When Roth conversions make sense

[kathyc2]

Another topic brought up Roth conversions.  This is is an area I have done several projections on, and there are definitely times when it's good planning.  I look forward to the discussions. 

 

 

[kathyc2]

Here are some things I’ve learned over to years to consider when planning for conversion/ tax in retired years:

 

Unless it goes to charity, someone sometime will pay tax on IRA/401K money.

Unless the 85% max is reached, adding more income has the effect of increasing marginal rates by 85%. 10% becomes 18.5%, 12% becomes 22.2%, LTCG 0% becomes 8.5%.

More often than not, the point where max 85% is taxable and start of 22% rate are vey close.

The first IRMAA starts close to top of 22% bracket.

SS floors are not indexed and over time a higher percentage will be taxable.  SS, std deduction and brackets are indexed, but not enough to keep things even with the floor that does not increase.

If one spouse dies, the total RMD will stay same for surviving spouse, but std deductions and brackets will be cut in half.

RMD is less than 6% of total for first 13 years.  If investments earn at least 6% the value of account will continue to increase over those years.

Money taken from IRA and not spent will earn taxable income.

Money passed to heirs will be taxed differently: 

Money in Roth can stay for 10 years and possibly double before it needs to be taken out and tax paid on earnings past that point.

NQ accounts will receive step up, but earnings past that will be taxable beginning in year one.

IRA can stay in for 10 years, but will probably have some taken each year to avoid big taxable hit in year 10.

 

[kathyc2]

Some examples of planning with lower income/ lower IRA’s:

 

1. It’s rare that I’ll recommend Trad to someone in 12% bracket, but there are times it makes sense.

Couple in early 60’s with no IRA’s but around 100K on NQ accounts.  I advised them to use NQ money to funds Trad taking tax deduction advantage.  After they retire and have only SS, they will be able to get it out free of federal tax if they spread it out intelligently.

Best of both worlds in the case:  up front tax savings and no tax on withdrawals.

 

2. Widower, mid 70’s 33K SS, 3K investment income.  Currently has about 80K left in trad.

No mortgage and lives how he wants from SS benefits.  QCD takes care of RMD and each year I give him the amount he can convert to Roth free of FIT.  For 2024 that amount is 11K.

 

3. Married couple retired at 65, started SS and both continue to work part-time.  Each year I calculate the amount to put into Trad to be at zero FIT with combination of taxable income and RSC.  After they are no longer working PT jobs, they will be able to convert or take money out of trad free of FIT.

 

4.  Elderly widow insisted on only taking RMD of around 2K a year in spite of my recommendation she take out or convert the amount she could tax free.  Her daughter had been bringing her to appointment last several years.  When daughter inherited the balance 50K or so, she took out the entire amount in one year and paid considerable tax.  I asked daughter if she needed the money, and she said not all but she didn’t want to stick her kids with tax if she passed.  That one didn’t work out all that well.

[kathyc2]

Example with higher IRA:

Couple retired at 63.  She was out of workforce several years when kids were young, so her SS benefits were on the lower side.  15K with starting early.  They had available cash to live on and wanted to not start his SS until later for higher benefits.  They had some in Roths, but majority was in Trad, around 1.2M at that point.

For the next few years, we converted as the amount from Trad to Roth to take them to the top of 12% bracket.  Over the course of 5 years, we converted close to 400K paying less that 35K in FIT.  They had money in NQ accounts to pay the tax so the full amount was converted.

They are currently 70 ½ and making QCD and converting the amount that can to keep FIT to zero.

When RMD’s kick in they will likely be able to stay at zero FIT at least for the first few years. 

This couple want to leave around 20% of total net worth to charity after the last one passes, so I’m not concerned about tax to children as the amount going to charity will come from trad and no one will pay tax on the funds.

 

[kathyc2]

Here's another one that doesn't deal with conversions, but an idea others may be able to use.  

Single gal turned 70 in 2023.  W-2 income mid 40's.  Around 100K in 401K.  She still has a mortgage and with what she had put back and SS things would be very tight.  

We discussed some options and decided it would be best for her to work one more year.  Started SS as there was no benefit to delay past 70.  Rather than having her just add SS benefits to taxable income, I had her max her 401K for that year.  If she wouldn't have done that 2024 tax would be over 6K.  With the 401K and way SS is taxed, 2024 tax will likely be zero or close to it.  Going forward she should have enough between withdrawals and SS to replace her W2 income while not paying FIT. 

[BrewOne]

thanks for posting.

Scenario 1 is a situation I had with a client who cuts hair--she will have no pension, just an IRA (most likely less than $50k) and Social Security.  A financial advisor had told her to contribute to a Roth (probably someone who thought it was always better) and I had to explain that with only a small IRA and Social Security, she probably would not be paying taxes when she retires; and even though it didn't save her much, optimally that savings could go into the IRA.  There is no one size fits all.

