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Roth IRA Conversion Plan:  A Case Study  Thumbnail

Roth IRA Conversion Plan: A Case Study

Estate Planning Investment Planning Tax Planning Retirement Planning

One of the most common services that we perform for our clients is Roth conversionsparticularly for our recently retired clients.  If you don’t mind how much you pay in income tax, it can be quite simple to do Roth conversions.  However, if you’ve accumulated significant wealth in your retirement accounts, you might have a hefty tax bill if you decide to do this all in one year.  If you want to keep your overall lifetime tax liability as low as possible, you’ll probably want to do your Roth conversions over time, and make annual adjustments depending on significant tax events that occur each year.  In other words, you probably need to establish a Roth conversion plan.   

Below is a case study from of a Roth IRA conversion plan that we’ve set up for one of our clients.  We’ve changed the names and other details to protect our clients’ privacy.  While this is based upon a real Roth conversion plan, please note that this case study is purely hypothetical. 

Before we begin, a disclaimer to make our compliance officer happy:   

If you are a state or federal auditor, please note that this article does not contain any investment projections and is for educational purposes only.  This article makes no assumptions, claims, statements, or projections about market performance and simply treats the account balances as if they were earning zero income.  While noting investment performance is an important part of a successful Roth conversion strategy, we at Lawrence Financial Planning believe that this should be reviewed with each client on a regular basis, with adjustments primarily based upon the client’s tax situation.  Hopefully, this disclaimer is long and detailed enough to have covered all the bases, as we believe this article is compliant with the Investment Advisers Act of 1940.  However, we understand and respect the SEC’s and state regulators’ opinions and will cheerfully make any recommended changes to ensure compliance with applicable state and federal law. 

Let’s begin, shall we? 

Meet the Smiths 

Not really.  But that’s their name for the purpose of this article.  John and Helen Smith came to us in 2020.  John, who is 60, has just sold business and retired.  He has about $10,000 in residual income from the sale of his business.  He has $195,000 in a traditional IRA.   

John’s wife, Helen Smith, plans to work until early 2023.  She currently earns about $35,000 in after-tax income and has 20% taken out for taxes.  She is 2 years older (age 62) and about $125,000 in her IRA and $178,000 in her 401k at work.   

She plans to max out her pre-tax 401k contribution in 2020, 2021, and 2022 because her workplace does not offer a Roth option.  They’re also pretty stingy and don’t provide an employer matching contribution.  This is an additional $78,000 that we’ll have to convert into a Roth account.   

The Smiths also have about $10,000 per year in dividend income (all qualified), and no other sources of income.  They plan to take Social Security at age 70, which will provide them with the maximum expected benefit over their lifetime.  Helen expects to have about $15,000 in annual Social Security income, while John will have about $30,000. 

How do we figure this out?  Let’s start by looking at what their current year’s tax projection will look like. 

Step 1:  Current year tax projection 

Running our tax planning software, we can input these numbers and come up with an estimated tax bill for 2020 (Exhibit 1).  A couple of things to notice: 

  • Even though the Smiths have $55,000 in adjusted gross income, their standard deduction takes their taxable income all the way down to $30,200.   

  • This puts them squarely in the 12% tax bracket, so there are several planning opportunities here. 

  • By the size of their projected refund, it appears that Helen is withholding way too much from her paycheck.  While this is a separate discussion, we would include withholding recommendations at our tax planning appointment. 

So, the key point is that the Smiths are squarely in the 12% tax bracket.  Since this is one of the lowest tax brackets, this is a prime tax planning opportunity in several areas—lets see how much we could possibly convert and stay in the 12% bracket.   

Step 2:  Current year Roth conversion scenarios 

Using our tax planning software, we run two conversion scenarios: 

  • A scenario that keeps us securely in the same tax bracket (12% in this case) 

  • A scenario that slightly bumps us into the next tax bracket (22%) 

In Exhibit 2, we’ve done just that.  In Scenario 2, $45,000 Roth conversion would result in $75,200 in taxable income, which keeps us squarely in the 12% tax bracket for 2020.  A $50,000 conversion (outlined in Scenario 3), would push us into the 22% tax bracket.  

Note:  Our tax planning software says 27% because there are other calculation, such as account phase-outs that would directly impact the next $1,000 of income.  After these phaseouts (i.e. if we were to use a $75,000 conversion number), this number goes back to 22%. 

We always take a conservative approach, just in case an unexpected event (like a higher than normal bonus) causes the income to go up.  In this case, we would recommend that the Smiths convert $40,000 this year, since this is their first year as our client.  In the future, we can make adjustments if we need to. 

But what does this look like for the long term?  What adjustments do we need to make each year to meet the client’s goals?  Let’s start by building the year-over-year projection. 

Step 3:  Long term Roth conversion projection 

In order to build a projection, we should start with some basic goals.  We usually start with the goal of: 

  • Converting everything into a Roth account by the time each client starts taking required minimum distributions (RMDs) 

  • Converting the older spouse’s accounts first, since they will be subject to RMDs before the younger spouse. 

