Roth Conversion Strategy Tips For Recent Retirees

When I was a financial planner, my recently retired clients would ask about Roth conversions more than any other topic. Specifically, they would ask questions like:

What are Roth conversions?
Why would I want to do Roth conversions?
Should I do Roth conversions?
How do I put together a plan for Roth conversions?

This article aims to help give more of an overview about Roth conversion strategies for recent retirees. and to help explain why they might be an important part of a successful retirement plan.

Of course, each person’s or couple’s situation is unique, so it’s practically impossible to write a tell-all for everyone. However, we’ve written several articles on this, to include considerations for recent retirees when doing Roth conversions, and a Roth conversion case study based upon a fictitious client example.

But first, a little background.

Contents

Traditional IRA and Roth IRA–what do they have in common?

First, let’s start with what a traditional individual retirement account (IRA) and a Roth IRA have in common.

They’re both retirement savings accounts for people who have earned income.
Once you retire (i.e. stop earning taxable income from work that you do), you can no longer contribute to them.
The earnings in either account are not taxed as long as the money stays in the account. This means that earnings are tax-deferred.
If you contribute to an employer-sponsored retirement plan (like a 401k or a 403b), you can transfer the funds in that account to a similar IRA, under certain conditions. Retiring and leaving your employer is one of those conditions.
This means that people with qualified retirement plans can transfer pre-tax contributions (and employer contributions) to a traditional IRA. If you have a Roth 401k (not as common), you could transfer those retirement assets to a Roth IRA.
Both IRAs have annual contribution limits. In 2022, the annual contribution limit for an IRA is $6,000 ($7,000 for IRA account owners age 50 and older).

What are the differences between a traditional IRA and a Roth IRA?

The simplest way to understand the difference between a traditional IRA and a Roth RIA is:

In a traditional IRA, you can generally deposit the money pre-tax. You get to take a tax deduction on your traditional IRA contribution each year. This means that you’re not paying federal income tax on your contribution before it goes into the traditional account. The money can grow tax-deferred until you start taking it out. Then it is taxed at your ordinary income tax rate.

In a Roth IRA, you pay income taxes on the money before it goes into the account. So your Roth IRA contributions are considered ‘after-tax.’ From there, not only are earnings tax-deferred, but you can take qualified distributions out without ever having to pay taxes on them again.

There are also non-deductible IRA contributions. These are primarily a concern for high income earners who have access to a workplace retirement plan. Since there are adjusted gross income limits, people in a higher tax bracket cannot contribute directly to a Roth IRA. But like with a traditional IRA, earnings on non-deductible IRA contributions are tax-deferred.

However, if you are making non-deductible IRA contributions, you could make a Roth IRA conversion without having to pay income taxes twice. Since this can be pretty tricky, as this case study article explains, this will be outside the scope of this article.

What about IRA withdrawals?

There are also different requirements on when you make withdrawals from a traditional IRA versus a Roth IRA:

In a traditional IRA, you must start withdrawing from the account at age 72. From there, each year, you must withdraw a minimum portion of your account based upon your age and account balance. This is known as a required minimum distribution (RMD).
In a Roth IRA, there is no withdrawal requirement during your lifetime. No required minimum distributions.

In both instances, if you pass away, and your account is inherited by someone other than an eligible designated beneficiary, the account must be completely distributed within 10 years. Depending on the circumstances, this requirement might have significant tax implications for your beneficiaries. At the very least, it’s worth discussing with your tax advisor.

In summary, you pay taxes on IRA contributions, either on the front-end (Roth contributions) or the back-end (traditional).

So, which one is better?

This is a common question, for which the answer might not be so straightforward.

For people who want to simplify this as a ‘one or the other’ type decision, you can make strong arguments (and counter-arguments) either way.

And ‘better’ might be hard to quantify. Is it better to definitely pay taxes now in exchange for the tax-free growth down the road?

Perhaps, a better question to ask would be:

“How can I minimize the amount of taxes I have to pay over the course of my lifetime? “

One might feasibly come up with a counter-point to this suggestion. But it seems that we can all agree that keeping taxes low is important to a lot of people. But even better, it poses a problem that we can actually attempt to answer.

Of course, even a question as simple as this one comes with a lot of complexity.

