Contributing to a traditional IRA during your working years allows you to defer taxes, but you'll have to pay taxes on your withdrawals. You can end up paying less in taxes by deferring them and withdrawing from your traditional IRA when you no longer earn a salary.
You can move funds from your traditional IRA to a Roth IRA to keep them in a tax-protected retirement account. Your early retirement years are some of the best times to conduct Roth IRA conversions. Acting quickly may feel unnatural to long-term investors, but you can save a lot of money in the long run.
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Future growth is tax-free
The sooner you move money from a traditional IRA to a Roth IRA, the sooner you won't have to worry about paying additional taxes on future growth.
Any money you move from a traditional IRA to a Roth IRA is treated as ordinary income. That's why you should make these conversions incrementally, and it's also why early retirement presents a great opportunity. The money you move into a Roth IRA in your early 60s will grow tax-free, which will become a significant advantage 20 years later.
Some people don't contribute to Roth IRAs when they are working due to high tax rates or exceeding the Roth IRA's income limits. It is possible to earn too much money to contribute to a Roth IRA, but backdoor Roth IRAs work for these individuals.
Even after considering backdoor Roth IRAs, the traditional route may still be better when high earners are working. They may have to pay more than 30% in taxes on their top dollar, depending on where you are in the tax brackets, and traditional IRAs defer those taxes. Traditional plans serve their purpose, but when your income is significantly lower due to retirement, Roth IRA conversions become more sensible.
You can delay Social Security
You can take out Social Security when you turn 62, but you'll receive maximum benefits if you wait until you turn 70. However, Social Security shows up as ordinary income, and if you combine that with traditional IRA withdrawals, you can end up with a high tax rate.
People who retire in their early or mid-60s may want to move more money from their traditional IRAs to Roth IRAs. That way, the conversions count as ordinary income without other sources like Social Security putting you in a higher tax bracket.
When you turn 70, you must begin taking Social Security if you haven't already done so. At that point, you will end up with higher tax rates for future traditional IRA withdrawals and conversions. Early conversions give you more breathing room and can keep you in a lower tax bracket while enjoying tax-free growth.
Required minimum distributions catch some retirees by surprise
Some retirees may think that they don't need to do Roth IRA conversions or similar actions because they have held their investments for their entire lives. Moving money from one account to another and incurring higher tax bills now may not feel like the right move, but you're actually avoiding much higher tax bills in the future.
The IRS imposes required minimum distributions for traditional IRAs and 401(k) plans when you turn 75, assuming you were born in 1960 or later. Anyone who was born between 1951 and 1959 must make these withdrawals when they turn 73.
These withdrawals are not subject to a minimum amount, such as $10,000 or $20,000. RMDs are minimum withdrawals based on your life expectancy, and that's always based on a total percentage of your portfolio. If you have a $5 million portfolio and are forced to withdraw 10% of it, you'll end up with $500,000 in ordinary income. That annual withdrawal percentage increases as you get older.
RMDs can lead to a substantial tax bill, especially if you have a large portfolio. Converting traditional IRA funds into Roth IRA funds minimizes your RMDs when you turn 75. You will also receive Social Security at this time, which will put you in an even higher tax bracket.
RMDs do not apply to Roth IRAs, which will continue to grow tax-free. High RMDs can catch many retirees by surprise, especially those who have been prudent investors throughout their lives.
A large nest egg that's tied into traditional retirement accounts can become a major tax liability if you don't gradually prune it. Roth IRA conversions in your early retirement years are one of the best ways to mitigate this obstacle.