[kathyc2]

7 minutes ago, BrewOne said:

There is no one size fits all.

Exactly!  I get so irritated with people who just repeat the mantra delay, delay, delay without looking if it's the best strategy.

I've been looking at how to best reduce long term tax for many years.  Every year I'll see something or read something to expand my thinking on the subject.  

I have Excel templates set up so I don't have to keep reinventing the wheel and I'm constantly refining and adding criteria to make long term projections better. I know I can't accurately predict the future, but even partial planning is better than no planning. 

[mcb39]

On 10/23/2024 at 8:11 AM, kathyc2 said:

Here are some things I’ve learned over to years to consider when planning for conversion/ tax in retired years:

 

Unless it goes to charity, someone sometime will pay tax on IRA/401K money.

 

 

This is not true.  I have retired clients nearly every year that ask how much they can draw from their retirement and avoid paying tax.  If all they have is interest, dividends and SS; it is easy to forcast the safe amount they can withdraw.  It can be any amount if you do the expected calculations correctly.  I have had clients withdraw the max that they can, whether they need it or not.  Going forward, the only tax they will pay will be on the interest if they don't spend it.  Some may even have CG or Capital Loss Carryforwards.  There is no one statement that is true for everyone.  I never advise rolling a conventional into a Roth.  Start a new Roth if you want but NEVER roll.  IMO

[kathyc2]

1 hour ago, mcb39 said:

This is not true.  I have retired clients nearly every year that ask how much they can draw from their retirement and avoid paying tax.  If all they have is interest, dividends and SS; it is easy to forcast the safe amount they can withdraw.  It can be any amount if you do the expected calculations correctly.  I have had clients withdraw the max that they can, whether they need it or not.  Going forward, the only tax they will pay will be on the interest if they don't spend it.  Some may even have CG or Capital Loss Carryforwards.  There is no one statement that is true for everyone.  I never advise rolling a conventional into a Roth.  Start a new Roth if you want but NEVER roll.  IMO

You are correct that if the amount is low enough it may be removed free of FIT.  Looks like I contradicted by own statement with the examples I gave. 

I like converting amounts over RMD rather than distributing for a few reasons:

1.  The earnings from distributions will reduce the amount than can be removed in subsequent years. 

2.  Even if income is low enough to not pay FIT on NQ investments, state income tax can be very likely.

3.  Once it becomes inherited, it gives the heirs more options.

Curious about why you put in new Roth account rather than converting to an existing one?

[jiji778]

Roth conversions make sense if you’re in a lower tax bracket now or want to ease future RMDs. It’s also a good way to give heirs more flexibility with less tax impact.

[BrewOne]

maybe because the converted amount has its own 5-year count? 

I don't think custodians necessarily do a good job of tracking and correctly coding Roth distributions although it's not their fault if someone moves the Roth money over to them and they take it out within 5 years.

[kathyc2]

1 hour ago, BrewOne said:

maybe because the converted amount has its own 5-year count? 

That doesn't matter if the person is over 59 1/2.  The reason the 10% penalty is in place is so those under 59 1/2 don't try to circumvent the 10% penalty on w/d from Traditional by running it through a Roth first.

There are ordering rules how distributions are deemed.  No tax or penalty if over 59 1/2. If under 59 1/2:

1.  Contributions no tax or penalty

2.  Conversions  no tax, 10% penalty if less than 5 years

3.  Earnings are taxed plus 10% penalty

[mcb39]

18 hours ago, kathyc2 said:

.

Curious about why you put in new Roth account rather than converting to an existing one?

The assumption being that they simply want to start contributing to a Roth rather than a conventional.  However, if they are no longer working, that idea would be redundant.  Sometimes our fingers work faster than our brains.  My apologies.

[mcbreck]

Thanks for starting this for me.

My basic recommendation for conversions is that it makes sense if you expect to have more income in retirement than you do while working. That's rarely the case but for people with substantial savings, inheritance and pensions, that is possible. I have a retired teacher who inherited about $1.5m and has two pensions which means he's paying a LOT in taxes. A roth while working would have been good for him but he actually has next to nothing in IRAs.

I simply don't understand people wanting to avoid RMDs. I'd guess 97% of the public will need those withdrawals. Their withdrawals might be a little less if there wasn't an RMD figure late in life but they still need a lot of it. I don't see that as a major factor for most people. I have a client with $6m in her IRA and complains every year about her IRA distribution but in reality needs about 75% of it because that's what she lives on (she has a lot of expenses in life).

[kathyc2]

1 hour ago, mcbreck said:

My basic recommendation for conversions is that it makes sense if you expect to have more income in retirement than you do while working.