First, it introduces another dimension that doesn’t normally come up at first. That’s the dimension of time.

Second, the question implies that there is a formulaic answer. There isn’t one answer that works for everyone.

Third, it understates the extremely high likelihood that any plan designed to last for one’s retirement will be impacted by things that cannot be accounted for today. We’re assuming that today’s plan is accurate 30-40 years from now.

To best answer that question, you might consider a Roth conversion strategy.

What is a Roth conversion strategy?

A Roth conversion strategy is simply a specific deliberate process during which you establish your Roth conversion goals, develop a plan, execute the plan, evaluate the plan periodically and make adjustments as required. To summarize:

Establish goals.
Develop a plan.
Execute the plan.
Evaluate the plan periodically.
Adjust as required.

Let’s take a look at each step, one at a time.

Roth Conversion Strategy Step One: Establish Goals

What are your Roth conversion goals?

It could be something as simple as asking the previously stated question—how to minimize taxes over the course of your lifetime.

But your goals need to address some significant considerations, such as:

Are charitable contributions important to you?

Charitably inclined account owners might want to give some of their money to charity. But you don’t want to convert money into Roth accounts that will eventually end up going to charity. But you don’t want to convert money into Roth accounts that will eventually end up going to charity.

Charities get tax breaks. You don’t.

What about other income sources?

Most people know about Social Security benefits. Social Security presents its own planning challenges and opportunities.

But you might have a rental property. Or you could have significant investments in a taxable account. These investments might be throwing off dividend income, capital gains and other investment income every year. Perhaps you’re considering a side-gig for some retirement income.

Your plan should account for all of these sources of extra income.

Plan for your beneficiaries too.

If you have high account balances, you should anticipate the possibility of not getting everything you want. This can happen after a working lifetime of contributing to a company-sponsored retirement plan, for example.

Eventually, those retirement accounts might be inherited by beneficiaries, and not withdrawn by the original account holder. These people will then be forced to withdraw all of the money from their inherited IRA over a 10 year period. And pay taxes on anything that’s not in a Roth account.

Depending on where they are in life, they might be at a higher income level than you. So they might be stuck paying at higher tax rates.

In light of this, perhaps you’d want to pay more in taxes on your Roth conversions so your heirs don’t have to.

Set your goals

Whatever the goal is, it should:

Be specific: When you take the time to know the dollar amounts, tax brackets, and timeframes, then your plan becomes more clear, and you’ll know when you’re off track.

Be realistic: Converting $5 million into a Roth IRA within 5 years is not realistic. You could do this. But you’d be paying for Roth conversions at a much higher effective tax rate.

So understand that you might not get everything you’d like to do. You will likely have to pay some taxes, so be realistic.

Be intentional: At some point, you’re going to have to make tradeoffs.

Do I pay higher taxes during my lifetime, so my kids pay less?
Do I pay at a lower tax bracket now, so I avoid creeping into the 32% bracket when I start taking Social Security?
What marginal tax rate is best for my financial planning picture?

Whatever it is, your goal should clearly define your position on the tradeoffs you might have to make.

Examples of well-thought out goals include:

My wife and I want to convert our $1 million IRA balances into Roth accounts before the age of 72. We’d like to stay in the 22% marginal tax bracket if possible. That way, our children inherit whatever’s leftover without having to pay taxes.
We have $2 million in our IRAs, $500,000 of which we’d like to leave to charity. We want to stay within the 12% tax bracket and convert as much as we can during our lifetime. After we pass, our children can work with our accountant to develop a plan on minimizing their tax bill.

Once you establish your goals, you need to develop a plan to achieve them.

Roth Conversion Strategy Step Two: Develop a Plan

At this point, you should have established specific, realistic, and intentional goals. If so, then the plan should be pretty straightforward. Let’s take the following goal as an example.

My wife and I want to convert our $1 million IRA balances into Roth accounts before the age of 72 while staying in the 22% tax bracket. That way, our children inherit whatever’s leftover without having to pay taxes.

Let’s add some facts about this fictitious couple that will help us formulate our plan.

Each spouse has just retired.
They’re both age 60.
They have about $20,000 in ‘other income,’ including interest, dividends, and a part-time job.
No other sources of anticipated income.
They both plan to defer taking Social Security until age 70.
They take the standard deduction.

