One of the most common topics that our recently retired clients (or clients looking to retire in the near future) ask us about has to do with Roth conversions. Specifically, they ask questions like:
Of course, each person’s or couple’s situation is unique, so it’s practically impossible to write a tell-all for everyone. However, we’ve written several articles on this, to include considerations for recent retirees when doing Roth conversions, and a Roth conversion case study based upon a fictitious client example.
This article aims to help give more of an overview about Roth conversions, and to help explain why they might be an important part of a successful retirement plan. But first, a little background.
Probably the first question you might ask is:
What is the difference between a traditional IRA and a Roth IRA?
First, let’s start with what they have in common.
They’re both retirement savings accounts for people who have earned income.
Once you retire (i.e. stop earning income from work that you do), you can no longer contribute to them.
The earnings in either account are not taxed as long as the money stays in the account. This means that earnings are tax-deferred.
If you contribute to an employer-sponsored retirement plan (like a 401k or a 403b), you can transfer the funds in that account to a similar IRA, under certain conditions. Retiring and leaving your employer is one of those conditions.
This means that if you have a pre-tax 401k (which most of them are), you can transfer those funds to a traditional IRA. If you have a Roth 401k (not as common), you could transfer it to a Roth IRA.
There are a lot of articles that explain the difference, but the simplest way to understand is:
In a Roth IRA, you pay taxes on the money before it goes into the account. However, not only are earnings tax-deferred, but you can take qualified distributions out without ever having to pay taxes on them again.
There are also non-deductible IRA contributions, which are primarily a concern for high income earners who have access to a workplace retirement plan. Again, earnings on non-deductible IRA contributions are tax-deferred. However, if you are making non-deductible IRA contributions, you could make Roth conversions without having to pay taxes twice. Since this can be pretty tricky, as this case study article explains, this will be outside the scope of this article.
There are also different requirements on when you make withdrawals:
In a traditional IRA, you must start withdrawing from the account at age 72. From there, each year, you must withdraw a minimum portion of your account based upon your age and account balance.
In a Roth IRA, there is no withdrawal requirement during your lifetime.
In both instances, if you pass away, and your account is inherited by someone other than an eligible designated beneficiary, the account must be completely distributed within 10 years. Depending on the circumstances, this requirement might have significant tax implications for your beneficiaries, and is worth considering.
In summary, you pay taxes on IRA contributions, either on the front-end (Roth) or the back-end (traditional).
So, which one is better?
This is a common question, for which the answer might not be so straightforward. For people who want to simplify this as a ‘one or the other’ type decision, you can make strong arguments (and counter-arguments) either way. And ‘better’ might be hard to quantify—is it better to definitely pay taxes now for the chance to lower your tax bill later?
Perhaps, a better question to ask would be:
"How can I minimize the amount of taxes I have to pay over the course of my lifetime? "
While one might feasibly come up with a counter-point to this suggestion, it seems that we can all agree that keeping taxes low is important to a lot of people. But even better, it poses a problem that we can actually attempt to answer.
Of course, even a question as simple as this one comes with a lot of complexity. First, it introduces another dimension that doesn’t normally come up at first—the dimension of time. Second, the question implies that there is a formulaic answer (I’ll save you the trouble—there isn’t a formula that works for everyone). Third, it understates the extremely high likelihood that any plan designed to last for one’s retirement (which could be as long as 30-40 years) will be impacted by things that cannot be accounted for today.
To best answer that question, you might consider a Roth conversion strategy.
What is a Roth conversion strategy?
A Roth conversion strategy is simply a specific deliberate process during which you establish your Roth conversion goals, develop a plan, execute the plan, evaluate the plan periodically and make adjustments as required. To summarize:
Develop a plan.
Execute the plan.
Evaluate the plan periodically.
Adjust as required.
Let’s take a look at each step, one at a time.
Roth Conversion Strategy Step One: Establish Goals
What goals? It could be something as simple as asking the previously stated question—how to minimize taxes over the course of your lifetime. But your goals need to address some significant considerations, such as:
Supplemental income: Most people know about Social Security, which presents its own planning challenges and opportunities. But you might have a rental property, significant investments in a taxable account (producing dividend income), or might be considering a side-gig to keep active in retirement.
Beneficiaries-If you have high account balances (which can happen after a working lifetime of contributing to a company-sponsored retirement plan), then you might have to anticipate the possibility that you might not be able to convert everything into a Roth IRA at a desirable tax bracket. Eventually, those accounts might be inherited by people who will then be forced to withdraw all of the money over a 10 year period. So you might consider the following question:
Do I want to pay more in taxes than I normally would, so that my children can pay less?
You can read more in depth about these considerations in this article.
Whatever the goal is, it should:
Be specific: When you take the time to know the dollar amounts, tax brackets, and timeframes, then your plan becomes more clear, and you’ll know when you’re off track.
Be realistic: Converting $5 million into a Roth IRA within 5 years is not realistic, because you’d be pushing yourself into the highest tax bracket. So understand that you might not get everything you’d like to do. You will likely have to pay some taxes, so be realistic.
