are concerned.

But there are some other things to think about. Remember that if you convert, you are paying taxes today to get a tax break in the future. If today you deposited the funds you would not have paid in taxes into a side account, what rate of return might you receive? This is impossible to predict, but the same could be said for future tax rates.

A recent study compared several different factors and discovered that the length of time between the conversion and when the funds are withdrawn can influence the advisability of the Roth conversion. Of course, calculating this factor’s impact is also complicated, since we cannot accurately predict the future rate of return or the future tax rate. It’s also important to consider the tax and time-value-of-money cost of liquidating other parts of the portfolio today to pay those taxes on the Roth conversion.

Additional Benefits of Roth Conversions

Another benefit that is often overlooked is that reducing future tax rates with a Roth conversion also reduces the IRMAA surcharge that the retiree must pay on Medicare premiums. Additionally, lower future retirement income may result in realized long-term capital gains from after-tax brokerage accounts falling into lower brackets, what are currently 0% or 15%. Of course, those future capital gains bracket thresholds are also impossible to predict.

Persons with capital loss carryforwards from taxable accounts may be able to use them to offset up to $3,000 of ordinary income per year (after offsetting any applicable capital gains), which can help reduce the tax bill generated by a Roth conversion. Also, those who have net operating loss (NOL) carryforwards, such as those generated by a business or real estate, may have an opportunity to convert traditional to Roth assets at lower rates, making future tax savings more likely. All things considered, most Roth conversions can be expected to reduce total taxes within the joint life expectancy of a typical married couple.

Work with Your Advisors

It is vital, of course, for anyone considering a Roth conversion to discuss the matter thoroughly with a qualified tax advisor and their financial planner. These professionals can help you project future income under a variety of scenarios and help you choose the course most likely to provide you with the tax savings or other advantages you seek. Your Aspen advisor is always ready to help.

Bonus article: How to manage gifts to your kids without damaging your retirement.