Retirees can stretch their savings with Roth IRAs

Are you afraid of running out of money in retirement?

That fear is so great among retirees that it exceeds the fear of dying, according to one AARP survey. And it intensifies when the stock market plunges and leaves IRAs looking thin, when a big medical expense or home repair comes along or when the end of the year rolls around and Uncle Sam makes people over 70 1/2 remove money from IRAs and pay taxes on it.

The nest egg that looked so impressive the day you retired starts to look more and more feeble as you are forced to pull money out to pay bills and then send a chunk of it to Uncle Sam for taxes.

Retirees are continually shocked by the impact of income taxes on their savings. When they retired, a $1 million nest egg might have looked huge, but given a 25 percent tax bracket, it should have looked like only $750,000. A $500,000 nest egg in the same tax bracket should have looked like $375,000 — or about $425,000 for a person in the 15 percent tax bracket.

When people look at their 401(k)s and IRAs "they should recognize that it's not all theirs," said IRA adviser Ed Slott.

While people often try to conserve their savings by not tapping 401(k)s or IRAs early in retirement, the tax bill ultimately comes due. Once you hit 70 1/2, Uncle Sam subjects your retirement accounts to a formula that requires you to take out a certain amount each year and pay taxes on that money. One result: When you need the money late in life, your wealth might be depleted. Try this calculator to see what are called "required minimum distributions" by age and dollars.

Retirees who conserved savings early in retirement are frequently surprised by the tax consequences later. The more that's sitting in an IRA, the more you are forced to remove and share with the government each year at tax time.

"The larger an IRA grows, the greater the risk that it will have to be liquidated in the higher tax brackets in the future," said financial planner Michael Kitces, who trains other advisers to cut that risk among their clients. "Eventually, huge required minimum distributions actually force the taxpayer into the upper brackets."

That's why Kitces says this is the time of year when retirees in their 60s should be thinking hard about tax planning. Rather than deferring taxes year after year, as people are often instructed to do, Kitces says individuals should focus instead on timing when they take income so it comes in the lowest tax years. Often incomes are low early in retirement when paychecks no longer are rolling in from jobs.

With the end of the year drawing near, Kitces suggests that 60-somethings in retirement move some money out of an IRA and into a Roth IRA. It's called a conversion. When you do a conversion, you will owe taxes for that year on the money you shifted from the IRA to Roth IRA. But once the money is in the Roth IRA, you won't ever owe taxes on it again. It can grow by thousands or even millions of dollars, and it will all be yours. Uncle Sam won't ever force you to remove any money from a Roth, because he won't get a penny of taxes from any withdrawal you make.

Also, conversions need to be done strategically, so you don't move such a big chunk from your IRA that it puts you into a higher tax bracket that year, Kitces said. He suggests moving a little money each year from an IRA into a Roth IRA, while trying to keep your income within your usual tax bracket. See the leeway you have to maneuver within brackets here.

Be aware of the impact on Social Security, too. That part of your income can be taxed.

Sometimes people worried about future taxes will convert a full IRA at one time, but Kitces warns people about setting off a huge tax. He notes a couple who would typically have just $60,000 in income after deductions. If they convert a full $500,000 IRA in a single year, their taxable income would pop up to $560,000 that year and bump them from the 15 percent bracket into the top 39.6 percent bracket for a good portion of the income. The taxes would be painful. Kitces' solution: Convert just $14,900 of the IRA to a Roth IRA in a single year. The couple then stays within the 15 percent bracket — saving themselves from unnecessary taxes.