Many people — myself included — have assets in a conventional individual retirement account (IRA). When I was younger it was conventional wisdom that when I retired, I would probably be in a lower tax bracket. Thus, IRA contributions could grow tax-free for many years before I finally began to make withdrawals, paying lower taxes on them in my retirement years.

I began to maximize my IRA contributions as soon as I started working. Over the years I built up a sizable nest egg in my various IRAs before the tax implications began to dawn on me.

A Growing Problem

As my IRA accounts grew, it became clearer to me that my retirement income would likely push me into a higher tax bracket. Those deductions I took when I was in a 15% federal tax bracket (and in a state with no state income tax) could get taxed at double that rate if my income was significantly higher in retirement. It could also be subject to state income taxes.

If your traditional IRA has grown substantially, you may fall into this category. Further, you may not have a choice, because of required minimum distribution (RMD) rules.

The IRS requires you to start taking withdrawals from your IRA, SIMPLE IRA, SEP IRA, or retirement plan account when you reach age 73. If you do not withdraw from your IRA according to specific formulas defining the RMD, you will be penalized significantly.

Thus, it is imperative that you manage this situation to minimize your taxes in retirement.

Roth IRA Conversions to the Rescue

You aren’t going to be able to escape taxes on your conventional IRA withdrawals, but there are some things you can do to minimize the pain.

Most importantly, you can convert your conventional IRA to a Roth IRA. The huge advantage of a Roth IRA is that the distributions aren’t subject to federal income taxes or most state taxes. So, if you think your tax rate will be higher in retirement, it makes more sense to shift as much money as possible into a Roth IRA.

Consider the following example. You have $1 million in a conventional IRA. The top tax bracket is 37%, so if you took that distribution all in one year some of it would be subject to that tax rate. Assuming the entire distribution was taxable, your total tax bill on that distribution could be more than $300,000 (depending on your filing status).

Further, if you take this distribution in a state with a high state income tax rate, you could be looking at paying another $50,000 to $100,000 in state income taxes.

Consider instead a structured approach where you make smaller conversions into a Roth IRA over time in order to manage your tax burden. Let me emphasize that everyone’s situation is different, and you may want to consult a tax attorney, but here is the gist.

Let’s say that instead of taking a $1 million lump sum — or being forced to do so by the IRS RMD rules — you spend ~11 years making $90,000 Roth IRA conversions. You will still owe taxes, but instead of owing >$300,000 to the IRS on this lump sum, each $90,000 conversion is only going to generate an IRS tax bill of about $11,000 because that would keep it in the 12% tax bracket (assuming this was your only source of income).

Thus, in 11 years of making these small conversions, your IRS tax bill would be around $121,000 instead of $300,000. Do these conversions in state with no income tax and save yourself another $50-100K.

This does of course assume that tax rates won’t increase, and that’s a pretty big assumption. If you are afraid that tax rates will increase in the future, you could make larger conversions each year. These larger conversions would push you into subsequently higher tax brackets. The point is to keep you out of the highest tax brackets and maximize what you get to keep.

In order to manage this process, you need to have a pretty good idea of what your income will be, and where the income limits are for each tax bracket. That way you can push the amount of conversion right up to the limit of your tax bracket. Just be sure you set aside enough money to pay the taxes on the conversion.

Beyond tax-free withdrawals, there are substantial benefits of the Roth IRA versus a conventional IRA. Notably, there are no RMD requirements for a Roth IRA. That means (subject to a few rules) you can take the tax-free withdrawals on the contributions and earnings whenever you want.

Then you can bequeath whatever is left to your heirs, and they will inherit it tax free. If you bequeath a conventional IRA to them, they are going to have to pay taxes on that inheritance.

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