Roth Conversions Part 2: A Five-Step Process to Determine if a Roth Conversion Makes Sense for You
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm tackling part two of our two-part series on Roth conversions. Specifically, I'm sharing how to determine if a Roth conversion makes sense, a Roth conversion case study, and common mistakes and pitfalls to watch out for. So 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, just head over to youstaywealthy.com forward slash 148. Okay, let's quickly recap the basics of a Roth conversion before we get further into the weeds here. 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 or converted is taxed in the year that you make the conversion. However, that money that you convert is permitted to live inside of your Roth IRA for as long as you want it to. So what's so great about that money living inside of a Roth IRA? Why do we love Roth IRAs so much? Well, three reasons.

One, assuming you invest the money inside your Roth IRA, your investments, your money grows tax-free. In other words, you don't pay taxes on dividends, interest, or capital gains. And in turn, that means that you'll have more investment growth over long periods of time.

Number two is you avoid those pesky RMDs, those required minimum distributions that often come at an inopportune time. And that's because money in a Roth IRA is not required to be withdrawn like a traditional IRA. You can leave your investments growing in there forever. And that actually leads us nicely to benefit number three, which is 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 are not forced to drain the account and pay the tax bill within a 10-year time period.

The other big benefit of having money inside a Roth IRA in retirement is the flexibility that it provides. For example, if you need a new roof on your house or you want to take a big unplanned vacation, well, you can withdraw money from your Roth IRA without worrying about what that withdrawal might do to your tax bill that year. And in retirement, spiking your tax bill can mean more of your Social Security becoming taxed.

Medicare surcharges kicking in and other things. It can also lead to overpaying the IRS if you have tax bills that 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 that everyone should just race out to process Roth conversions tomorrow. With

With that in mind, let's talk about how to determine if you are a good candidate for Roth conversions. And to preface here, 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 this process as simply as possible. I just want to give you a foundation for evaluating this 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 at least a CPA with a planning background, even if it's just paying for a few hours of their time to validate your findings. So with that disclaimer behind us, here is a simple five-step process that you can use as a starting point for determining if a Roth conversion or a series of Roth conversions might make sense.

Step number one is to add up all of your pre-tax retirement account dollars. So your traditional IRAs, traditional 401ks, SEP IRAs, simple IRAs, add up all those pre-tax account dollars, that money that's never been taxed before and write that number down.

Step number two is to estimate your required minimum distributions that kick in at age 72. Now, I know there may be some upcoming changes here with the Secure Act 2.0, but let's just table that for now. Let's estimate your required minimum distributions, assuming that they're going to hit you at age 72.

Step number three, add up additional taxable income that will stack on top of those required distributions at age 72. From there, step number four, estimate your tax bracket at age 72. And then step number five, compare that estimated tax bracket to your current tax bracket.

A couple of notes before we break this down even further. First, estimating your RMDs at age 72 can be a little tricky. It's a two-step process with part one being a future value calculation and part two applying the IRS uniform lifetime table. So I want to try to help you here.

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 forward slash 148. And I've also linked to the updated IRS tables so that you get quick access to those as well.

The one assumption that 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, your 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, well, your RMD will also grow along with it. And

And while the stock market has historically had an average annual rate of return of around 10%, and some of these calculators will push you towards using that number, 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.

You know, keep in mind 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 that when you go to estimate your taxable income that's going to stack on top of your RMDs at age 72, you'll want to include income sources like dividends and interest that you earn in taxable investment accounts, pensions, social security, and any other investment income.

And remember, with regards to Social Security, if your total gross income in a given year is above $34,000 as an individual or $44,000 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.

So to recap the five step process, number one, add up all of your pre-tax retirement account dollars. Step two, estimate your first RMD at age 72.

Step number three, add up additional taxable income that will stack on top of those RMDs. Number four, estimate your tax bracket at age 72. And number five, compare that estimated tax bracket 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 here is that we don't want the rate that we pay on a Roth conversion to be higher than our future tax rate in retirement or and or when required minimum distributions hit us at age 72. For example, if we're in the 35% tax bracket today and our future projected tax bracket is 22%,

We probably don't want to rush out 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, well, 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.

Now, one common question I get is what to do if my 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. So 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

or do nothing, let that $100 grow into, let's say, $200, and then pay 22% on that higher balance of $200.

As I 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 that money out. So if your projected tax bracket appears to be the same as your current and you believe that your investments will grow between now and age 72, then you might lean towards paying taxes on that money now to stop the tax liability from growing.

Which leads to the other assumption that 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, well, that might further incentivize you to get your pre-tax dollars converted to a Roth. Okay, let me attempt to string all 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 that five-step process with her. So step number one is to add up her pre-tax retirement account dollars. Anna has been a great saver, and we determined that she has about $1.8 million in a traditional IRA.

Step number two is to estimate her first RMD in 15 years when she reaches age 72. Since she has 15 years and she's more of an 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 determined that her $1.8 million IRA will turn into just over $4.3 million in 15 years.

Now, using the IRS uniform lifetime table, we simply take the $4.3 million and divide it by the life expectancy factor given to us by that table of 27.4. So 4.3 million divided by 27.4, and that gets us to her first estimated RMD amount of, we'll just round up and let's just call it $160,000.

