Our topic on this episode of the Ready for Retirement podcast is about understanding when it makes most sense to consider making Roth Conversions.
Questions answered: When should I consider a Roth Conversion? What are the pros & cons of a Roth Conversion? What is the best approach for my individual situation?
Are you ready to start focusing on the things that truly matter when it comes to your financial future?
Key Points
- When Should I Consider Making Roth Conversions?
- Listener Question Assumptions:
- Age 59.
- ~$2,600,000 in IRAs.
- Assume withdrawals from age 59 -72 aren’t required and other accounts are used to maintain lifestyle.
- Assuming a 6% return, $2,600,000 would grow to ~$5,600,000 by age 72.
- ~$3,000,000 of growth is fully taxable.
- Listener Question Assumptions:
- RMDs
- RMDs are a % of your account balance that must be taken out each year
- At Age 72, a RMD on a $5,600,000 portfolio would be ~$215,000/year and increasing each subsequent year
- RMDs push you into a higher tax bracket
- Why I like Roth IRAs
- Roth IRAs don’t have RMDs.
- Roth IRAs grow tax-free forever.
- Roth IRA distributions don’t impact IRMA surcharges – premiums for Medicare.
- The higher your income, the higher your surcharges on Medicare taxes will be and Roth IRAs don’t count against that, whereas IRAs do.
- Should everyone do Roth Conversions?
- No! Roth Conversions can be a great tool to decrease your future tax bill, but it depends on your individual situation.
- When should I begin considering Roth Conversions?
- When income is low.
- If you know you will be in a higher tax bracket in the future, converting a piece of your IRA into your Roth IRA allows you to lock in a lower tax bracket.
- Check out Episode 50 – How To Use Roth Conversions To Save Huge Amounts In Taxes
- When the market is down.
- Example: Let’s assume you have $500,000 in a Traditional IRA.
- If you are invested in an S&P 500 index fund and you wish to convert $50,000/year from your IRA to Roth IRA over the next 5 years, that $50,000/year represents 10% of the account balance.
- In year one, you have 10% in your Roth IRA and 90% in your Traditional IRA.
- 10% of the growth is happening in your Roth IRA and 90% is in your Traditional IRA.
- Let’s assume the market drops 50%.
- In your IRA, your $500,000 has dropped to $250,000.
- When the market is down significantly, it can be a great time to convert funds from your Roth IRA to your IRA.
- If you were to convert the same $50,000 in year one, that now represents 20% of your overall account value, not 10%.
- As the market recovers, 20% of the growth is now happening in your Roth IRA and 80% is happening in your Traditional IRA.
- After assuming Roth Conversions make sense for your situation, market downturns can be a great opportunity
- In your IRA, your $500,000 has dropped to $250,000.
- When income is low.
- Tax Deductions
- Is there a year where you have significant deductions?
- Check out Episode 51 for more on deductions: Episode 51 – The Ultimate Tax Planning Strategy – Combining Roth Conversions With Other Deductions
- Roth Conversions can be a great way to create income and paired best when you have significant deductions in any given year.
- Is there a year where you have significant deductions?
- Creating Provisional Income Low
- Social Security isn’t taxable like other income sources.
- If you add up all of your provisional income, file your taxes as MFJ (Married Filing Jointly) and all of your Social Security Income is under $32,000, there are no taxes due.
- How is Provisional Income Taxed?
- Cut your Social Security benefit in ½.
- If you file MFJ and you both have $2,500/month of income, which is $30,000/year per spouse – the total is $60,000.
- ½ of $60,000 is $30,000.
- $30,000 is the amount that is counted towards your provisional income.
- Example:
- Assume you have a Roth IRA with $10,000,000 and you are taking out $500,000/year to live on in addition to your $60,000 of Social Security.
- When you’re looking at what you owe on Social Security, $30,000 is counting towards provisional income, but $0 is counted towards provisional income from your Roth IRAs (one of the main reasons Roth IRAs are so powerful).
- In this example, $30,000 is your provisional income, which is under the $32,000 threshold, so 0% of your Social Security income is taxed.
- Roth Conversions can make sense to keep provisional income low so you can never owe taxes again when you retire.
- Social Security isn’t taxable like other income sources.
- When Shouldn’t I Do Roth Conversions?
- Without understanding your net worth, future projected tax brackets, income, etc. there’s no way to determine whether a Roth Conversion or anything discussed on this podcast makes sense for you
- If you think taxes are going to be the same or lower in the future, Roth Conversions may not make the most sense.
- Example: If you’re in a high tax bracket today and know you’re going to be in a lower tax bracket in the future, Roth Conversions likely won’t make sense for you.
- If you are living in California today and planning on moving to Texas, Roth Conversions may not make the most sense. If you plan on moving to a state with a high income tax, it may make sense to do Roth Conversions today to avoid paying a higher income tax in the future.
- What order should I do Roth Conversions in?
- If all Roth Conversions belong to the same individual, it may make most sense to convert the most aggressive portfolios first to leverage the amount of future growth in your Roth IRA.
- Which spouse should do Roth Conversions first?
- The older spouse, more often than not, should convert their IRA first as they are going to be forced to take RMDs sooner than the younger spouse.
Timestamps
1:44 – Listener Question
3:50 – Higher Tax Brackets
5:40 – When Should You Consider Roth Conversions?
7:00 – Determining How Much You Should Convert
9:22 – Roth Conversions When Markets Are Declining
11:38 – How To Calculate Your Provisional Income
13:30 – Social Security Taxes
15:12 – When Shouldn’t I Do Roth Conversions?
18:18 – Which Spouse Should Do Roth Conversions First?
19:00 – Aligning Your Investments With Your Financial Goals
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