Extend the Life of Your Nest Egg 

Roth IRA Conversion

After reaching financial independence, you have two options to generate income to cover your expenses: 

  1. Continue working 
  2. Draw income and principal (eventually) from your investments 

Yes, it is possible to live only on the income generated from your investments. Yet, for many people, they will be required to dip into the principal at some point. 

At financial independence, you will have created several buckets of income sources. In general, these buckets may look like this: 

  • Taxable today bucket 
    • Interest 
    • Dividends 
    • Capital Gain 
  • Taxable withdrawal bucket 
  • Tax preference bucket 
    • Real Estate 
    • Oil & Gas 
    • Tax-exempt bonds 
  • Tax-free withdrawal bucket 

Reaching financial independence means you were great at filling these different buckets. Emptying these buckets requires an entirely different outlook. 

The way you decide to empty these buckets can affect the life of your nest egg by up to 10 years.  

What this means is if you spend $50,000 a year, you could add up to $500,000 of additional income on to your nest egg without spending less or earning more.  

How is this done? By implementing a tax strategy 

Retirement income tax strategy 

A retirement income tax strategy is taking advantage of differences in tax rates between today and tomorrow. As well as the tax characteristic of the money needed to fund your living expenses. 

Looking at the tax rates between today and tomorrow is the most important step in the decision process.  

In practice, the general consensus is that tax rates will continue to climb in the future. While a forecast is unreliable, there are many reasons to believe this is true.  

In the short-term, you are able to make decisions over your future tax rate.  

When you are under 70 1/2 years old, you are able to dictate where you generate your living expenses. Once you turn 70 1/2 you no longer have the same flexibility. 

By age 70 1/2 you must take Social Security and Required Minimum Distributions.  

This creates what is called the “Tax Torpedo.” Your taxable income reaches a steady threshold for the rest of your life, creating your perpetual tax rate.  

What is not a Retirement Income Tax Strategy  

After entering retirement there is a common belief that you should keep your tax rate as low as possible. This means living off low, or no tax rate income sources.  

Drawing from the list above this typically means covering living expenses with the Taxable Today Bucket as well as Tax Preference Bucket. Your Taxable Withdrawal and Tax-Free Withdrawal Bucket remain untouched.  

It’s common that this strategy will leave you in the lower tax brackets of 10% or 15% for the first bunch of years during retirement.  

Living in this low tax bracket is great in the short-term, but long-term you could be missing out a very important opportunity.  

Instead of passively enjoying a low tax bracket you should consider employing a tax strategy … one that is highly likely to extend the life of your nest egg. 

Incremental Roth Conversions 

An active approach to extending the life of your nest egg is employing incremental Roth Conversions. 

Incremental Roth Conversions is a strategy that takes money out of your Taxable Withdrawal Bucket and put into a Roth IRA. Here are the steps: 

  1. Distribute money from your Taxable Withdrawal Bucket 
  2. Pay tax on the disbursement from your Taxable Today Bucket 
  3. Deposit the money into your Roth IRA 

The combination of Step 2 and Step 3 might leave you scratching your head…. Why would I take money out to pay tax and then reinvest that money? Why don’t I let the money grow tax-deferred? 

The answer… Arithmetic! 

The arithmetic behind this tax strategy can be tremendous. The combination of the time value of money and tax bracket management (i.e comparing today’s tax rate to tomorrow’s) creates an opportunity to add up to 10 years on to the life of your nest egg!  

Roth IRA Conversion – How much? 

Employing a Roth IRA Conversion strategy has a lot going for it. Executing the transaction is where some difficulties exist.  

The key to a Roth IRA Conversion is to convert the money at a tax rate lower than when you would begin to live off the money. The second key is the years that the Roth IRA money will be invested. The longer the time horizon, the less the future tax rate matters.  

That said, it’s rarely recommended to complete a Roth Conversion into higher tax brackets. Executing a Roth IRA more than your projected future tax rate will have limited benefits. Be careful. 

The general strategy is executing Roth Conversions up to a given tax bracket. For example, your income sources to cover living expenses get you to the 15% tax bracket. Your analysis states you should complete Roth Conversions up to the 25% tax bracket. 

In our current tax rate environment, there are 5 dimensions to keep in mind. In addition to the 5 dimensions, there are Medicare Part B premiums, which could be negatively affected by a Roth Conversion strategy.  

While there are obstacles to executing a good Roth Conversion, the benefits behind the strategy can significantly outweigh those obstacles.  

Establish your retirement income tax strategy, and you could enjoy 10 additional years on your nest egg. 

 

This is one example of how one couple can increase their wealth with a tax strategy. Your situation might be different causing the need to for a different strategy. Become educated in this area or work with a qualified expert.  

___________________________________________________________________________________________

Do you want to understand how to make your money work for you and keep more of what you have earned? 

Reach out to me at nbyers@jbcwealthadvisors.com or schedule a free consultation.

___________________________________________________________________________________________

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor,  and all rights are reserved. Read the full Disclaimer in the footer below.