Roth conversions often dominate the tax-efficient retirement planning conversation during lower income years. But another approach might be one to also consider—one that’s often easier to implement and still impactful: the step-up in basis strategy for your taxable investments. 

Understanding the “Sweet Spot” in Retirement

Before we dive into a strategy comparison, it’s important to talk about timing. We often see a window in retirement when your income might be significantly lower; namely, the years between when you stop working and when you must start taking Required Minimum Distributions (RMDs) from your retirement accounts.

This dip in income creates a unique opportunity for tax planning.

The More Commonly Discussed Approach: Roth Conversions

First, let’s take a look at the more common strategy for repositioning assets during the low- to no-tax zone period we mentioned above. Roth conversions involve transferring money from a Traditional IRA to a Roth IRA. You pay ordinary income tax on the converted amount, but future withdrawals are tax-free. Roth IRAs are also free of RMDs, which inherently decreases taxes in future years by decreasing RMDs.

While a Roth conversion can be an excellent strategy, there are a few challenges and other factors to consider:

• Taking an immediate tax hit. If you convert, for example, $100,000 from a traditional IRA to a Roth at a 24% tax rate, you’ll be taxed $24,000
• Your break-even timeline. Typically, you need to live about 15-20 years after the conversion to make it financially worthwhile
• The primary beneficiaries. Often, it’s the next generation—not you—that ends up the primary beneficiary of a Roth IRA.

Because of these factors, we see only about one in five clients who could benefit from Roth conversions actually following through with them.

A Compelling Alternative: Step-Up in Basis Strategy

Another option for tax-efficient retirement planning is called a step-up in basis strategy. First, a quick explanation and example. Think of your “basis” as what you paid for an investment, or your starting point for measuring gains or losses. 

Imagine you buy 100 shares of a stock for $50 each ($5,000 total). This is your initial basis. Over time, the stock grows to $150 per share, or $15,000 total. 

The embedded gains make it difficult to make the decision to sell the stock when one is in higher income tax years – when you sell the stock, you’ll pay capital gains tax on the $10,000 profit ($15,000 – $5,000). 

This becomes an easier “problem to solve” during the “sweet spot” in retirement, because capital gains tax will be lower than during higher income years. When you execute a “step-up” in basis, you deliberately sell and repurchase an investment to establish a new, higher basis for tax purposes. It’s like hitting the reset button on your cost basis. 

Using our example, let’s say you sell the shares at $150, or $15,000 total, then immediately buy back the same shares at $150. Your new basis is now $15,000 rather than $5,000, and future gains will be calculated from this new, higher price.

When you execute this strategy during lower-income years, you’ll potentially pay little to no capital gains tax on the sale while securing a higher basis for future tax calculations.

Unlike Roth conversions, which we see executed at a rate of about one in every five eligible clients, nearly all of our clients who can leverage the step-up in basis strategy choose to do so. 

While Roth conversions certainly have their place in tax-efficient retirement planning, the step-up in basis strategy often provides a more palatable and immediately beneficial approach to tax management.  A well-crafted, straightforward strategy is often easier to implement, but it still needs to address the complexities of the problem at hand. The key is taking advantage of those lower-income years between retirement and RMDs.

Please share this article with family members or friends who might be entering that window of time between retiring and beginning to take required minimum distributions—they might benefit from understanding an alternative to Roth conversions. 

“Everything should be made as simple as possible, but not simpler.”  -Albert Einstein

 

^{This material is distributed for informational purposes only. Investment Advisory services offered through Journey Strategic Wealth, a registered investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”). The views expressed are for informational purposes only and do not take into account any individual’s personal, financial, or tax considerations. Opinions expressed are subject to change without notice and are not intended as investment advice. Past performance is no guarantee of future results. Please see Journey Strategic Wealth’s Form ADV Part 2A and Form CRS for additional information.}