Be intentional: At some point, you’re going to have to make tradeoffs. Do I pay more in taxes during my lifetime, so my kids pay less? Do I pay at the 24% tax bracket, so I avoid creeping into the 32% bracket when I start taking Social Security? Whatever it is, your goal should clearly define your position on the tradeoffs you might have to make.
Examples of well-thought out goals include:
We have $2 million in our IRAs, $500,000 of which we’d like to leave to charity. We want to stay within the 12% tax bracket and convert as much as we can during our lifetime. After we pass, our children can work with our accountant to develop a plan on minimizing their tax bill.
Once you establish your goals, you need to develop a plan to achieve them.
Roth Conversion Strategy Step Two: Develop a Plan
At this point, if you’ve established specific, realistic, and intentional goals, then the plan should be pretty straightforward. Let’s take the following goal as an example.
Let’s add some facts about this fictitious couple that will help us formulate our plan.
Each spouse has just retired.
They’re both age 60.
They have about $20,000 in ‘other income,’ including interest, dividends, and a part-time job.
No other sources of anticipated income.
Based upon these facts, you can make the following assumptions:
They have up to 12 years to fully convert everything before they start taking required distributions. This means they would need to convert approximately $83,333 per year for the next 12 years to get everything into a Roth account.
According to 2020 tax tables, the 22% tax bracket tops out at $171,050 for a married couple filing jointly. This appears to give sufficient leeway to account for:
Market returns-When the market goes up, so do account values (usually). As account values go up, the amount you have to convert goes up. The converse is true when the market goes down.
Social Security-Taking Social Security at age 70 means that between age 70 and 72, you’ll have additional income to account for.
Based upon this, let’s just simplify this and plan for them to convert $100,000 per year, for the next 10 years. This keeps them in the 22% tax bracket pretty easily, and gives them an extra 2 years of cushion in case there are any unexpected taxable events. This plan would look like:
Not rocket science, is it? But it’s specific, realistic, and intentional. Just what we need to be able to execute.
Roth Conversion Strategy Step Three: Execute the Plan
Now that we know what needs to be done, all we have to do is actually do it, right? Of course, it’s not always that simple, for a couple of reasons.
There’s the mechanics—how do you actually do this? To do this involves answering questions like:
Do I have both a traditional IRA and Roth IRA? If not, how do I set them up?
If I have shares of securities (like stocks or mutual funds), do I sell them and transfer the cash, or can I transfer the securities directly?
Which securities should I transfer to a Roth IRA, and which ones are best left in my traditional one?
Do I have them send me a check, then deposit that check into my Roth IRA, or can they directly transfer the money without me receiving it?
How do I do this without messing up my current asset allocation?
2. There’s the dread of actually doing the work. It’s the same dread that causes many people to wait until the day before the tax filing deadline to do their tax return—even if they are expecting a refund and have had all the paperwork for weeks. You might like the sausage, and even want to know how it’s made—you just don’t want to actually make it yourself.
3. Because of fear that you might get it wrong. Because if you get it wrong, that might mean tax consequences for you.
And that fear causes the execution to not happen.
This is where your investment advisor can take work off your plate. In fact, it’s one of the things they should be doing for you, for the simple reason that it actually gets done. But more than that, your advisor should be helping you keep an eye on your plan.
Roth Conversion Strategy Step Four: Evaluate the Plan
Keeping an eye on your plan. For what? A couple of things:
Taxes. Doing this properly results in paying the least amount of taxes possible. Doing it improperly can lead to anything but.
Changes in your financial situation. What if an emergency came up, and you had to sell $50,000 in stock from another account to deal with it? That might have a direct impact on this year’s conversion opportunity.
Investment rebalancing. Keeping your money properly invested while you’re making Roth conversions is important. It’s your advisor’s job to worry about this so you don’t have to.
There should be at least one meeting per year where you and your advisor discuss this plan, and whether any adjustments need to be made. For us, we cover this during our tax planning meeting, which we usually hold between July and September. And if adjustments are needed, then we set aside time to discuss them.
Roth Conversion Strategy Step Five: Adjust as Required
Exactly that. For example, if you had an extra $50,000 in income this year, you might decide to adjust the plan so that you’re only converting $50,000 this year, and that you’ll convert $110,000 each year (instead of $100,000) for the next 5 years.
And we’re doing these last three steps—executing, evaluating, and adjusting, during our tax planning meetings.
Roth conversions can make absolute sense for people, when done with a specific, realistic, and intentional goal in mind. Once the goal is established, then putting together a plan, which you systematically execute, evaluate, and adjust, will help you ensure that your Roth conversions go more smoothly.
If you have a financial advisor, they should help you do this. If you don’t have one, and this seems daunting to you, then contact us. This is a routine service we provide for all of our recently retired (and soon-to-be retiring) clients. We’d be more than happy to schedule a complimentary phone call to see if we’re the right firm to serve your needs.