I think it makes more sense to look at what the effective tax rate may be during retirement.  Like I previously stated, although in the 12% marginal rate, the effective rate if often 22.2% as it make more SS benefits taxable.  

Then if it pushes them to the actual 22% marginal rate, they lose the 0% LTGC rate.  Add IRMAA surcharge and it becomes higher.

If someone is already at 22% marginal and 85% SS taxed, there's not a lot that can be done.  Unless someone has a true pension which is pretty rare other than gov't workers, it's rare that I see clients in that situation.

I've never catered to high income clients, so I may look at this differently than those that do.  I'd say 95% of my clients are in 22% or lower brackets.

[Lee B]

I have several clients who are still working, drawing a salary and dividends as business owners plus SS, who have no need for their RMDs.

If their retirements funds were in IRAs they could use QCDs, but when their retirement funds are in SIMPLE plans or 401 k s

then  they end up receiving taxable income they don't need or want.

[mcb39]

1 hour ago, Lee B said:

I have several clients who are still working, drawing a salary and dividends as business owners plus SS, who have no need for their RMDs.

If their retirements funds were in IRAs they could use QCDs, but when their retirement funds are in SIMPLE plans or 401 k s

then  they end up receiving taxable income they don't need or want.

Wouldn't it be nice if everyone had that problem?

[BrewOne]

my own observation is that about 30% of taxpayers have made adequate preparations for retirement.  That may be high because Tallahassee has a lot of State employees, who should appreciate those pensions with COLA's.

[kathyc2]

4 hours ago, BrewOne said:

my own observation is that about 30% of taxpayers have made adequate preparations for retirement.

The majority of those who have not is likely due to not knowing how to live below their means, follow a budget, knowing difference between wants and needs, or understand finances. 

[mcbreck]

5 hours ago, BrewOne said:

my own observation is that about 30% of taxpayers have made adequate preparations for retirement.  That may be high because Tallahassee has a lot of State employees, who should appreciate those pensions with COLA's.

The median for 55-64 year olds is a retirement plan balance of $185k. 30% is probably pretty correct.

People learn their saving and spending habits from their parents and grandparents. We need to ramp up the education in that department because if the job isn't being done at home, they need to be educated on it in school or at work.

 

 

[kathyc2]

2 hours ago, mcbreck said:

We need to ramp up the education in that department because if the job isn't being done at home, they need to be educated on it in school or at work.

Remember a lot of people get rich and powerful by keeping the populace poor, stupid and angry. 

[mcb39]

When clients bring their paperwork in; one of the things I look for is interest income.  So few have any.  That doesn't mean they don't have any retirement plans or investment income; but where is their cushion of ready cash for an emergency.  So few have it.  I think that Kathy said it best in reference to wants and needs, budgeting, etc.  We taught our boys to save from little on.  When they got an allowance, they could spend half and half went in the bank.  That learning has carried them well into adulthood and nearly to retirement age.  I am so proud of them AND their children.  I try to counsel my clients in the gentlest of ways.  Sixty-five years ago we started life as a young married couple with not much to our name.  I am proud to say that we have practiced what we preach and are comfortable now with what we have built.  And both still working...just because!

[mcbreck]

For the past few years, interest rates were so low you were getting essentially 0% interest on savings accounts and money markets. If a client doesn't take steps, they get .3% at our firm. You can get 4.66% by sweeping into a money market.

When I got into investments in 1992 it was very common to find people who had never owned a stock. Today it is very common to find someone who has never owned a bond or CD.

[Sara EA]

On 11/12/2024 at 10:34 AM, kathyc2 said:

The majority of those who have not is likely due to not knowing how to live below their means, follow a budget, knowing difference between wants and needs, or understand finances.

Also instant gratification.  Picking up that "deal" on Amazon and having something desired in your hands the next day is much easier and more exciting than sticking that $500 in the bank and someday being glad you did.

[mcb39]

23 hours ago, mcbreck said:

For the past few years, interest rates were so low you were getting essentially 0% interest on savings accounts and money markets. If a client doesn't take steps, they get .3% at our firm. You can get 4.66% by sweeping into a money market.

When I got into investments in 1992 it was very common to find people who had never owned a stock. Today it is very common to find someone who has never owned a bond or CD.

However, this was not the case with CDs.  I have been laddering CDs for the past several years and have reaped decent benefits.  Particularly, in the past two years.  I purchase a CD at the end of every tax season.  BUT, I cannot even talk family members into doing the same.  Mainly, I believe that they just don't understand that they have nothing to lose.  I did convert a few clients who totally GOT it and enjoy playing the renewal game.  The caution is to always leave enough of a cushion in regular savings for emergencies, if needed.