  • Staying in the lowest possible tax bracket.  That would normally be the current year’s tax bracket, unless one or both of the clients are working. 

In the case of the Smiths, we’d like to convert all of their accounts ($498,000) into Roth accounts by the time each of them turns 72, and we’d like to stay in the 12% tax bracket the whole time.  We plan to start with Helen’s IRA (which will include her 401k once she retires and rolls it over into her IRA).   

Exhibit 3 shows us that we could convert $45,000 per year and safely have everything into a Roth account by the time either Helen or John turn 72.  However, there are quite a few things missing: 

  • We’re not taking into account Helen’s annual 401k contributions 

  • When Helen retires in 2023, we can increase the amount of each conversion within the tax bracket. 

  • Social Security income  

  • Other taxable events, like regular IRA withdrawals 

  • Investment returns—we won’t account for them in the article, but err conservatively to stay within our desired tax bracket. 

To have a more accurate projection, we need to make adjustments. 

Step 4:  Making adjustments to the projection 

Using what we already know, we can make the following adjustments to our projection: 

  • Add $26,000 per year to Helen’s 401k balance because she is maximizing her contributions. 

  • When Helen retires in 2023, we will do the following: 

  • Transfer her 401k balance to her IRA 

  • Increase her annual conversions by $15,000.  While her salary was $35,000 per year, we will start with a modest increase in her conversions just in case they need to generate income to support their living expenses.   

  • Decrease annual conversions when Helen starts Social Security.   

Exhibit 4, which shows these adjustments, still has everything safely converted into a Roth account, at the desired tax bracket, by the time either John or Helen would be required to take minimum distributions from their accounts.   

Of course, we might have a situation where we can’t convert everything at the desired tax bracket within the desired time.  So we might have to revisit our assumptions. 

Step 5:  Revisiting assumptions and making tradeoffs. 

In the Smiths’ case, we’ve got everything we want.   

100% Roth conversions before having to take required distributions?  Check.   

Everything converted at the 12% tax bracket?  Check.   

Major life events accounted for?  Check. 

Enough wiggle room in the case we’re off by a bit?  Check. 

But things don’t always work out this way.  If the Smiths had $1 million in their IRAs to convert, this would not be possible.  Not without considering some tradeoffs.  Here are some tradeoffs you might consider: 

  • Conversions at a higher tax bracket.  Certainly, 12% is the most desirable realistic tax bracket for most people to stay in.  But if your IRA balances are really high, future required distributions could push you into a much higher tax bracket than you would have thought.  So you might be willing to make Roth conversions at the 22% or 24% tax bracket now so you can avoid the 32% tax bracket in your 70s. 

  • Longer timeframe.  The Smiths started their Roth conversion strategy in their early 60s.  What if you’re starting in your mid or late-sixties?  You might consider making Roth conversions through your 70s (you can do this, but only after you’ve already taken your RMD for the year). 

  • Leave some in your IRA.  Perhaps you declare victory when your IRA is at a low enough balance.  If your RMDs don’t have a significant impact on your taxable income, perhaps you simply incorporate them as part of your retirement plan.  Or perhaps you’re charitably inclined, and would like to leave enough in your IRA to support qualified charitable distributions, which can be made tax-free from your IRA. 

Of course, we can’t make adjustments for everything that might happen.  For example, we did not make adjustments for investment returns, which will have an impact.  If John and Helen decide to start taking IRA withdrawals or sell stock to cover living expenses or to travel, we would have adjust our Roth conversion accordingly.   

Likewise, changes in the tax code (like annual adjustments to the income tax brackets and the standard deduction) can’t be projected too far out, either—there will likely be more opportunity to convert to Roth within the same tax bracket.  This is where the annual planning comes in. 

Step 6:  Annual adjustments 

The Smiths have a Roth conversion strategy that stretches over 12 years.  What good is a 12 year plan if we don’t periodically check it to see if we’re still on track. 

While this is fairly simple to explain, the execution is the hard part.  Not only do we have to get our projection correct in 2020, but we have to look at this each year—2021, 2022, etc.  We’re looking to make sure that: 

  • Our basic assumptions are still correct 

  • We have updated the account balances—this is how we account for any investment changes. 

  • The current year’s tax projection is in line with the plan. 

Since we do a tax planning meeting with the Smiths each year, this is simply part of our regularly scheduled meeting.  We generate a tax projection, then offer a conversion amount that keeps them in the desired tax bracket.  Usually, this will be pretty close to the plan.  However, if we see a change that we think will last (like a permanent change in income), we incorporate that into the current year tax projection and the conversion plan.  That helps us keep things in line for the current year and future tax years. 

Conclusion 

It can be difficult to figure out how Roth conversions work.  Not only do you have to figure out what you want to do in the current year, but it’s important to recognize that you might not get everything done in one year.  If that’s the case, then you probably need to develop a plan that focuses on the things you think are most important. 

If you’re wondering how a Roth conversion strategy might work for you, please contact us.  This is a service we provide for all of our clients.  We’d be more than happy to see if we are the right fit for you. 

 




The foregoing content reflects the opinions of Lawrence Financial Planning, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will recover or react as they have in the past.




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