So at age 72, she'll be required to withdraw an estimated amount of $160,000 from her traditional IRA, whether she needs that money or not. And she'll have to pay taxes on that amount. She'll be forced to take similar sized annual withdrawals every year thereafter.

But that's not her only income, right? That leads us to step number three. Step number three is to add up additional taxable income that she'll have on top of those RMDs. Well, Anna has a pension of $30,000 per year, and she anticipates about $15,000 per year in dividends from her taxable investment account. And she also expects social security to be about $40,000 per year, assuming she delays it to age 70.

So she'll 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 number four is to then 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 five, is to compare her projected tax bracket to her current tax bracket. Well, since Anna's now retired, she only has her dividend income and pension income to take into consideration here, which is about $45,000 per year.

Now, that won't completely cover her living expenses, but she has money in taxable accounts that 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 need to plan appropriately for paying taxes on any realized long-term capital gains that she might use to fund living expenses, they aren't factored into her taxable income that's 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 her tax rates.

So 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 in 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. Uh,

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 quite some time here for the next 15 years.

Given all 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 start to withdraw that money at age 72.

And if she was up for being a little more aggressive, which she is, there's even a case to be made to convert up to the 24% bracket. Yeah.

So if she did annual Roth conversions between now and age 72, and she maxed out her 24% tax bracket each year, some quick back of the napkin math shows that her first required minimum distribution might get knocked down to about $70,000. So her first RMD might get cut by more than half, which after factoring in her other taxable income would place her in about the 24% bracket at age 72.

instead of the 35% bracket that she was projected to be in initially. 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 paying the IRS.

But by how much? How much is she avoiding overpaying the IRS? Well, that's a complicated calculation, as I mentioned in part one of this series. By my estimate, if she did nothing and waited for the IRS to just come knocking on her door at age 72, she's looking at a total retirement tax bill of around $8 million. That's the amount that she's 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, before you send a bunch of emails to me, I strongly, strongly, strongly discourage anyone from getting too attached to these numbers and projections because they are just that. They are projections. And we're 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 till age 78, well, you can throw most of this out the window. So it may not be a $3.2 million tax savings. It might be $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 here, 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 as well.

Lastly, it's important to note here that Anna is not 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, 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.

Okay, to bring us home, I want to highlight three common mistakes and pitfalls related to pursuing Roth conversions. Number one mistake is paying the Roth conversion taxes from your IRA. So yes, technically you can pay the tax bill owed from a Roth conversion from your traditional IRA or existing Roth IRA dollars if those Roth IRA dollars have met the five-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 and a half, paying the tax bill from your traditional IRA would trigger the 10% early withdrawal penalty because the traditional IRA money used to pay the tax bill would actually be considered a withdrawal and not part of the 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 up into your gap years. So if you didn't plan ahead or don't have non-retirement dollars to pay the tax bill with, you might reevaluate the benefit of Roth conversions to begin with.

The number two mistake I want to talk about is not considering your charitable goals. And 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, also known as 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 you can avoid paying the taxes on that distribution. So if your RMD is projected to be, let's say, $50,000 per year, you can donate up to

and you plan to donate most or all of that distribution every year, then pursuing Roth conversions might not make sense. Like why convert money to a Roth and pay taxes on it when you can just wait and send that money straight to charity when the RMDs hit and avoid the tax bill altogether?

The second mistake when it comes to charitable gifting is, for those who are charitable 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 that 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.

Lastly, mistake number three is forgetting about IRMA, that 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 and if they might affect your Medicare premiums.

Remember, Roth conversions spike your taxable income. And if your taxable income gets above a certain threshold, Medicare IRMA surcharges kick in. And I actually just published a giant article on IRMA surcharges and the 2022 IRMA tax brackets to the Stay Wealthy blog. So if you want to learn more, I'll link to that in the show notes as well.

And this leads to my second point here around Irma, which is that sometimes I see Irma surcharges stop people from pursuing Roth conversions entirely.

Yes, Medicare Part B IRMA surcharges can be as high as $408 per 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 just getting money into a Roth IRA are very meaningful to you, might you be okay with paying an extra $4,800 per year in Medicare premiums for a handful of years? No.

Maybe, maybe not. I don't know. But don't run from Roth conversions solely because you might get hit with IRMA surcharges. The benefit of conversions and or the benefit of getting money into a Roth for your heirs, let's say, might far outweigh the increase in your Medicare premiums for a few years.

In summary, Roth conversions are not a magic bullet. They're also not a fitting strategy for every single retirement saver. The reason I love talking about Roth conversions is not necessarily because if you do them right, they can save you six or seven figures in taxes over your lifetime. It's because it forces you to be proactive in your tax planning. Too many retirement savers do nothing. They enjoy their gap years when 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 that they don't need.

And now Irma 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 that 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 realized that 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 that I made, please do let me know. Send an email to podcast at youstaywealthy.com.

And if I receive enough of them, I'll consider jumping back in and doing a Roth conversion listener Q&A episode just to make sure we avoid any confusion and everyone gets their questions answered.

For the links and resources mentioned today, head over to youstaywealthy.com forward slash 148. Thank you as always for listening, and I will see you back here next week. 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.