Converting Traditional Retirement Assets to Roth Assets in Retirement

Converting Traditional Retirement Assets to Roth Assets in Retirement

Authors Note:

Several of my recent posts have been about mortgage debt in retirement and whether people should consider downsizing to a smaller home. 

I am working on the downsizing decision tree, which will appear behind the paywall in around a week.  I hope you subscribe.

This post is on a strategy for increasing financial wealth after downsizing.  The strategy has three components – (1) delay Social Security claims, (2) delay retirement plan disbursements and (3) convert traditional retirement assets to Roth assets.  

Introduction:

Many financial advisors recognize the benefits from delaying claims in Social Security benefits.

Social Security benefits are reduced by 30 percent for workers born 1960 or later who claim retirement benefits at age 62 instead of 67. In addition, each month delay in claiming retirement benefits after reaching the full retirement up to age 70 age, increases benefits by two thirds of one percent.  

Go here to the SSA site for a discussion of advantages of waiting until the full retirement age to claim Social Security benefits.  Go here for a discussion of the advantage to claiming Social Security at age 70.

The combined gains in delays from 401(k) disbursements and Social Security benefit claims while converting traditional retirement assets to Roth assets have not been fully publicized.   

The strategy of converting traditional retirement assets to Roth assets early in retirement can only be profitably implemented if the household has a low marginal tax rate. (The cost of the conversion is the additional tax on the amount converted, which depends on the household's marginal tax rate.).

Retirees must cover living expenses. If they are not claiming Social Security or taking funds from their retirement account, they must use liquid non-retirement assets.

The only taxable income for a retired person who is not claiming Social Security benefits or distributing funds from retirement account is usually a small amount of investment income.  (The basis on liquid assets from a house sale will be small compared to the basis of stock purchased 20 years ago. Also, the gains on sales of stock are taxed at a preferential rate.)

Retirees who have a lot of cash because of the sale of their home and can delay claiming Social Security and retirement plan disbursements are well positioned to convert traditional retirement assets to Roth assets.

The benefits of the conversion of the traditional assets to Roth assets are the reduction in tax during the year Roth assets are disbursed instead of traditional assets. There are two gains from the use of Roth assets.

·      The Roth distribution is not taxed.

·      The Roth distribution is not included in adjusted gross income and thereby reduces the amount of Social Security subject to tax. Go here for a discussion of the taxation of Social Security benefits.

Funds obtained from investment returns on the conversion of conventional assets to Roth assets cannot be disbursed without penalty or tax for five years starting January 1 of the year of the disbursement.   The five-year rule pertains to investment returns on all conversions, even those that occur after age 59 ½. 

An example of returns from converting traditional assets to Roth assets in retirement:

Examples of the potential advantages of converting traditional retirement assets to Roth assets early in retirement was published in this Tax Notes article.

A married couple with neither spouse claiming Social Security or disbursing funds from a 401(k) plan has substantial liquid assets.  Their investment income largely from capital gains taxed at a preferential rate on a joint return is $10,000.

They convert $34,550 in traditional assets to Roth assets, have $19,750 in taxable income and pay $1,975 in tax.

The cost of conversion in this instance is $1,975, the difference in tax paid with the conversion and the tax paid without a conversion. 

The investment of $34,550 in a Roth account that earns a 6 percent annual return would be slightly more than $46,000 in five years.

The one- year conversion covers a $39,000 distribution and leaves $7,000 for future distribution. 

A household distributing $50,000 from a traditional retirement account would pay around $7,072 in tax.  

The household that distributes $39,000 from a Roth account and $11,000 from a traditional account would pay approximately $400 in tax.  

The total tax savings from the reduction in tax five years after the conversion is $6,672.

The return in tax reduction from the conversion after five years is 28 percent.

R=(6672/1975^)(1/5) -1

There is an additional tax savings in year six from the disbursement of the remaining $7,000 plus additional gains in Roth assets.  The overall rate of return after a tax savings in a sixth year is around 31 percent.

Concluding Remark:  The possibility of being able to convert substantial traditional retirement assets to Roth assets is one of the factors considered in the downsizing decision tree, available soon.