Today I’m tackling part two of our 2-part series on Roth conversions.
Specifically, I’m sharing:
Key Takeaways
- How to determine if a Roth conversion makes sense
- A Roth conversion case study
- Common mistakes + pitfalls to avoid
If you’re ready to master Roth conversions and take control of your tax bill, you’re going to love today’s episode.
How to Listen to Today’s Episode
Episode Links & Resources:
- Retired or Close to It? Need a Retirement + Tax Analysis?
- Roth Conversions Part 1: What, How, Why
- Medicare IRMAA 2022 Tax Brackets [Updated!]
- Taxation of Social Security Benefits
- Donor-Advised Funds
- Qualified Charitable Contributions (QCDs)
- Projecting Your Future RMD
- Step 1: Future Value Calculator
- Step 2: IRS Uniform Lifetime Table
Episode Transcript
Roth Conversions Part 2: A Five-Step Process to Determine if a Roth Conversion Makes Sense for You
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m tackling part 2 of our two-part series on Roth conversions.
Specifically, I’m sharing:
1. How to determine if a Roth conversion makes sense
2. A Roth conversion case study
3. Common mistakes and pitfalls to watch out for
If you’re ready to master Roth conversions and take control of your tax bill, you’re going to love today’s episode.
For all the links and resources mentioned, head over to youstaywealthy.com/148.
Ok, let’s quickly recap the basics of a Roth conversion before we get further into the weeds.
A Roth conversion is the process of transferring money from a Pre-Tax Retirement account (like a Traditional IRA) into an After-Tax Roth IRA account.
The amount that’s being transferred (i.e., converted) is taxed in the year you make the conversion, but that money is permitted to live inside a Roth IRA for as long as you want it to.
So, what’s so great about that money living inside a Roth IRA?
Three things:
1. Assuming you invest the money inside your Roth IRA, your investments grow tax-free. In other words, you don’t pay taxes on dividends, interest, or capital gains, which, in turn, means you will have more investment growth over long periods of time.
2. You avoid those pesky Required Minimum Distributions that may come at an inopportune time. That’s because money in a Roth isn’t required to be withdrawn like money inside a Traditional IRA. You can leave your investments growing in there forever. And that leads us nicely to benefit #3, which is…
3. Roth IRAs can be inherited by your heirs AND they offer a more tax-friendly way to inherit retirement dollars. Unlike Traditional IRAs that are inherited, your heirs aren’t forced to drain the account and pay taxes within a 10-year time period.
The other big benefit of having money inside a Roth IRA in retirement is the flexibility it provides.
If you need a new roof on your house or want to take a big, unplanned vacation, you can withdraw money from your Roth IRA without worrying about what the withdrawal will do to your tax bill that year. And, in retirement, spiking your tax bill can mean more of your social security becoming taxed and medicare surcharges kicking in. It can also lead to overpaying the IRS if you have tax bills you didn’t plan ahead for.
So, hopefully, we’re all on board with why Roth IRAs are so great. But just because they’re great doesn’t mean everyone should race out to process Roth conversions tomorrow.
With that in mind, let’s now talk about how to determine if you’re a good candidate for a Roth conversion. To preface, there are a lot of moving parts when it comes to Roth conversions. I can’t possibly cover every single little nuance and exception, so my goal here today, and in this series, is to approach the process as simple as possible, giving you a foundation for evaluating this popular tax planning opportunity.
And, just like you wouldn’t take a prescription without talking to a doctor first, I don’t recommend processing a Roth conversion without talking to a financial planner or a CPA with a planning background. Even if it’s just paying for a few hours of their time to validate your findings.
With that disclaimer behind us, here’s a simple 5-step process you can use as a starting point for determining if a Roth conversion or a series of Roth conversions might make sense.
1. Add up all of your pre-tax retirement account dollars (Trad IRAs, 401ks, SEP IRAs, Simple IRAs)
2. Estimate your Required Minimum Distributions at age 72 (I know there may be some upcoming changes here with the Secure Act 2.0, but let’s table that for now)
3. Add up additional taxable income that will stack on top of those Required Distributions
4. Estimate your tax bracket at age 72
5. Compare that to your current tax bracket
Two quick notes before we break this down further.
First, estimating your RMDs at age 72 is a two-step process, with part one being a future value calculation and part two applying the IRS uniform lifetime tables. To help you with the future value calculation, I’ve linked to a free calculator in the show notes which again can be found by going to youstaywealthy.com/148. I’ve also linked to the updated IRS tables for quick access as well.
