Doug Gjerde, MBA, CEPA, CFP©
Are you in the sweet spot for saving taxes? We all have a 12 1/2-year period we’ll have the maximum chance to use some powerful tax strategies. If you take the right steps, you can cut your lifetime tax rate significantly. Yet many people miss out.
Many people are unaware of the sweet spot because they are on autopilot – they’re following what seems like common wisdom. It seems like common sense, and they have heard it from co-workers and friends and read it in articles. They’ve been advised to put off paying taxes on their retirement funds as long as they can.
This seems wise, and it used to be good advice. Now, for more and more people, this is not the best advice. Following it blindly may cost tens, if not hundreds of thousands more in taxes than is required. We may be the first generation to have higher taxes in retirement than in our working years. Many people are not thinking this through soon enough and they are missing out. Proactivity and education are two benefits you may gain from a professional advisor.
Can you answer these two questions?
- When is the earliest point at which you may take funds from your tax-deferred retirement savings (IRAs, 401(k), 403(b), etc.) without incurring a fine?
You’re correct if you guessed that it’s 59 1/2.
- There is a penalty for not taking some of your money out (and paying taxes on it) after what age?
If you guessed 72, you are right. You are required to take out a certain amount of money each year starting at 72. These are called Required Minimum Distributions (RMDs). If you miss the deadline, the IRS will fine you 50% of the missed distribution. That’s right, the IRS will take 50% of your retirement savings if you mess up.
The IRS wants to make sure you pay taxes, that you’ve deferred for decades, on your retirement savings eventually. Those rules favor the government. The problem is that the government’s rules are not always in sync with what is best for the retiree.
There is a period when we can take money out of these accounts without being penalized and we can let it be and we won’t get fined either. We get a “penalty-free period” between 59 ½ and 72 years old. One of my mentors, Ed Slott, refers to this as a period of relatively rule-free bliss or the calm before the storm. This is the best time to take advantage of some powerful strategies that may reduce your lifetime tax rate.
What should you do during the sweet spot?
If you are in the sweet spot, there are three key things you can do to help reduce your taxes.
- Convert your traditional IRA to a Roth IRA
- Do a backdoor Roth conversion
- Max out your retirement accounts
Which is best for you depends on your unique situation. In this article, I’ll focus on Roth conversions.
One of the things people can do during these gap years is to do strategic Roth conversions. This is a way to move money from IRAs (which are always taxed) into Roth IRAs (which never have to be taxed again).
I’ve seen clients with large IRAs who can save hundreds of thousands over their lifetimes by converting funds from IRAs – money that must be taxed at some point – to Roth IRAs, where it may grow tax-free for many years and when used is tax-free. The catch is that you must pay tax on the conversion. What we’re doing is paying a little now to avoid being compelled to pay much more later.
I also have clients who retired early and converted all their IRA money before 68, meaning they will never have an RMD throughout their lives. They converted their IRAs in low-tax brackets, and this got the money compounding tax-free early, and because later RMDs would have caused more of their Social Security to be taxed, they will save tax on their Social Security benefits as well.
There is a lot of opportunity in the gap years – the sweet spot for tax planning. Don’t let it pass you by.
Converting from a traditional IRA to a Roth IRA is a taxable event.
This piece is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.