Why Early Retirement Roth Conversions Can Matter: Navigating Tax Brackets After Spousal Loss
Many of our clients approach us as retirement looms on the horizon, typically between the ages of 57 and 67. This period marks a significant transition in their lives. They're not only grappling with new regulations surrounding Medicare and Social Security but also shifting from being accumulators (saving money into their 401k) to decumulators (needing to spend their savings). Moreover, they're faced with the challenge of reinventing their identity beyond the occupational roles they've held for decades.
As you can imagine, this is a time filled with both challenges and excitement. However, amidst these immediate concerns, married individuals often overlook a crucial aspect of long-term financial planning: preparing for the day when only one spouse remains. While this reality is unfortunately inevitable and could occur at any moment, it's a topic I'd like to address today — specifically, why considering Roth Conversions early in retirement could potentially save a surviving spouse a substantial amount in federal taxes.
1. Increased Tax Burden for Surviving Spouses
While Roth 401(k)s have been around for a while, a good portion of our new clients still come to us with retirement savings heavily (if not predominantly) leaning towards being tax-deferred. This means that most of their savings is not entirely theirs - they still owe a significant piece to the IRS. Remember, all that money in your Traditional 401k will be considered additional taxable income if you withdraw it into your bank account for retirement spending.
What many retirees miss is that after a lifetime of filing their federal income taxes as Married Filing Jointly, when one spouse dies, the remaining spouse will eventually have to start filing their federal income tax as an Individual. If you're like some retirees, you may have a pension, your spouse may have a pension, and you each may have a Social Security check. While not always the case, most retirees will select a large portion (if not all) of their pension check amount to continue on to their spouse after their passing. Social Security works a bit differently, as the remaining spouse gets to retain the higher of the two Social Security checks, but the smaller benefit check disappears.
Let’s look at a married couple (John and Mary) while they are both alive:
Household Income While Both John and Mary Are Both Alive
Here’s what happens to Mary’s income if John dies before her (and John has it setup for Mary to receive all of his pension):
Household Income While Only Mary Is Alive
As you can see, Mary’s income drops but not by that much!
Now compare the Federal Income tax brackets for a married couple filing versus an Individual. You can see that higher income tax brackets kick in much faster for an Individual.
As a financial planner, I often advise retirees to consider Roth conversions while they can still file taxes as Married Filing Jointly. Here's why:
Lower tax rates: The Married Filing Jointly status typically offers more favorable tax brackets compared to filing as Single. This means you can potentially convert larger amounts to a Roth IRA at lower tax rates.
Future tax savings: By converting now, you're essentially "locking in" current tax rates. This can be particularly beneficial if you expect tax rates to increase in the future or if the surviving spouse might be pushed into a higher tax bracket. As of the writing of this article, the current Tax Cuts Jobs Act of 2017 is scheduled to expire at the end of 2025. If nothing happens at the Congressional level between now and then, tax rates are scheduled to revert to higher rates for most retirees.
Flexibility in retirement: Roth conversions can provide more flexibility in managing taxable income during retirement, potentially reducing the tax burden on the surviving spouse.
However, it's crucial to note that the optimal strategy can vary significantly based on individual circumstances, including current and projected future income levels, how pension survivor benefits are elected, overall retirement savings, and specific financial and estate planning goals. A personalized analysis is essential to determine if Roth conversions are right for your situation.
2. Capitalizing on Dynamic Income Years and Current Tax Rates
When I began working with retirees, I quickly realized that their paths through the retirement transition were far more varied than I had initially expected. While you might assume most follow a straightforward path—working until a specific month, then immediately transitioning to a stable income from Social Security, pensions, and scheduled investment withdrawals—this is often the exception rather than the rule.
In reality, the years surrounding retirement can be quite dynamic, presenting unique opportunities for tax planning and Roth conversions. Here are a few scenarios that illustrate why income during this period may differ significantly from later years in retirement:
Staggered Retirement: Often, spouses don't retire simultaneously. One might retire earlier, perhaps due to reduced household expenses (like paying off the mortgage or finishing children's education). This can lead to a substantial income drop until the second spouse retires, creating a window for tax-efficient Roth conversions.