The one assumption you’ll need to make with the future value calculator is the estimated rate of return on your investments between now and age 72, and that’s because your annual Required Minimum Distribution (or RMD) is based on the year-end value of your pre-tax retirement account or accounts.
So, if your accounts grow between now and age 72, your RMD will also grow. And while the stock market has, historically, had an average annual rate of return around 10%, I personally would lean on a more conservative assumption when using the future value calculator and projecting your first RMD. Perhaps something in the 4-6% range is more appropriate depending on how close you are to age 72, and how your investments are allocated.
Yes, a lower rate of return assumption will make Roth conversions potentially look less attractive, but we don’t want the opportunity to look overstated either. I’d rather analyze this opportunity using more conservative numbers, knowing that if we achieve higher rates of returns, it will only make our Roth conversion decision look even better.
The second thing to note is when you go to estimate your taxable income that will stack on top of your RMDs at age 72, you’ll want to include income sources like dividends and interest earned in taxable accounts, pensions, social security, and other investment income. And remember, with regards to social security, if your total gross income in a given year is above $34k as an individual or $44k as a married couple, 85% of your social security benefit will become taxed. And since RMDs are considered taxable income, part of this exercise is bringing to the surface what those RMDs are going to do to the taxation of your social security benefit.
To recap the 5 step process:
1. Add up all of your pre-tax retirement account dollars
2. Estimate your first Required Minimum Distribution amount at age 72
3. Add up additional taxable income that will stack on top of those Required Distributions
4. Estimate your tax bracket at age 72
5. Compare that to your current tax bracket
So, why are we going through this exercise? Why are we comparing our current tax bracket to our future projected tax bracket?
Well, one of our big guiding rules is that we don’t want the rate we pay on a Roth conversion to be higher than our future tax rate in retirement and/or when Required Minimum Distributions hit us at age 72.
For example, if we’re in the 35% bracket today, and our future projected tax bracket is 22%, we probably don’t want to rush to convert money from a traditional IRA to a Roth this year. Why pay 35% on that money when we can pay 22% at some point in the future?
On the other hand, if we’re currently in the 12% bracket because we’re retired and income shut off, and our future projected tax bracket is 22% when RMDs and social security kick in, it might make sense to do partial Roth conversions now to get money out of our pre-tax accounts at a more favorable tax rate.
One common question I often get is what to do if our current tax bracket and future projected tax bracket are the same. In other words, what if I’m in the 22% bracket today, and it appears I’ll be in the 22% bracket at age 72 and beyond?
To answer this, we have to make an assumption about our investment growth. Because as mentioned earlier, as our account balance grows, so does our Required Minimum Distribution amount. Understanding that, the question really then becomes, would you rather pay 22% today on $100 and get that $100 into a Roth IRA to grow tax-free forever, or do nothing, let that $100 grow into, let’s say, $200, and then pay 22% on that higher balance of $200.
As mentioned in part one of this series, money inside of a pre-tax retirement account is a growing tax liability. The more it grows, the more we have to pay to get the money out. So if your projected tax bracket appears to be the same as your current, and you believe your investments will grow between now and age 72, you might lean towards paying taxes on that money now to stop the tax liability from growing.
Which leads to the other assumption we have to take into consideration with Roth conversions, and that is future tax rates. If you believe taxes will be higher in the future than they are today, that might further incentivize you to get your pre-tax dollars converted to a Roth.
Ok, let me attempt to string all of this together by going through a case study about a totally hypothetical retirement saver named Anna.
Anna is 57 years old and she retired on January 1st of this year. With that in mind, let’s go ahead and go through the 5-step process with her.
Step 1 is to add up her pre-tax retirement account dollars. She’s been a great saver and we determine she has about $1.8M in a Traditional IRA.
Step 2 is to estimate her first RMD in 15 years when she reaches age 72. Since she has 15 years and is a more aggressive, risk-tolerant investor, let’s assume she has a 6% rate of return on her Traditional IRA dollars over that time period. So, using the future value calculator, we determine that her $1.8M IRA will turn into just over $4.3M in 15 years.
Using the IRS uniform lifetime table, we simply take $4.3M and divide it by the life expectancy factor of 27.4, which gets us to her first estimated RMD amount of, let’s round up and call it $160,000. So, at age 72, she will be required to withdraw $160,000 from her Traditional IRA, whether she needs that money or not, and pay taxes on that amount. She will be forced to take similar-sized annual withdrawals every year thereafter. But that’s not her only income which leads us to step 3.
