Roth Conversions-Why, When & How

Many investors understand the basics of Roth conversions, however just as many do not. In this blog we will discuss the basics of Roth conversions as well as why you might do them, when you might do them and how you actually do them.

Why do Roth conversions even exist?

When you contribute to a tax deferred retirement account such as a Traditional 401k or a Traditional IRA, the money goes into those accounts pre-tax. That means the contributions lower your taxable income for that current tax year which lowers your taxable income which lowers your income tax bill. While that is very helpful, it can lead to a large tax bill in retirement because when you withdraw money from those accounts in retirement, the money is taxed like income from your previous job was taxed.

So, when you are retired and need $80,000 from your 401k or IRA for living expenses, a new car, or a nice vacation, the IRS treats you just the same as if you worked and had $80,000 in earned income.

Worse yet, as you get older the government will force you to withdrawal more and more from your IRA and 401ks. This is known as an RMD, or required minimum distribution.The RMD starts of small but grows continually as you age.

We find that many retirees, may have $1 million dollars in retirement accounts and have no plan on how they are going to effectively manage that money when it comes time to pay taxes on it. That brings us to what is a Roth conversion?

What are the basics of a Roth conversion?

A Roth conversion moves assets from a traditional IRA or a 401k into a Roth IRA. The "conversion" of this money means you pay taxes today on whatever amount you decide to convert.

How much in taxes will you pay when doing a Roth conversion? That depends on your other income and your effective tax rate. Your effective tax rate is the average percentage of income you pay in taxes. Because the IRS uses marginal tax rates and tax brackets to calculate your federal income taxes, finding your effective tax rate requires a bit of additional math. Divide your total tax by your taxable income to estimate your effective tax rate.If we assume your effective tax rate is 10%, about where many retirees see themselves at today, that means you will pay $10,000 in taxes to convert $100,000 from a traditional IRA to a Roth IRA. Is that a smart move? Let's look at an example.

Example of who might need to consider a Roth conversion

A married couple in Missouri, retired, both 67 years old, each with $500,000 in their IRAs, invested in a 60/40 stock/bond split. Besides their $1 million in retirement assets, they have $100,000 in cash and CDs. Their IRA investments are projected to grow at 7.2% per year.

Their only retirement income is a monthly Social Security benefit of $2,500 per month for each spouse. We assume this benefit rises 2% per year.

They desire to spend $90,000 per year for the next 10 years, then plan for spending to decline to $75,000 per year thereafter. All living expenses increase 3% a year to keep up with assumed inflation.

This couple has done very well for themselves. Their diligent savings habits and responsibility to live below their means has led to them amassing a million dollars in their retirement accounts!

But – Here’s what they don’t realize. In just a few years, their tax burden will skyrocket.

Assuming one of our couple live to be 95, how much do you think this retired couple will pay in taxes? (assuming no changes from today’s tax laws)

Approximately $1.1 million!

How can that be?

Much of this tax burden occurs late in life, when the combination of RMDs and Social Security force our retired couple into a high tax bracket. For our example couple, some of their withdrawals later in retirement are going to be taxed at a 32% rate!

This hypothetical retired couple is in a very familiar position that we see many retirees today. While the first few years of retirement will result in a low tax rate – the future looks much different.

Our retired couple has little to no tax burden early in retirement. At the onset of Social Security and RMDs, most of their income is taxed only at the 10% or 12% rate.

Many retirees today are celebrating over their low tax rate. But that can be a big mistake, because their tax rate is going to increase substantially.

As RMDs increase and Social Security benefits rise with inflation, so does our retired couple’s tax rate. By the time they are late in their retirement, money is being taxed as high as 32%!

What can that couple do to avoid that tax bill?

The couple can avoid some of these high tax rates by doing Roth IRA conversions early in retirement.

Remember that the couple’s tax rate was very low early in retirement. If that couple could convert assets from their traditional IRA to a Roth IRA in those early years, they would pay a very low tax rate.

For example, what if we had this couple convert just enough assets to be taxed at the 12% tax rate, but no higher?

Their tax rate later in life would be greatly reduced. Gone are the years of a 32% marginal tax rate!

With this simple Roth conversion schedule, our retired couple could reduce their total tax bill to just over $700,000 – a near $400,000 reduction in total taxes paid compared to if they did no conversions at all!

The Benefit to Heirs and Beneficiaries

Each of your retirement and savings accounts have a beneficiary. This is the person that will inherit your account when you pass. For most, this is your spouse or your children or possibly a Trust.

If you pass along a traditional IRA, your beneficiary will have to pay taxes on every dollar they withdrawal from the account- And the government will force them to take this money out in 10 years. They can do it all in one year or spread it out over 10 years but it has to be completely gone by year 10.

If the account beneficiary has a high income at the time the account owner passes, they are already in a high income tax bracket. Then, the income from the inherited IRA will push their total taxable income even higher – and it will all be subjected to a higher tax rate.

For example, if the inheriting household has a taxable income of around $190,000, they are in the 24% income tax bracket for 2023.

This means that if your heir inherits $100,000 in a traditional IRA – at least $24,000 of it will likely go to taxes! After taxes, that $100,000 inheritance is down to $76,000.

