A previous post explored the potential gains from converting traditional retirement assets to Roth assets whenever taxable income was low. This post explores a specific situation, the conversion of traditional retirement assets to Roth assets early in retirement prior to a person claiming Social Security benefits.
Many financial advisors recognize the benefits from delaying claims in Social Security benefits.
Social Security benefits are reduced by 30 percent for workers born 1960 or later who claim retirement benefits at age 62 instead of 67. In addition, each month delay in claiming retirement benefits after reaching the full retirement up to age 70 age, increases benefits by 2/3 of 1 percent. Go here to the SSA site for a discussion of advantages of waiting until the full retirement age to claim Social Security benefits. Go here for a discussion of the advantage to claiming Social Security at age 70.
The potential gains from delaying 401(k) disbursements and delaying claiming Social Security benefits while converting traditional retirement assets to Roth assets have not been fully publicized.
The strategy of converting traditional retirement assets to Roth assets early in retirement can be profitably implemented if the household has substantial financial assets outside of a retirement account to fund current consumption. In some cases, these liquid assets can be obtained by a household downsizing to a smaller home and using the house equity to fund consumption.
The cost of converting traditional retirement assets is the additional tax paid on the increased income stemming from the conversion. A household in retirement not claiming Social Security benefits and not disbursing 401(k) funds will have a low marginal tax rate and low conversion costs.
The benefits of the conversion of the traditional assets to Roth assets are the reduction in tax during the year Roth assets are disbursed instead of traditional assets. The amount of Social Security benefits subject to federal and state income tax is linked to modified adjusted gross income. Since Roth disbursements are not taxed and not included in modified adjusted gross income the disbursement from a Roth instead of traditional retirement plan can have a substantial impact on taxes.
Go here for a discussion of the taxation of Social Security benefits.
Funds obtained from investment returns on the conversion of conventional assets to Roth assets cannot be disbursed without penalty or tax for five years starting January 1 of the year of the disbursement. The five-year rule pertains to investment returns on all conversions, even those that occur after age 59 ½.
An example of returns from converting traditional assets to Roth assets in retirement:
This example of the potential advantages of converting traditional retirement assets to Roth assets early in retirement was published in this Tax Notes article.
A married couple — filing a joint return with $10,000 in investment income — converting $34,550 in traditional assets to Roth assets would have taxable income of $19,750 and would pay $1,975 in tax. The cost of conversion in this instance is $1,975, the difference in tax paid with the conversion and the tax paid without a conversion.
The investment of $34,550 in a Roth account that earns a 6 percent annual return would be slightly more than $46,000 in five years. The one- year conversion would, in this instance, pay for the $39,000 distribution and would leave $7,000 for future distribution.
A household distributing $50,000 from a traditional retirement account would pay around $7,072 in tax. The household that distributes $39,000 from a Roth account and $11,000 from a traditional account would pay approximately $400 in tax.
The total tax savings from the conversion, assuming a 6 percent return on converted assets is around $7,700.
The rate of return on the conversion is estimated a 30.7 percent.
Concluding Remark: People entering retirement can extend the longevity of their retirement savings by initially using non-retirement assets to fund consumption, by delaying claiming Social Security benefits and 401(K) disbursements, and by converting traditional retirement assets to Roth assets.