Dorothy is a 60-year-old widow who recently retired with $25,000/year in Social Security widow’s benefits and an inflation-adjusting survivorship pension of $45,000/year. In addition, she has a $300,000 brokerage account, and a $1.5M IRA. When Dorothy turns 72, and RMDs begin, her IRA is projected to be almost $3.4M. That will produce an RMD of almost $132,000… which, stacked on top of her inflation-adjusted pension and Social Security benefits (which will rise to almost $100,000/year at a 3% inflation rate) will drive Dorothy up into the 32% tax bracket, with more and more of her future RMDs taxed at 32% as the RMD obligation grows with age.
To manage the exposure, Dorothy decides to begin doing partial Roth conversions today of $90,000/year, all of which will be taxed in either her current 22% tax bracket or the 24% tax bracket. By repeating this process every year, Dorothy is able to substantially slow the growth of her pre-tax IRA to be ‘only’ $2.1M by age 72, which will result in an RMD of only $84,000… similar to her ongoing withdrawals during the interim years, and leaving her room to avoid ever being subjected to the 32% tax bracket in the future.
In essence, the value of income harvesting strategies is tax-rate arbitrage — the opportunity to shift income from higher-tax-rate years (in the future) to lower tax rate years (today). For income that was otherwise inevitably going to be recognized and taxable someday, triggering that income in lower tax rate years instead of higher tax rate years is effectively ‘free’ wealth creation (in that it doesn’t require taking on risk to generate the additional wealth, simply harvesting the available tax rates).