Tax Diversification in Retirement Accounts

Learn why converting pre-tax accounts to a Roth IRA may reduce overall taxes and increase flexibility in retirement.

As retirement approaches, many people focus on investment allocation and income needs, however tax strategy is just as important. One effective way to improve the long-term efficiency of your retirement savings is by diversifying your accounts from a tax perspective.

Many retirees hold the bulk of their savings in pre-tax accounts like traditional IRAs or 401(k)s. Distributions from these accounts are taxed as ordinary income, which can lead to higher tax bills in retirement, particularly when Required Minimum Distributions (RMDs) begin.

The Role of Roth Conversions

A strategic option to consider is converting a portion of your traditional IRA or 401(k) into a Roth IRA. While the amount you convert is subject to income tax in the year of the conversion, the long-term benefits can be substantial:

• It’s all about tax rates today vs tomorrow: Simply put, you want to defer your taxes in a pre-tax account such as an IRA or 401(k) when you believe that your tax rate at deferral (today) will be higher than the tax rate in the future when it comes out of the account (tomorrow). If you believe your tax rate will be higher in the future, electing Roth contributions or converting pre-tax accounts to a Roth IRA now may make sense.
• Tax-Free Future Withdrawals: Qualified distributions from Roth IRAs are tax-free, giving you a valuable source of tax-efficient income in retirement.
• No RMDs: Unlike traditional retirement accounts, Roth IRAs are not subject to Required Minimum Distributions during the original owner’s lifetime. This gives you more flexibility in managing your income and taxes each year.
• Greater Withdrawal Flexibility: With both pre-tax and Roth accounts available, you can better manage your taxable income in retirement by choosing which account to draw from based on your tax situation in any given year.

Important Considerations

Keep in mind that Roth conversions are taxable events. It's important to understand how they might affect your current tax bracket, Medicare premiums, and overall financial plan. Always consult with your tax advisor or financial planner before proceeding.

By thoughtfully diversifying your retirement savings, you can gain more control, help reduce tax drag, and potentially extend the life of your portfolio.

Things to think about before you retire

• Not sure whether to elect Pre-Tax or Roth contributions on your current 401(k)?
  • We can help you think about the pros and cons of each
• Just retired with a large 401(k) and minimal income?
  • We can help you think about the potential benefits of beginning the Roth conversion process now that you may be in a lower tax bracket
• Worried about RMDs inflating your tax bill?
  • We can help you build a withdrawal strategy that may minimize taxes and maximize flexibility
• Need a second opinion on your current retirement plan?
  • Reach out to one of our Advisors and we would be happy to have a general discussion to see if you are on the right track