While Millennials begin to pony up for their first homes, many Baby Boomers have been happy to oblige the younger generation’s pursuit of a dream house. Since the start of 2020, a booming housing market has enticed a wave of retirees to consider downsizing from their existing home. Downsizing refers to homeowners, oftentimes retirees now with an empty nest, who pursue a more manageable and/or convenient living situation. Financially, that can often mean selling a larger highly appreciated home, and buying a cheaper smaller home which can leave the retirees with a pile of cash. This particular situation leads to a profound opportunity for creating tax-free generational wealth.
For the fortunate retirees who have the financial freedom and flexibility to relocate in their golden years, one question likely to arise is ‘What do I do with the leftover cash from the sale of my previous home?’ In simple terms, there are essentially two options: 1) Keep the money in cash or 2) Invest it in some form or another. Both options should be carefully considered, and the answer should depend on your unique financial circumstances and priorities. However, a strong argument can be made for keeping it in cash, and using it to fund your retirement lifestyle for as long as possible. This is an especially good option for retirees with large portions of their wealth sitting in IRAs and 401ks.
What's the big idea?
Many retirees would agree that the most irritating and unsettling financial element of retirement is paying taxes. It’s difficult to come to terms with the idea that a good portion of your hard earned nest egg will be paid to the IRS throughout your retirement. This concept becomes even more relevant, and often unnerving for the many retirees who are highly dependent on a finite pool of IRA assets. However, with a bit of financial planning these uncomfortable emotions can be avoided. One of the most common workarounds for decreasing your tax bill throughout retirement is implementing a Roth conversion strategy. This is where you strategically withdraw from an IRA to pay the taxes now, and move that withdrawal into a Roth IRA where it can be invested and grow tax free. This strategy essentially eliminates the government’s ability to tax those Roth assets going forward. Simultaneously, it reduces the Required Minimum Distribution (RMDs) amounts you will be forced to take from your IRA assets starting at age 72.
Yearly Roth conversions are commonly used by retirees who seek to reduce their long term tax exposure and RMD amounts. However, more often than not, the IRA withdrawals used for Roth conversions are on top of the retiree’s monthly withdrawals used for living expenses. Therefore, in most years the opportunity to do large Roth conversions at a favorable tax rate is substantially reduced. Herein lies the key advantage downsizing homeowners with a profit have.
Cashing In On Your Home Sale
For downsizing retirees who want to reduce their tax exposure and RMDs, spending down the previous home’s proceeds could be an attractive solution. By living off of the home sale’s profit for as long as possible, you are in essence keeping your income artificially low. The gain from your previous home is not taxable up to $250,000 for singles, and $500,000 for couples. Living off of the proceeds from your prior home sale gives way to the opportunity to halt/forgo taking withdrawals as you normally would from your IRA. By doing so, this could in theory reduce your taxable income to zero for months or even years. During which time, the opportunity for massive Roth conversions arise.
Let’s say the recently retired Smiths have been living off of $100,000 of annual withdrawals from their IRA to sustain their retirement so far. They decide they would like to move closer to their children, and end up downsizing their home in January while pocketing an extra $300,000 due to their home’s significant appreciation in value. They now ponder as to what to do with their excess cash. In speaking with a financial planner, and based on their unique situation, he recommends that they implement a Roth conversion strategy. Instead of continuing to take withdrawals from their IRA each month, he encourages them to use the cash from the home proceeds. At the end of the year the Smith’s taxable income is close to zero. In order to take advantage of their low taxable income they do a Roth conversion by taking $100,000 from their IRA and convert it into a Roth. By doing so they pay no more in taxes then they have in previous years, and they now have $100,000 growing in a tax free account. This strategy is repeated for the next two years or until the Smiths spend down their home sale profits. At which point, they now have approximately $300,000 in a tax-free Roth account which directly reduces their future RMDs, and their risk of paying higher taxes in the future.
Tilting The Tax Scales In Your Favor
Once money has made its way into a Roth account, the tax deck becomes heavily stacked in favor of the account holder. First and foremost, Roth account holders no longer have to worry about higher tax rates impacting these assets in the future. This is the inverse of traditional IRA assets which remain at the mercy of current and future income tax rates. Additionally, Roth accounts are not subject to RMDs, so the money is able to stay invested indefinitely. This feature makes Roths a tax efficient and common way to pass on assets to legacy recipients, who will also pay no taxes on the amount they receive.
Retirees downsizing their homes and walking away with a profit has become more common in the current housing boom, but a similar Roth Conversion strategy can apply to any retiree who experiences an influx of outside cash. Living off of the profits from a home sale can be substituted with similar liquidity events, such as receiving an inheritance or gains from the sale of other personal assets. Essentially, any time there is a substantial amount of post-tax money at your disposal the door for a significant Roth conversion is open. A Roth conversion strategy isn’t a catchall solution, but in the right situation it can act as a gateway to creating tax-free generational wealth.
