How to Use Roth Conversions to Save Huge Amounts in Taxes

Our topic on this episode of the Ready for Retirement podcast is about how to use Roth Conversions to save huge amounts in taxes over time.

Questions answered: When should I do a Roth Conversion? When is the best time to invest for retirement? What are the benefits of Roth Conversions and when is it best to do them?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

• Roth Conversions
  • A tax planning tool used to take advantage of where tax rates are today to potentially limit paying higher taxes in the future.
  • Example: Assume you have $1.9 million in your IRA, and you choose to withdraw from your brokerage account in order to cover living expenses for 11 years, until age 72. 
    • Age 72: Begin RMD (Required Minimum Distributions).
    • Assume growth rate of 7%.
    • 7% growth for 11 years would just more than double the account value to ~$4,000,0000.
    • There is a RMD of 3.9% ( $156,000) and it is required to take this in the first year of RMDs, which is fully taxable.
    • Listener Question’s Total Taxable Value : ~ $300,000/year
      • $156,000 from RMDs
      • $65,000 from pension
      • $80,000 of taxable Social Security earnings
      • This would put you in the 24% tax bracket in today’s Federal Tax Bracket
  • 2016 Tax Rates
    • Four years ago, $300,000 of income would put you in the 33% tax bracket, and we don’t know where tax rates will be in the future, but likely higher than it is today
    • If a spouse predeceases the other, MFJ (Married Filing Jointly), and the surviving spouse has to file as Single, there are significant tax planning opportunities.
      • Today, $300,000 of income puts you in the 24% tax bracket, but if you file as Single, with $300,000 of income, you’re in the 35% tax bracket. 
  • Income
    • The listener who submitted this question likely has plenty of income to last the rest of their life, but can they optimize their funds to ensure they’re taking advantage of tax planning opportunities?
    • With a high income, there are high taxes owed, and the opportunity to decrease taxes in the future arises with proper tax planning.
  • Brokerage v. Traditional IRA
    • Should I withdraw on my IRA or withdraw from my brokerage account in retirement?
    • How do we keep the taxable portion of our portfolio lower?
    • Roth IRAs – no RMDs (required minimum distributions)
    • Withdrawing from your IRA today would limit the growth of the IRA, thus decreasing the RMD amount in retirement.
  • Roth Conversions
    • Should I convert portions of my IRA into my Roth IRA?
      • Historically, tax rates are low today.
        • How can we take advantage of today’s tax rates and fill up certain brackets that we think will rise over time?
  • Roth Conversion Example
    • Let’s assume your total taxable income for 2021 is $65,000, coming from a pension.
      • The Standard deduction in 2021, if MFJ, is $25,100.
        • If one spouse or both spouses are 65+, there’s an additional $1,300/spouse.
      • If we take the $25,500 standard deduction, taxable income is now $40,000 ($65,000 – $25,000)..
        • You have 10% Federal Taxes owed on the first $19,900 on taxable income that you have.
        • You then pay 12% on any income from $19,900 – $81,500, which would be $20,100.
        • In this example, the individual(s) would pay a blended rate between 10% and 12% Federal Tax Brackets.
      • If you chose not to explore tax planning opportunities, it would seem great in the near-term by paying a low tax bill, but in the future you would likely be paying much higher tax rates.
      • Can we fill up low tax brackets?
        • In this example, we’ve only used $20,100 of the 12% tax bracket. 
        • Ideally, we would show income of $81,500 to take advantage of the 12% tax bracket, which is likely to be one of the lowest tax brackets you will be in over the course of your lifetime. 
        • To do so, we would convert $41,500 from a traditional IRA to a Roth IRA. 
        • If you wanted to fill up the 22% tax bracket, you could convert another $91,700 to fill up the 22% tax bracket at what we hope are lower tax rates today than if we continued to let our money compound in the future.
          • This is a total conversion of $132,750.
          • Taxes are owed on this today, which asks the question of, how much should you convert?
            • What amount is right for you to convert?
            • Can you convert enough to fill out the lower ends of the tax thresholds to manage the future liability of taxes?
          • This allows you to convert funds into a Roth IRA, where growth is completely tax-free for the rest of your life. 
        • This is not an IRA withdrawal.
• Overview
  • Roth Conversions are about balancing taxes today and taxes in the future, by taking advantage of historically low tax rates.
  • It’s not about leaving everything in your IRA or converting everything into Roth IRAs. 
    • It’s about finding what’s best for your individual situation.
  • Roth Conversions are a great tool to take advantage of low tax brackets so you can lower your overall tax bill throughout retirement. 

Timestamps

00:40  – Listener Question

3:20 – Viewing Your Entire Tax Picture

4:00 – Understand Your Expenses

6:35 – RMDs & Tax Planning (Required Minimum Distributions)

10:03 – Tax Brackets: Married Filing Jointly (MFJ) v. Single

12:00 – Taxable Accounts v. Traditional IRA

14:34 – Roth Conversion Example

17:30 – How To Keep Taxes Low & Implement Roth Conversions

21:00 – Aligning Your Investments With Your Financial Goals

Resources:

Submit your question:

Subscribe to the show

Work with James