Based on those facts, we can assume that they have up to 12 years to fully convert everything before they start taking required distributions. This means they would need to convert approximately $83,333 per year for the next 12 years to get everything into a Roth account.

According to 2020 tax tables, the 22% tax bracket tops out at $178,150 for a married couple filing jointly. This appears to give sufficient leeway to account for:

Market returns

When the market goes up, so do account values (usually). As account values go up, the amount you have to convert goes up. The converse is true when the market goes down. The result is that you can usually convert more into a Roth IRA during a down market.

Social Security benefits

Taking Social Security at age 70 means that between age 70 and 72, you’ll have additional income to account for.

Based upon this assumption, we could simplify this. We would build a plan to convert $100,000 per year for the next 10 years.

This keeps them in the 22% tax bracket pretty easily, and gives them an extra 2 years of cushion in case there are any unexpected taxable events. This plan would look like:

Year 1: $100,000
Year 2: $100,000
Year 3: $100,000
Year 4: $100,000
Year 5: $100,000
Year 6: $100,000
Year 7: $100,000
Year 8: $100,000
Year 9: $100,000
Year 10: $100,000

Not rocket science, is it? But it’s specific, realistic, and intentional. Just what we need to be able to execute.

Roth Conversion Strategy Step Three: Execute the Plan

Now that we know what needs to be done, all we have to do is actually do it, right? After all, the best strategy is one that gets executed. Of course, it’s not always that simple, for a couple of reasons.

The mechanics of Roth conversions

Literally-how do you actually do this? To do this involves answering questions like:

Do I have both a traditional IRA and Roth IRA? If not, how do I set them up?
If I have shares of securities (like stocks or mutual funds), do I sell them and transfer the cash, or can I transfer the securities directly?
Which securities should I transfer to a Roth IRA, and which ones are best left in my traditional one?
Do I have them send me a check, then deposit that check into my Roth IRA, or can they directly transfer the money without me receiving it?
How do I do this without messing up my current asset allocation or investment strategy?

There’s the dread of actually doing the Roth conversions.

It’s the same dread that causes many people to wait until the day before the tax filing deadline to do their tax return. This happens even if they are expecting a refund and have had all the paperwork for weeks.

You might like the sausage. You might even want to know how it’s made. But you just don’t want to actually make it yourself.

Because of fear that you might get it wrong.

Because if you get it wrong, that might mean tax consequences for you.

And that fear causes the execution to not happen.

This is where your investment advisor can take work off your plate. In fact, it’s one of the things they should be doing for you, for the simple reason that it actually gets done. But more than that, your financial advisor should be helping you keep an eye on your plan.

Roth Conversion Strategy Step Four: Evaluate the Plan

Keeping an eye on your plan. For what? A couple of things:

Taxes. Doing this properly results in keeping in a lower income tax bracket and paying lower tax rates. Doing it improperly can lead to anything but.

Changes in your financial situation. What if an emergency came up, and you had to sell $50,000 in stock from another account to deal with it? That might have a direct impact on this year’s conversion opportunity.

Rebalancing investment assets. Keeping your money properly invested while you’re making Roth conversions is important. Making sure the converted amount is properly put to work is important. It’s your advisor’s job to worry about this so you don’t have to.

There should be at least one meeting per year where you and your advisor discuss this plan. Ideally, that would be your tax planning meeting.

During the meeting, you’d review the plan and discuss whether any adjustments need to be made. Many tax-focused financial planners cover this during between July and September. That way, you can make any changes before the end of the year.

Roth Conversion Strategy Step Five: Adjust as Required

Exactly that. For example, if you had an extra $50,000 in income this year, you might decide to adjust the plan so that you’re only converting $50,000 this year, and that you’ll convert $110,000 each year (instead of $100,000) for the next 5 years.

And you should be doing these last three steps—executing, evaluating, and adjusting, during your tax planning meetings with your financial advisor.

Conclusion

Roth conversions can make absolute sense for people, when done with a specific, realistic, and intentional goal in mind. Once the goal is established, then putting together a plan, which you systematically execute, evaluate, and adjust, will help you ensure that your Roth conversions go more smoothly.