How to Spend, and Pay Taxes on, Your 401(k)

At some point after 59½, when a client can tap tax-deferred accounts without penalty, but before 70½, when they must, Reardon has them convert chunks of a regular IRA into a Roth before they retire. The point is to take advantage of a period when they're in a low tax bracket. Without income yet from RMDs, a pension, or Social Security, there may be a gap between current income and the limit for remaining in the 15% tax bracket, for example. The point is to fill that gap with money withdrawn from your traditional IRA, pay tax on it, and put it in a Roth. How much you convert depends on a lot of things, including how much you have in taxable accounts both to live on and to cover the tax, and how close your income is to the next tax bracket. And of course, there are big benefits to having money compound tax-free in an IRA. Planners have to weigh these considerations against the chance of a higher tax bracket when you start taking distributions and other income streams kick in. Reardon's clients typically delay taking Social Security until age 70. That gets them a much higher monthly benefit than if they'd taken it earlier. It also means Social Security benefits — which are taxed to a degree — don't add to income while clients are trying to fill their 15% "tax bucket." You Must Convert!

Here's an example of how the strategy could work, courtesy of certified financial planner John Shanley of Pinnacle Investment Management in Simsbury, Connecticut. His firm worked with a married couple, 67 and 59 years old, who are retiring later this year. The older client is deferring Social Security until 70, and the couple will have $17,000 in income coming from a pension starting in 2017. The couple's spending needs in 2017 and 2018 will come from taxable accounts. Since they have low income for two years, they'll convert $75,000 of a traditional IRA to a Roth in both years. A small part of that conversion falls in the 10% bracket and the rest in the 15% bracket. By lessening future RMDs, the client won't be bumped into the 25% tax bracket in 2019 or the 28% bracket they might have hit in later years, said Shanley. 

A helpful way to look at the savings is to compare the tax bill generated by a conversion today with what it would likely cost down the line, he said. For instance, a $75,000 move from an IRA to a Roth now at a 15% rate costs $11,250 in tax. The same transfer later, while in a 25 percent tax bracket, would cost $18,750. 

The conversion's tax benefit in later years may be diminished if new income streams start, say from another pension or more RMD income, but it's still a way to take advantage of a few years at a lower rate, Shanley said.  

And finally, if you've done so well that the RMDs aren't needed, you can make "qualified charitable distributions" of up to $100,000 a year. That way, RMDs won't be included in gross income. You have to be careful, though — the company holding your tax-deferred account must send the money directly to a qualified charity.

— Related on ThinkAdvisor:

• Finke: For Retirees, Spending Too Little May Tarnish Golden Years
• How Health Care Will Crush the 80% Income Replacement Idea in Retirement