Step 3 is to add up additional taxable income she will have on top of her RMDs. She has a pension of $30,000 per year, anticipates about $15,000 per year in dividends from her taxable investment account, and expects social security to be about $40,000 per year if she delays to age 70. So, she will have about $85,000 in annual income on top of the $160,000 of RMD income at age 72, a total of $245,000.
Step 4 is to estimate her tax bracket at age 72, so looking at the federal tax brackets, if we assume taxes won’t change, she will clearly be in the 35% bracket when she takes her first Required Minimum Distribution.
The last step, Step 5, is to compare her projected tax bracket to her current tax bracket. Since she’s now retired, she only has her dividend income and pension income to take into consideration here, which is about $45,000 per year. That won’t completely cover her living expenses, but she has money in taxable accounts she can lean on to supplement her income without spiking her tax bill.
Remember, long-term capital gains are taxed on a separate schedule, so while we do need to plan appropriately for paying taxes on any realized gains that might fund living expenses, they aren’t factored into her taxable income used to determine her federal tax bracket.
So, with $45,000 of projected taxable income, that puts her into the lower end of the 22% bracket for the next 15 years unless something dramatically changes with her situation or tax rates.
To summarize, Anna’s first projected RMD is $160,000, and assuming her investments continue to grow, that amount will continue to get higher each year, especially when you consider the life expectancy factor in the IRS tables. Remember, we’re talking about pre-tax money here. The IRS would really like to get paid, so the older you get, the more they require you to take out. Adding in her other taxable income of $85,000, she’s expected to be in the 35% bracket at age 72. Today she’s in the 22% bracket and expects to be there for the next 15 years.
Given all of that, it appears that she has a pretty nice opportunity to pursue Roth conversions between now and age 72 (aka her gap years) while she’s in the 22% tax bracket. She can get money out of her Traditional IRA at a lower rate today than if she did nothing, let her investments grow, and waited for the IRS to force her to withdraw it at age 72. And if she was up for being a little more aggressive, there’s even a case to be made to convert up to the 24% bracket.
If she did annual Roth conversions between now and age 72 and maxed out her 24% tax bracket each year, some quick back-of-the-napkin math shows that her first Required Minimum Distribution would get knocked down to about $70,000. So, her first RMD would get cut by more than half, which, after factoring in her other taxable income, would place her in the 24% tax bracket at age 72 instead of the 35% she was projected to be in.
By being proactive and paying taxes when it’s most opportune for her, she’s able to take control over her tax bill, keep more money in her pocket, and avoid overpaying the IRS.
By how much? Well, that’s a complicated calculation as mentioned in part one of this series. By my estimate, if she did nothing, and waited for the IRS to come knocking on her door, she’s looking at a total retirement tax bill of around $8 million. That’s the amount she is projected to pay the IRS between now and end of life on all of her earnings, RMDs, dividends, interest, etc.
On the other hand, processing annual Roth conversions and filling up her 24% tax bracket each year, would knock her total retirement tax bill down to about $4.8 million, a savings of about $3.2 million.
Now, I strongly discourage anyone from getting too attached to these numbers and projections. Because they are just that, they are projections. And we are projecting things out, in this case, 43 years, until Anna is age 100. As we all know, A LOT is going to happen that we can’t predict between now and when Anna turns 100. One of which might be that Anna doesn’t live until age 100.
If she only lives until age 78, well, you can throw most of this out the window. So, it may not be a $3.2 million savings, it might be a $500,000 savings. Or, it might be a $5 million savings. Nobody knows. But if you do the calculation properly, and you use conservative assumptions and accurate inputs, you should be able to at least identify that an opportunity exists, which should help you make a more informed and educated decision around Roth conversions.
Also, what often brings comfort to a lot of people, knowing that these are just projections, is the benefit of getting money into a Roth IRA to begin with. Maybe your total retirement tax bill doesn’t get reduced at all. But, maybe getting money into a Roth IRA for your heirs to inherit is really important to you and, that on its own, is a win. Or maybe having flexibility later on in life to tap into tax-free money for unplanned expenses is enough of a benefit.
Lastly, it’s important to note that Anna isn’t committing to annual Roth conversions for 15 years on day one even if we see a clear opportunity. It’s a year-over-year calculation and analysis that needs to be done. As her personal situation changes, as tax laws change, and as RMD dates potentially change, we have to make adjustments, update our projections, update her plan, and make a new informed decision around Roth conversions. Maybe this year a Roth conversion makes sense and next year it doesn’t. It’s an ongoing, fluid analysis, and not a one-time decision.
Ok, to bring us home, I want to highlight three common mistakes and pitfalls related to pursuing Roth conversions.