Social Security Maximization: Some clients aim to maximize their Social Security benefits, especially if one spouse has a higher benefit, by delaying until age 70. During this gap between retirement and age 70, they might rely on more tax-efficient income sources, inadvertently creating another opportunity for Roth conversions.
Required Minimum Distributions (RMDs): Some retirees find their basic expenses covered by Social Security, pensions, annuities, or rental income, negating the need for additional investment withdrawals. However, at age 73, RMDs from tax-deferred accounts become mandatory, potentially causing a significant income spike. This creates a prime opportunity for Roth conversions in the years leading up to age 73.
These dynamic income years before settling into a more stable retirement income pattern offer an excellent opportunity to consider Roth conversions. By doing so, you can potentially lock in lower tax rates and provide long-term benefits, especially considering the eventual shift from Married Filing Jointly to Single filing status for the surviving spouse.
While Roth conversions might not be done solely for this reason, they can be a valuable strategy if you're on the fence about whether it makes sense for your situation. Remember, the opportunity to file taxes jointly only lasts as long as both spouses are alive, making it crucial to consider these strategies early in retirement.
3. Simplicity and Peace of Mind for the Surviving Spouse
The benefits of a Roth IRA are easy to sell. Once you pay the tax on a Roth Conversion, the funds grow tax-free for the rest of your life, there are no Required Minimum Distributions for Roth IRAs, withdrawals are tax-free after age 59 1/2, and when you die, the Roth funds go to your beneficiaries tax-free. What often gets overlooked is that it might not always make financial sense to pay the known initial Roth Conversion tax for the simplicity it provides, given the unknown factors of your future (such as lifespan, future tax brackets, future legislation, and your beneficiaries' income levels when they inherit).
However, what I've learned from experience is that sometimes financial planning and the decision to convert to a Roth IRA isn't solely based on optimal financial outcomes or minimizing taxes. Instead, sometimes it can be about moving towards simplicity. While I don't always recommend a Roth Conversion for these purposes, I genuinely appreciate conversations with clients who can see beyond the dollars and cents. These clients prioritize their overall financial and retirement goals, even if it means not maximizing every dollar over their retirement lifetime.
This pursuit of simplicity can be particularly relevant in early retirement, especially when considering the current Married Filing Jointly (MFJ) tax brackets. Here are some scenarios where simplicity might take precedence:
Cognitive Decline: As we age, managing complex financial situations can become more challenging. Converting to a Roth early on can simplify financial management for the surviving spouse.
Legacy Planning: Some retirees prioritize leaving a tax-free inheritance to their beneficiaries, even if it means paying more taxes upfront.
Flexibility in Retirement: Roth conversions can provide more flexibility in managing taxable income during retirement, potentially reducing stress related to tax planning.
While these considerations might not always align with strict financial optimization, they can significantly contribute to a retiree's overall well-being and peace of mind. As financial planners, it's crucial to balance the numbers with these more intangible, yet equally important, factors.
Conclusion
Similar to meeting with an attorney to update your will and other core estate planning documents, I understand that considering tax planning and Roth Conversions in light of a future loss of yourself or a spouse isn't a topic many of us want to pause and consider on the precipice of one of life's most exciting transitions. However, I do believe the current landscape of tax brackets and laws warrants this discussion sooner rather than later.
If you would like further reading on ways to simplify your retirement transition, please look at the bottom or on the side of this page for our guide: "5 Steps To A More Enjoyable Retirement: Simplifying Your Financial Life".
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Disclaimer: The following article is for informational purposes only and does not constitute personalized financial or tax advice. Please consult with qualified professionals before making any financial decisions based on this information.
As financial planners, we strive to provide valuable insights to help you navigate the complexities of retirement planning. However, it's crucial to remember that every individual's situation is unique. The strategies and examples discussed in this article are simplified for illustrative purposes and may not apply to all circumstances. We strongly encourage you to consult with a qualified financial advisor and tax professional to determine the best approach for your specific situation.
While we've discussed potential future changes in tax laws, such as the scheduled expiration of the Tax Cuts and Jobs Act in 2025, it's important to note that tax laws are subject to change. Always stay informed about current regulations and seek professional advice when making financial decisions.