4 Steps for Managing Income Withdrawals in Retirement

4 steps for managing income withdrawals in retirement

A huge golden egg sits in a bird’s nest on a green hill under a blue sky. Getty Images

If you’re like most Americans nearing retirement, you’re worried about whether you have enough savings. In fact, only 22% of those approaching retirement believe they’ve saved enough to retire comfortably.

At a time when the stock market is down, inflation is rising and Americans are living longer than ever, concerns over the sustainability of retirement savings are no surprise. What you may not realize is that there are approaches that can stretch the savings you do have to position yourself more favorably in retirement.

    One such strategy is Roth IRA conversions. Essentially, when you make a Roth conversion, you pay the taxes that would otherwise be due during retirement at the time you convert. Then, when you retire, you’ve already paid the tax that you would otherwise pay during retirement on required minimum withdrawals (RMDs) from traditional IRAs. As tax laws currently stand, those withdrawals must begin at age 72.

    By engaging in Roth conversions, you gain freedom from at least some of your RMD requirements, while also positioning yourself to ultimately pay lower taxes in retirement. In this article, I’ll walk you through the four-step process you can follow to lower your taxes and stretch your savings dollars further in retirement.

    Step #1: Assess Your Retirement Savings

    The first step in this process is to analyze your retirement savings. By that I mean understanding the tax status of your retirement savings.

    For this purpose, divide the savings you have now into three categories:

    • Taxed Later: Traditional IRAs and 401(k)s are types of savings accounts that give you a tax deduction at the time you contribute. Those savings will be taxed later in retirement, when you withdraw them –  and the amount you pay taxes on includes both your contributions and the growth they accumulated over the years.
    • Taxed Now: Taxable savings are held in brokerage accounts, mutual funds, banks, etc. In other words, these are savings that you put in investment or savings accounts that you already paid taxes on but received no deductions. Taxes will be due on these savings if you realize capital gains through a sale or receive interest or dividends.
    • Taxed never: You will never pay taxes on qualified withdrawals from your Roth IRAs. Taxes will never be due on those funds because you already paid them when you converted a traditional IRA to a Roth or contributed to the Roth. One thing to keep in mind: You can withdraw your contributions to your Roth IRA at any time without paying taxes on them, but in order to withdraw the gains on your investments tax-free and penalty-free, you must be at least 59½ and have owned a Roth IRA for at least five years, with a few exceptions, such as a first-time home purchase and paying for college expenses.

    Here’s an example for a couple, who we’ll call Ed and Susan, who have a total of $2 million in savings at age 60.

     

    Total

    Susan

    $800,000

    $0

    $0

    $800,000

    Ed

    $1,200,000

    $0

    $0

    $1,200,000

    Joint

    $0

    $0

    $0

    $0

    Total

    $2,000,000

    $0

    $0

    $2,000,000

    Percentages

    100%

    0%

    0%

     

    Taxed Later:

    Traditional 401(k)

    Taxed Now:

    Investment Account

    Taxed Never:

    Roth IRA

    Ed and Susan’s situation is extremely common. Most of the individuals and couples who are getting closer to retirement have most – if not all – of their assets in the Taxed Later bucket. This is why the strategy I’m describing to you offers advantages –  because it has the potential to reduce your tax burden while stretching your overall savings, as we’ll see.

    That means you’ll be more comfortable and confident in retirement.

    Step #2: Create a Roth Conversion Strategy

    Of course, the obvious issue with Roth conversions is paying the taxes today. It’s no fun to increase your tax bill on purpose, on top of what is already a significant tax bite. But here’s the good news: If you’re like most Americans, you pay your taxes through payroll deduction, which means you essentially don’t see that expense come out of your bank account.

    That means it is definitely possible to create some room in your budget to pay the taxes on some amount of a Roth conversion. Think about it like another form of retirement savings – you’re paying taxes now to reduce your taxes in the future, when you’re in retirement.

    There are ways to manage a Roth conversion over time to suit just about any budget. The earlier you start, the easier it is.

