IRAs are one of the most popular tax breaks for U.S. taxpayers. Traditional IRAs allow retirement savers to put money in a tax-favored account and defer any taxation on income or gains until they make withdrawals from the account. The longer you keep money in the account, therefore, the longer you can wait before having to pay taxes.
Tax deferral is a good thing, and that's why many people wait until the age at which the IRS forces them to start taking required minimum distributions (RMDs) from their retirement accounts. Currently, that age is 72, but in many cases, waiting that long actually doesn't lead to the best result for retirees. In some cases, an alternative can actually save you in taxes over the long run.
The other side of the RMD coin
Nobody likes to pay taxes sooner than they have to, and that's why delaying IRA distributions until hitting the RMD age is so popular. However, if you can pay less in taxes now in order to avoid paying more later, most people will find a way to reach that favorable outcome.
Image source: Getty Images.
Delaying your RMDs is a double-edged sword. On one hand, you do get to defer taxes that much longer. Yet by allowing the account to keep growing for a longer period of time, you'll typically end up with substantial increases in the amounts you have to take as RMDs when the time comes. Depending on the size of your account, the RMD amount can be so large that it forces you to pay a higher tax rate on a portion of your income.
In addition, large RMDs can cause havoc with other aspects of a retiree's personal finances. Taxable income from RMDs can push you over the limits to reap other tax breaks. Furthermore, those whose incomes exceed certain thresholds have to pay substantial surcharges on their Medicare Part B premiums.
Paying some taxes sooner to avoid paying more later
One strategy can give you more flexibility to handle RMDs more effectively throughout your retirement years. Specifically, doing conversions to a Roth IRA can help those who don't really need to take withdrawals from their traditional IRAs take advantage of low tax brackets earlier in retirement.
As an example, say someone retired at the beginning of 2022 upon turning 65 and has taxable income of $20,000 for the year. The person's filing status is single, and so for 2022, the 12% tax bracket extends up to $41,775 in taxable income.
In this case, the retiree could convert up to $21,775 in traditional IRA money to a Roth for the 2022 tax year while paying a 12% income tax rate on the converted amount. Doing so would reduce the retiree's traditional IRA balance in favor of boosting the Roth IRA account's assets.
Admittedly, the retiree would pay about $2,600 in extra taxes as a result of this move. However, doing so would achieve two positive outcomes: getting money into a Roth to generate tax-free future income and reducing the amount of the traditional IRA that would be subject to future RMD rules. Indeed, by age 72, those who haven't taken distributions or done Roth conversions often find that the RMD amount is high enough to send them into tax brackets of 22% or higher. In other words, paying that $2,600 now could save you from paying $4,800 or more in taxes later.
Using this strategy in multiple years between retirement and the age at which RMDs kick in can keep your tax rate on future distributions lower. Moreover, it partially protects you from potential tax law changes that could increase tax rates, as you'll already have paid taxes on the money converted to a Roth IRA, and it will be tax-free thereafter.
What to consider
There's no one-size-fits-all answer to the question of when it's best to start doing something with your traditional IRA money. Those who remain in top tax brackets even after retirement might not benefit much from doing Roth conversions, while those who need the income from their retirement accounts immediately upon retiring won't have the Roth conversion strategy as a viable option.
Nevertheless, it's useful to note that popular wisdom isn't always right when it comes to IRA distributions. If you can take advantage of low tax rates early in retirement, it could save you a lot in the long run.
