Summary/TL;DR
A Roth IRA is one of the most powerful tax-planning tools that retirees have at their disposal because they give one the ability to better control their adjusted gross income. With this control, numerous tax-planning strategies such as avoiding the social security tax-torpedo, planning for RMDs, maximizing the premium tax credit, making tax-free IRA distributions or Roth conversions, paying a 0% long-term capital gains tax rate, and passing tax-free wealth down to your heirs, may all be pursued independently or in combination to realize massive amounts of lifetime tax-savings.
Introduction
The single most valuable thing that Roth accounts afford you in retirement is flexibility. When all of your retirement savings are held in pre-tax accounts, you have no ability to control the taxability of your distributions, and therefore no ability to take advantage of a variety of tax planning tools that, when properly applied, will save you an astounding amount in taxes. Distributions from Roth accounts, however, are never included in taxable income. A healthy mix of retirement savings between pre-tax and Roth accounts therefore grants options when distributing from retirement accounts in order to optimize tax-efficiency without sacrificing take-home pay.
The common theme in all of the examples we’ll discuss today is that the ability to control your adjusted gross income (AGI) is of paramount importance when it comes to tax planning. The utility of this potential will be explored in six examples of proactive tax planning.
1) Save Taxes On Social Security
Many retirees (and many financial advisors) don’t know that social security is unique in the way it is taxed. Only a percentage of your total social security benefits, ranging from a minimum of 0% and a maximum of 85%, will ever be included in taxable income. The number that determines where in the range you will fall is called provisional income. All you need to know about provisional income is this – the lower your AGI, the lower your provisional income. Therefore, the lower your AGI, the less of your social security benefits will be taxed. Roth IRAs are exceptional tools for keeping provisional income low, creating the potential for massive amounts to be saved in taxes on social security benefits.
Let’s assume, for example, that a married couple needed $120,000 in take-home pay and received $60,000 in annual social security benefits. If their only investment account was a Traditional IRA, they would need to distribute about $70,000 to receive $120,000 after-taxes for the year, with an annual tax liability of about $10,550.
If, however, they were better tax diversified and were able to take a $32,000 distribution from a Roth IRA, then they would receive the same $120,000 in take-home pay, but would save about $8,500 in taxes for the year (cutting their effective tax rate by more than 50%!).
Notice the highlighted cell in the example above. The Roth IRA distribution not only had the effect of reducing taxable income in an amount equal to what wasn’t taken from the Traditional IRA, it also dramatically reduced the amount of social security benefits included in taxable income (from $51,000 to $19,600).
2) Pay Less In Health Insurance Premiums
Those that plan on retiring before Medicare eligibility will need to spend a few years on a private health insurance plan, the cheapest of which can still cost over $1,000/mo per person. Fortunately, a tax-credit (called the Premium Tax Credit) currently exists for “low-income” taxpayers in which the government will reimburse you for a portion of premium costs. The way the tax credit is determined is quite complex, but you can likely guess by this point in today’s post that the key variable is AGI.
Similar to how utilizing a Roth IRA to lower taxable income had the secondary effects of reducing the amount of social security included in taxable income or making long-term capital gains be taxed at 0%, using a Roth IRA to keep taxable income low can also have the secondary effect of increasing the Premium Tax Credit that you are eligible for.
I’ve recently introduced this tax-credit to a new client’s financial plan, and she is expected to save up to $10,000 in health insurance premiums beginning next year! While its relevance is usually limited to only a few years, the savings generated from Premium Tax Credit can still make a very large impact in the long term.
3) Pay 0% Long Term Capital Gains Tax
When you sell securities in a non-qualified account, the amount sold that’s attributable to a long-term capital gain is taxed at a different (more favorable) rate than your ordinary income. In 2024, for those with $47,025 of taxable income ($94,050 if married), the long-term capital gains rate is 0%! In other words, by using a Roth IRA to keep your taxable income low and utilizing some savvy distribution planning, you can essentially turn your non-qualified accounts into a Roth IRA.
If we made the same assumptions as the social security example above but replaced the $30,000 taxable IRA distribution with a $30,000 distribution from a non-qualified account (75% of which was attributable to long-term capital gains), then this couple would still receive their $120,000 in annual take home pay, but would owe $0 in taxes! The $22,500 in long-term capital gains, while included in taxable income, is all taxed in the 0% bracket.
4) Decrease Your RMDs
Required minimum distributions (RMDs) from pre-tax retirement accounts become mandatory between ages 73-75, depending on your birth year. If you have poor tax diversification, allowing your pre-tax accounts to continuously grow without converting anything to Roth, you could be headed straight for a tax-bomb that will have far more of your wealth than is necessary going to Uncle Sam instead of to your heirs.
For example, a 75-year-old with a $4,000,000 Traditional IRA will be forced to distribute around $160,000 from their IRA. Assuming they and their spouse also had $60,000 in annual social security benefits, they would immediately find themselves comfortably within the 22% tax bracket for the rest of their lives!
Their RMD would increase as their accounts continue to grow and as they get older, threatening to put them into an even higher tax bracket, increase their Medicare premiums, or both! Furthermore, this will crowd-out their ability to pursue any of the tax-planning strategies explored above, as the mandatory nature of these distributions places a high floor on their taxable income that nothing can be done about. Roth IRAs, however, are not subject to RMDs and are allowed to grow, uninterrupted and tax-free, for as long as you and your spouse are alive.
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