Taxes and tax credits are a critical piece of the puzzle when it comes to retirement. This week we look at a couple inquiring about the best tax strategy for their assets now that they’re retired.
The situation
Michael, 63 and Sandy, 61, of Grand Junction, have been married for 32 years and have both entered retirement in the past three years.
Michael and Sandy’s primary question is should they convert some traditional IRA money to a Roth IRA that grows tax-free? Last year they actually had negative income (a loss of over $20,000) with their rental depreciation and other deductions greater than their income. Their situation has an added twist because if they create income with a Roth conversion they will give up some or all of the health insurance “Premium Tax Credit” they could receive by converting.
The Premium Tax Credit was created under the Affordable Care Act. It offsets the cost of health insurance for low-income families who qualify. Michael and Sandy retired early and used the website to purchase their health insurance. Last year they received a refundable $13,400 Premium Tax Credit. Michael and Sandy asked What’s The Plan for help when they realized that they could use this credit in future years to offset income from a Roth IRA conversion.
Together they receive approximately $5,000 per month from three rental properties on the Western Slope. Sandy has $321,281 in a traditional IRA, $100,432 in a Roth IRA, and receives $2,489 from her pension each month. Michael has $317,204 in a traditional IRA, $162,934 in a Roth IRA, and $1 million in a self-directed rollover IRA. Their home is worth $1.2 million. They’re thinking of moving to the Fort Collins and purchasing a home of similar value, and if they do will still choose to have a low-cost mortgage of 3.25 percent with a balance of $370,000.
Recommendations
The couple’s research into this topic is very insightful. It makes sense for many individuals in Michael and Sandy’s situation to convert enough IRA to Roth IRA to bring their income up to $0 — in their case by converting about $20,000 each year. It is wise for them to consider voluntarily paying taxes while they are in a low tax bracket before age 70½ so they will not be forced to pay higher taxes after age 70½ when they are required to begin taxable IRA distributions. The question of how much to convert should be estimated in each individual’s situation and within each calendar year.
We modeled numerous scenarios for Michael and Sandy and we recommend that for the next two years Michael and Sandy convert approximately $57,000 per year. The cost for these two years is approximately $12,340 per year between the additional tax of approximately $4,343 and the credit reduction of approximately $7,997 due to the conversion. We project that approximately five years of tax-free growth in the Roth IRA will outweigh the cost. Although this is a logical recommendation, it is very difficult emotionally to forgo the tax credit! If they decide to convert only $20,000 per year for the next two years, we can empathize with that decision to enjoy the immediate gratification of receiving the $13,400 tax credit each year!
Between Michael’s ages of 65 and 70½, when they are eligible for Medicare and no longer eligible for the premium tax credit, they should take the opportunity to convert as much as possible while remaining in the 15 percent Federal Tax Bracket. They’ll need to continue to calculate how much to convert into a Roth IRA year by year.
When Michael is 70½, he will be required to start distributing money from his IRAs, a process called “Required Minimum Distributions.” If they do no Roth conversions before then, it is very likely that the minimum distribution will have to be taxed in the 25 percent Federal Tax Bracket. This is where the Roth conversion will really save money. Having less money in the Traditional IRAs will result in smaller required taxable distributions. We project that converting over the next 7 years could save over $2,400 per year in taxes starting at his age 70½!
The above nuances will optimize this couple’s picture, and their smart choices for over three decades set them up for success. Our projections show that they can spend approximately $13,000 per month, after adjusting for taxes and inflation and continue until Sandy’s age 95. They’ve made many wise decisions, and it’s an honor to contribute to their continued prosperity.
Pam Dumonceau has 21 years of experience in the financial planning industry. What’s the Plan is not a substitute for financial planning or dedicated professional advice.
What’s your plan?
Ask Pam what you should do — e-mail whatstheplan@consistentvalues.com to get advice. Names and identifying information are changed to protect confidentiality.
