Do you have a path to be close to $0 traditional IRAs at the time you start Social Security?
Posted on May 10, 2024

If you can convert traditional to Roth at the 22% marginal rate before you retire and are on Social Security, you will gain about 4% after taxes relative to holding traditional IRAs. You’ll have more by paying 22% tax now and avoiding 25% or more tax later on the intital distributions from a traditional IRA. You will never pay less than 22% effective tax rate. This post explains how to judge if you have a path to convert all or almost all traditional IRA to Roth before you start collecting Social Security. If you have no path, it does not make sense to convert.


My last post described two bad effects of distributions from traditional IRAs that increase the effective tax rate to ~25%: your initial distributions increase the percentage of Social Security that is taxed, and enough distributions trigger 15% tax rate on capital gains income, not 0%. You avoid these effects if you only had Roth IRAs.


This table shows that if you convert traditional to Roth at 22% rate you gain 4% after taxes relative to keeping your traditional IRA that will be taxed at 25%.


== Example of a path ==


Joe and Jane are married and file a joint return. They are both 57 years old. They have annual ordinary income – almost solely wages – of $160,000. They only contribute to Roth IRAs for their retirement savings. They have traditional IRAs of $600,000 from prior employers. They plan to retire in nine years at age 66. They plan to start taking Social Security then. They expect their income to remain constant relative to inflation until they retire. They do not itemize deductions. How much traditional IRA can they convert to Roth and still remain in the 22% marginal tax bracket?



Their taxable income for 2024 is ~$131,000. They are in the 22% marginal tax bracket and ~$70,000 below the top of that bracket. They can convert $70,000 per year for the next nine years. That ~$70,000 is about right for nine years, since their portfolio will likely grow. Unless portfolio returns are wild, they will be able to start retirement – before they start on Social Security – with NO, or essentially no, traditional IRAs. They will net ~4% more after taxes in retirement relative to keeping their traditional IRAs.



== If you have no path ==


It’s a bit of all or nothing: if you don’t see that you have a path that gets you to NO or very little traditional by the time you start collecting Social Security, you have little reason to convert traditional to Roth. You can’t avoid the eventual required distributions from your traditional IRAs that will effectively be taxed at 25%. You can’t capture the full benefit of avoiding a high effective tax rate on distributions from traditional IRAs.


== Converting is straightforward ==


• Joe and Jane will convert $70,000 of traditional to Roth this year. That all will be in the 22% marginal federal tax rate.


• They could sell $70,000 of securities, have their broker withhold $15,400 and transfer a total of $54,600 cash to their Roth IRAs, and then invest it. (They could also sell $15,400 of securities in their traditional IRAs and have their broker withhold that cash for taxes. They then then transfer shares equal to $54,600 in value to their Roth IRA.)


• Their tax reporting statements issued next January (1099-Rs) will show a total of $90,000 distributed from traditional IRAs with $19,800 of taxes withheld. They’ll enter the $90,000 on page 1 of their 1040 tax return. They’ll add the $19,800 to total taxes withheld.



Conclusion: The ideal would be to have all Roth IRAs and no traditional IRAs at the start of retirement, since much of the distributions from traditional are effectively taxed at 25% or more: that’s from their effect of increasing the percentage of Social Security is taxed and their effect on the level of taxable income that triggers 15% capital gains tax, as opposed to 0%. If you only have Roth, you’d escape those effects.


If you plan this early enough, you may be able to convert enough of your traditional IRA such that you have NO or very little traditional IRA before your start taking Social Security. The potential benefit is about 4% more in retirement: you are paying 22% to convert but avoiding at least 25% tax if you held on to your traditional IRAs.

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