1. Paying the Roth conversion taxes from your IRA. Yes, technically you can pay the tax bill owed from a Roth conversion from your Traditional IRA or existing Roth IRA dollars that have met the 5-year rule. However, this reduces the benefit of the Roth conversion and/or causes an additional tax bill, both of which are not ideal. Also, if like Anna, you’re under age 59.5, paying the tax bill from your Traditional IRA would trigger the 10% early withdrawal penalty, because the Traditional IRA money use to pay the taxes would be considered a withdrawal and not a conversion.
So, to optimize the benefit of Roth conversions, it’s best to pay the tax bill from a non-retirement account, which highlights the importance of cash management in retirement and, especially, leading into your gap years. If you didn’t plan ahead and/or don’t have non-retirement dollars to pay the tax bill, you might reevaluate the benefit of Roth conversion to begin with.
2. Not considering your charitable goals. This can be a mistake for two reasons. First, if you’re charitably inclined – meaning you currently give a meaningful amount to charity or plan to give a meaningful amount to charity in the future – pursuing Qualified Charitable Contributions (aka QCDs) might be more beneficial for you than annual Roth conversions. It depends on how much you’re wanting to donate and your anticipated RMD amount, but it’s important to take into consideration.
As a reminder, you can donate up to $100,000 of your RMD per year directly to a 501c3 nonprofit organization and avoid paying taxes on the distribution. So, if your RMD is projected to be, let’s say, $50,000 per year, and you plan to donate most or all of that distribution every year, pursuing Roth conversions might not make sense. Why convert money to a Roth and pay taxes on it when you can just wait, send it straight to charity when RMDs hit, and avoid the tax bill altogether?
The second mistake to be aware of for those who are charitably inclined is to fail to consider pairing your Roth conversions with a charitable gifting strategy like a donor-advised fund. Contributing to a donor-advised fund the same year you process a Roth conversion can help to offset your tax bill from the conversion while also fulfilling your charitable goals. These two strategies pair really nicely together for the right person, so be sure to take charitable giving into consideration when putting together your Roth conversion plan.
3. Forgetting about IRMAA - the medicare surcharge you get hit with if your income is above certain thresholds. Two things to mention here as well. First, nobody likes to get caught off guard with a penalty or a surcharge. So, if you do pursue Roth conversions, just be sure to factor in how they might affect your medicare premiums.
Remember, Roth conversions spike your taxable income, and if your taxable income gets above a certain threshold, medicare IRMAA surcharges kick in. I actually just published a giant article on IRMAA surcharges and the 2022 IRMAA brackets to the Stay Wealthy blog, so if you want to learn more, I’ll link to it in the show notes.
And this leads to my second point here around IRMAA, which is that sometimes I see IRMAA surcharges stop people from pursuing Roth conversions entirely. Yes, medicare part B IRMAA surcharges can be as high as $408/month in 2022. But, if you determine that annual Roth conversions can save you six or seven figures in taxes over your lifetime – or the benefits of getting money into a Roth IRA are very meaningful to you – might you be ok with paying an extra $4,800 per year in medicare premiums for a handful of years? Maybe, maybe not.
But don’t run from Roth conversions solely because you might get hit with IRMAA surcharges. The benefit of conversions and/or getting money into a Roth for your heirs, let’s say, might far outweigh the increase in your medicare premiums for a few years.
Roth conversions are not a magic bullet. They are also not a fitting strategy for every retirement saver. The reason I love talking about Roth conversions is not necessarily because, when done right, they can save people six or 7 figures in taxes over their lifetime, it’s because it forces you to be proactive in your tax planning.
Too many retirement savers do nothing, enjoy their gap years where income is low and taxes are low, and then age 72 hits, and bam, they get hit with this giant spike in income, oftentimes income they don’t need. And now IRMAA surcharges kick in, social security becomes more taxable, and they’re in a higher tax bracket at age 72 than they were as a working professional.
So, even if you don’t end up pursuing Roth conversions, it’s still such a great exercise to go through. It forces you to better understand your current and future tax situation, make more informed decisions, and potentially take control over something that a lot of people assume you have no control over.
As noted earlier in this episode, my goal in this series was to keep things as simple as possible. In doing so, I realize I could have created additional questions and “what ifs”. So if you have more questions around Roth conversions, if you’re still confused about something and want me to go deeper on a particular concept or clarify a comment I made, please let me know. Send an email to podcast@youstaywealthy.com.
And if I receive enough of them, I’ll consider jumping back in and doing a Roth conversion listener Q&A episode to make sure we avoid any confusion and get everyone's questions answered.
Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com/148.
Thank you, as always, for listening and I’ll see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.