A Path to Tax-Free Income

Our client David (not his real name) retired back in 2009 when he was 62.  His 401(k) retirement plan at that time was worth about $800,000, which he rolled over to us into a self-directed IRA.  Plus, he had a non-retirement account, owned jointly between him and his wife, which was worth about $500,000.  One thing that he had always told us was that he was very sensitive to taxes and that he wanted to make sure that his long-term financial plan was as tax-efficient as possible.

We sat down with him and his wife and illustrated just how inefficient a 401(k) or an IRA is from a tax perspective – that, even though on paper it looked as if he had an $800,000 account, part of that money always belongs to “Uncle Sam.”  Further, any time he earned something inside that account, he had to share those gains with the IRS.  And, worse, if Congress ever voted to increase tax rates, he would lose even more of his nest-egg.

But we had a solution for him that we thought made a lot of sense.

We discussed the benefits of systematically converting his IRA into a Roth IRA by, in essence, pre-paying the taxes on his money today in order to build a completely tax-free source of income for the future.

So, our recommendation was to slowly and systematically move the money inside this IRA into his Roth IRA.  And that’s exactly what we did.

Because he was over 59½ when we began this strategy, he was able to do these conversions and direct that his State and Federal taxes be paid out of the proceeds.  And, in order to avoid having him pay tax at the highest tax rates, rather than convert his entire account all at once, we decided to do these conversions annually – with the goal to have his IRA completely converted by the time he turned 70.

In the seven-year period between 2009 and 2016 he successfully did this, converting his entire IRA into a Roth IRA.  Meantime, he and his wife used the money in their non-retirement account to pay for their retirement expenses during that time frame.

In 2016, he was about to turn 70 and ready to file for Social Security, and his Roth IRA was now worth approximately $662,000 (remember, he had to pay tax on each annual distribution).

But just look at how tax-efficient his portfolio has become.

His income now comes from three sources – his Social Security, which is about $42,000 a year (it is higher because we encouraged him to delay filing for benefits until he was 70 in order to maximize his income), his wife’s Social Security (about $19,000/year) and a withdrawal from his Roth IRA of about $33,000

That equates to an annual income of about $94,000 . . . and, here’s the beautiful part . . . all of it is completely tax-free!


You see, Social Security is only taxable if you have other sources of taxable income.  In this case, David and his wife have NO taxable income . . . therefore their Social Security benefits are completely tax-free!

So, we were able to help this couple manage their retirement income in the way that was most important to them – and that is by creating the most tax-efficient plan that we could.  And, no matter how much his Roth IRA may grow over time, he will never pay a dime of income tax on any of those earnings.  Plus, Roth IRAs do not have required minimum distributions when you turn 70½, which gives you much more control of your money.

* These are hypothetical case studies and are for illustrative purposes only. Actual performance and results will vary. These case studies do not constitute a recommendation as to the suitability of any investment for any person or persons having circumstances similar to those portrayed, and a financial advisor should be consulted.