Roth conversions give you the chance to pay those taxes in advance, potentially at a much lower rate. Remember our example client above who was able to convert a significant portion of their traditional IRA into a Roth IRA just by filling up the 12% income tax bracket? That action would cut their family’s net tax bill by $12,000.

And that savings amount potentially increases as the value of the inherited account rises. If you could have similar savings on a larger Roth IRA balance, say $500,000, that tax savings for your heirs rises to $70,000!

Roth IRA conversions allow you an opportunity to pay taxes at a lower rate than your heirs would. For those expecting to leave a sizable inheritance, and whose children are professionals with a decent income – This can be a tremendous benefit.

Roth conversions can be a valuable tool – But there is one more step. How to calculate the optimal amount to convert to a Roth IRA.

How Much to do in Roth Conversions?

When determining the optimal amount of IRA assets to convert to a Roth IRA, we typically target an amount that would “fill up” a specific tax bracket. For example, in 2023 household income between $89,450 and $190,750 was taxed at 22%. If you had $140,000 in income for a year, we may have looked to convert enough IRA assets to generate income to use up the rest of the space in the 22% tax bracket, or $50,750 in this case ($190,750 – $140,000 = $50,750).

We would refer to this as a “22% Roth Conversion Strategy”, meaning we would plan on converting enough assets each year that causes the client to recognize income that fills up the 22% income tax bracket.

For some wealthy individuals likely to leave assets to their heirs, an aggressive conversion schedule may be ideal.

For a retiree with little savings, little to no Roth IRA conversions may be the better strategy.

When to do a Roth conversion?

Because Roth conversions generate income, there is some strategy on the optimal times to perform the conversions in order to avoid an unnecessarily large tax bill. For many retirees, finding a period of low income allows for larger conversions with smaller tax burdens. When is the best time for perform Roth conversions? There is no single answer. It depends on your retirement plan.

What are the risks of a Roth conversion?

Since performing IRA conversions means paying taxes today, you are making a bet that future tax rates do not decline significantly in the future. If tax rates were to fall, it may mean you could convert or withdrawal assets at a lower tax rate later.

There are other political risks with Roth IRAs as well. Congress may someday mandate required minimum distributions from Roths, or even potentially tax them. There’s no guarantee the laws regarding Roth's stay unchanged over the next few decades.

Next, Roth IRA conversions should typically only be done only for long-term investments. Since the process of converting your IRA account to a Roth results in taxes, it is best to take advantage of the ROTH’s long term, tax free growth. If you convert and then need to immediately pull out the money, it may result in higher taxes than you would normally have paid.

Lastly, if you plan to contribute to any charities, or leave any assets to charity at the end of your life, fully converting your 401k and IRA to Roth IRAs may not be a good idea. Since charities do not pay taxes, it does not make sense for you to pay taxes (via a Roth conversion) prior to giving the money to charity.

Is a Roth conversion right for you?

That depends on what your goals are in retirement.

If you are currently at a lower tax rate than you will be in the future, Roth conversions create value. That value will depend on your current and future tax rate, and the amount you convert.

For example, let’s say you can do a $20,000 Roth conversion and remain in the 12% income tax bracket. In this case, you will pay $2,400 in taxes to do the conversion. If in the future your IRA withdrawals would be subject to 22% income tax rate, you would pay $4,400 in taxes in the future. In this case, Roth conversions would be worth about $2,000 in tax savings every year you did them.

You need a plan. We can help.

At 80/20 Financial Services, we are retirement planners and we specialize in working with electric cooperative employees. We can help you answer questions like:

Should you take your cooperative's monthly pension or lump sum offer?
Do you have enough money between your R&S and/or 401k to retire?
Could you possibly retire at age 55?
Is your cooperative 401k invested correctly for your retirement goals?
Should you be investing in a Traditional 401k or a Roth 401k?
Are you contributing too much or too little to your 401k?
Should you quasi-retire from your cooperative?
Should you accept an early retirement offer from your cooperative?
When should you claim Social Security benefits?
How can you lower your tax bill in retirement?
How do you invest your retirement money so that you increase your income in retirement?
How do you create an income stream in retirement that is similar to when you were working?

I started this firm specifically to help electric cooperative employees with retirement planning. I worked for an electric cooperative for 11 years and I know your profession and benefit plans better than any other financial advisor will. You have excellent retirement benefits available to you. I can help you optimize those benefits while creating a retirement income and investing plan that aligns with your retirement goals.

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Thanks for reading!

Brian Coleman-Owner/Advisor

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80/20 Financial Services is an Independent Registered Investment Advisor (RIA) registered in the state of Missouri (CRD# 300772). We help cooperative retirees in Missouri and throughout the United States prosper in retirement. Being independent allows us to work exclusively for YOU.

80/20 Financial Services is the legal name of our Registered Investment Advisory Firm (RIA). Electric Cooperative Retirement Planning is what we do. We are a small boutique type firm that only works with current and former electric cooperative employees and their families. We only work with approximately 50 households at any given time. This allows us to know our clients on a more intimate level. Unlike the big financial advisory firms, you're more than just a number to us.

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