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Roth Conversions in Non-Traditional Scenarios & Investing in Muni Bonds

James · October 5, 2021 · Leave a Comment

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Our topic on this episode of the Ready for Retirement podcast is about Roth Conversions in non-traditional scenarios & investing in municipal bonds.

Questions answered: When do Roth Conversions make the most sense to implement? What are some examples of non-traditional scenarios where a Roth Conversion makes sense? Should I be investing in municipal bonds for tax-free income? What is the best approach for my individual situation? 

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Key Points

  • Roth Conversions 
    • Once you’ve determined a Roth Conversion is best for you, you usually have a few years to implement this strategy. 
    • But what if there’s an age gap between spouses (i.e. one spouse retires as another approaches RMDs?
      • RMDs = Required Minimum Distributions
  • Be Intentional About Your Conversions
    • In most cases, converting the assets of the older spouse approaching RMDs can be most tax-efficient.
      • Convert the older spouse’s assets first to minimize a larger pre-tax amount and your RMD amount each year.
  • RMD Age
    • There’s talk that the RMD age may get pushed back further.
      • RMDs currently start at age 72 
        • Prior to this, RMDs were at 70 ½ 
  • Asset Location
    • Check out this episode for more information: How to Manage Asset Allocation and Asset Location Leading Up to Retirement | Episode 76
    • Asset Location is about taking the most tax-inefficient assets and putting them into a tax efficient account (i.e. IRA) and putting tax-efficient assets into tax inefficient accounts (Taxable).
    • It may make sense to move bonds into your IRA as bond interest is subject to ordinary income as opposed to capital gains taxes (tax-preferential).
      • Bonds are often used to manage the IRA balance and limit RMDs.
  • Convertible Years
    • Assuming a Roth Conversion makes sense for you, you may have 6-12 years (not in this particular case, but in general) to convert pre-tax dollars to after-tax dollars in a tax-efficient manner.
  • RMD Deferral
    • Consider deferring your first RMD until April 1st of the following year.
    • Your RMD is in the year you turn age 72, but your first RMD must be taken by April 1st of the following year.
      • In some cases, it may make sense to defer the first RMD until the following year.
        • This means an additional RMD must be taken at age 73, but it allows for an additional year of conversion opportunities.
  • RMD Example
    • Assume the RMD in Year 1 is $50,000 and you choose to wait to take the RMD until the following year.
      • Implementing a Roth Conversion of $50,000 will allow your funds to grow tax-free forever.
      • There will be additional taxes the following year because there are two RMDs occurring as opposed to one.
  • Charitable Giving
    • If charitable giving is of any interest to you, I highly recommend you check out: The Ultimate Tax Planning Strategy – Combining Roth Conversions with Other Deductions
  • Are You In The Highest Tax Bracket?
    • How often should we rebalance?
      • It’s common for people to set up rebalancing of a portfolio on a consistent basis (semi-annually, annually, etc.)
        • This isn’t a terrible approach, but I don’t feel it’s the most effective approach.
    • It’s not only income taxes you must look at.
      • Net Investment Income Tax is a 3.8% tax on investment income if your MAGI is above $250k (MFJ) or $200k (Single).
      • IRMAA Surcharges
        • You may pay an additional $433.50/month per person if you’re at the highest rates.
          • Ex: A MFJ couple would pay an additional $10,400/year in taxes that would be paid based upon extra medicare premiums.
            • This applies if your MFJ and MAGI is $750,000 or more.
            • It begins to tier up starting at $176,000 (MFJ) of MAGI and $88,000 (Single) of MAGI.
      • Estate Taxes
        • If you’re in the highest income tax bracket, it’s likely you have a significant amount of assets.
          • As of today, you have $11,700,000 of lifetime estate tax exemptions per person.
        • Example: Let’s assume your net worth is $30,000,0000
          • If you are married, you have a $23,400,000 lifetime estate tax exemption (MFJ).
          • If you and your spouse were to both pass, there would be $6,600,000 that is taxable. 
            • The estate tax would be $2,640,000.
        • The proposed tax law change may decrease this lifetime estate tax exemption. 
        • If you’re in a position where you’re in the highest tax bracket today and anticipate you will be in the future, this is where taking a broad look at everything will allow you to limit the amount you must pay in taxes.
    • Municipal Bonds
      • I advise that you first determine if it makes sense to even own bonds in your taxable account, as we often want our IRAs to receive the interest (no taxes in retirement accounts) and limit future RMDs.
        • If you choose to use municipal bonds, you want to put them in your taxable account because they are tax-free.
      • I recommend using Roth IRAs for maximum growth and not putting bonds in this type of account.
      • Let’s assume you want to use Municipal bonds for after-tax income.
        • Income from investing in Municipal bonds is generally exempt from federal and state taxes for residents of the issuing state.
        • Any capital gains are fully taxable (i.e. if you buy a Municipal Bond the interest is tax-free, but the capital gain is taxable).
        • Municipal bonds fund the day-to-day operations of states and municipalities (i.e. Building Schools, Sewer Systems, Roads, etc.).
          • Municipal bonds tend to have lower yields.
      • Example: Let’s assume you have a taxable account and you’ve determined you want bonds in your account.
        • Now let’s assume you have two options: 
          • Option 1: Corporate bond paying interest of 5%.
          • Option 2: Municipal bonds paying interest of 3.5%.
            • Assume a combined tax rate of 20%.
        • To determine what is best for you, you want to run an analysis to determine the best after-tax yield.
          • Option 1: (5% x .20% = 1%). 5% – 1% = 4% (after-tax)
          • Option 2: (3.5% x (tax-free)) = 3.5% (after-tax)
        • Although Municipal bonds are tax-free, you’ll notice in this case that the corporate bond still pays a higher after-tax interest rate.
      • Start with asset location and determine if you need bonds in your portfolio.
        • I often see asset location implemented prior to determining the asset allocation, which can greatly decrease the potential return over time.
        • If you determine you need bonds in your portfolio, consider owning them in a tax-free account as bond interest is less tax-efficient than capital gains.

Timestamps


1:00 – We’re on YouTube!

2:53 – Roth Conversions for Married Couples 

5:21 – Asset Location

7:54 – Convertible Years

10:12 – RMD & Roth Conversion Strategy

12:48 – Tax Planning

15:03 – Net Investment Income Tax

18:34 – Estate Tax

21:37 – Municipal Bond Strategies

23:47 – Tax-Equivalent Yield

25:09 – Submit Your Question!

26:02 – Aligning Your Investments With Your Financial Goals

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