    Let’s say that at age 60, Ed and Susan potentially have 12 years to convert before they reach age 72, the age at which RMDs start. I don’t want to overcomplicate this, but you should know that the IRS does have rules around withdrawing money from a Roth IRA after conversions. Those rules, known as five-year rules, essentially restrict your ability to withdraw money tax free from a Roth until after the money has been in the account for five years. To be safe, that means I would advise Ed and Susan to only withdraw funds from their Roth IRA that have cleared this five-year threshold.

    Once you’ve identified your situation and how much money you have in the Taxed Later bucket, you can decide, based on your budget and tax bracket, how much you could afford to convert each year. Obviously, the more you can convert the better. But even converting over time 20%, 30% or 50% of your Taxed Later bucket will go a long way toward reducing your tax burden and stretching your savings.

    Step #3: Compare Retirement Taxes with and without Roth Conversions

    Let’s take a look at Ed and Susan’s tax situation in retirement.

     

    Without Roth Conversions

    With Roth Conversions

    Social Security

    $60,000 taken at age 67

    $60,000  taken at age 67

    Taxed Later

    $70,000 from Traditional IRA

    $20,000 from Traditional IRA

    Taxed Never

    $0

    $40,000 from Roth IRA

    Annual Gross Income

    $130,000

    $120,000

    Taxable income

    $92,300

    $6,645

    Federal Tax Rate

    22%

    10%

    Federal Tax Due

    $11,540

    $665

    Let’s unpack this example. In the first column we see what happens without any Roth conversions. In this case, because Ed and Susan must rely on their traditional IRAs for all of their income needs in retirement outside of Social Security, they must withdraw $70,000 a year to maintain their standard of living and pay their expenses, including their $11,540 federal tax bill. To simplify this example, I haven’t included state taxes, but if you live in a state where state income taxes are levied, you need to include that in your personal calculations.

    However, in the Roth Conversion column, because they engaged in a significant amount of Roth conversions, they can minimize their withdrawals from their traditional IRA. Their conversions also reduce their required minimum distributions, or RMDs, that the IRS requires from traditional IRA owners once they turn 72 – which reduces their taxable income.

    In addition, because their taxable income is much lower after their conversions, less of their Social Security benefit is subject to tax. When your adjusted gross income, tax-exempt interest income and half of your Social Security benefits are between $32,000 and $44,000 if you are married filing jointly, you are taxed on up to 50% of your benefits. However, if your income exceeds $44,000, up to 85% of your benefits may be taxable.

    This example clearly illustrates the benefits of Roth conversions. Ed and Susan actually withdrew slightly less money under the Roth Conversion example, but had more net income that they could spend, since they didn’t have to pay any federal taxes. Without the Roth conversions, they would continue to have tax obligations that put a dent in how much of their income they could actually spend.

    Step #4: Execute on Roth Conversions

    The final step in this process is actually engaging in Roth conversions. Before you do so, it’s a good idea to consult with your tax adviser as to what your tax obligation will be from these conversions. You’ll also need to involve your financial adviser or the financial institution that holds your IRA accounts. They will execute the actual conversion based on your instructions.

    A Final Word

    When strategically utilized, Roth conversions have the ability to minimize your tax burden in retirement while stretching your savings. As you prepare for retirement, it’s important to determine your specific situation and whether Roth conversions might work for you.

    This information has been provided by a financial professional and does not necessarily represent the views of the presenting professional.  The statements and opinions expressed are those of the author and are subject to change at any time.  This material has been prepared for informational purposes only.  All information is believed to be from reliable sources; however, presenting insurance professional makes no representation as to its completeness or accuracy. Provided content is for overview and informational purposes only and is not intended and should not be relied upon as individualized tax, legal, fiduciary or investment advice. The hypothetical examples provided are for illustrative purposes only; they do not represent any real-life scenarios and should not be construed as advice designed to meet the particular needs of an individual’s situation. The information contained herein is based on our understanding of current tax law. The tax and legislative information may be subject to change and different interpretations. We recommend that you seek professional legal advice for applicability to your personal situation. This information is not approved, endorsed or authorized by the Social Security Administration. Investment advisory services offered by duly registered individuals through CreativeOne Wealth, LLC a Registered Investment Adviser.  CreativeOne Wealth, LCC and MOKAN Wealth Management are unaffiliated entities.

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