When people retire they often drop down a tax bracket because they no longer have any earned income. For example, a couple may be in a 25% tax bracket while they're working, but after they retire they could easily find themselves in the 15% tax bracket.
Once they reach age 70 1/2, these retirees have to start taking required minimum distributions out of their IRAs and other tax-advantaged retirement plans. Also, they may have delayed Social Security until 70 to get a bigger check. When all of this extra taxable income kicks in after age 70, they often jump right back up into a higher tax bracket, like 25%, for the rest of their lives.
For example, when a couple retires at age 65 they may have a five-year window, sometimes called the Goldilocks Zone, where from 65 to 70, they can take advantage of being in a lower tax bracket to cut their taxes through the use of tax bracket Roth conversions.
The idea is to pull money out of your pre-tax IRA while you're in a lower tax bracket, like the 15% bracket, and convert it to a Roth IRA. You'll lose 15 cents on the dollar in taxes when you do the conversion, but it may save you on taxes in the long run.
When you reach 70 1/2 and those taxable required minimum distributions kick in and possibly some delayed taxable Social Security, if it throws you into a higher bracket, like 25%, for the rest of your life, you'll save 25 cents on the dollar from that point on when you spend the Roth IRA money because it's now tax-free.
To illustrate, let's say Bob and Alice, a married couple filing a joint return, retire at age 65 and because they no longer have any earned income, they drop into the 15% tax bracket. Let's also assume they can trigger an extra $30,000 a year in taxable income and still be in the 15% bracket.
Now they convert $30,000 of their pre-tax IRAs into Roth IRAs to use up the rest of their 15% tax bracket. They would have to pay $4,500 in federal taxes when they convert. In 10 years, the $30,000, which is now in Roth IRAs, is worth $53,725 assuming it averages a 6% rate of return. If this couple now decides to pull the money out, it's all free and clear of income taxes forever.
On the other hand, if they had left the $30,000 in the pre-tax IRA and took it out in 10 years, they would have to pay tax in a 25% bracket, assuming their required minimum distributions and delayed Social Security pushed them into this bracket after age 70.
Using the same 6% rate of return, after they pay the tax, they would have $40,294. They would still have the $4,500 that now wouldn't have to be used to pay tax on the Roth conversion. This would have grown to about $7,524 after-tax. Add these two numbers together and the total is $47,818 after-tax vs. the $53,725 on the Roth which is tax-free. That's a $6,000 difference in favor of the Roth.
If this couple repeats this same strategy for five years from age 65 to 70, while they are temporarily in a 15% bracket, it would save them $30,000 in taxes. Welcome to the Goldilocks Zone.
Mike Piershale, ChFC, is president of Piershale Financial Group in Crystal Lake, Illinois. He works directly with clients on retirement and estate planning, portfolio management and insurance needs.