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In a prior video, we discussed Roth Conversions. Specifically what they are, how they work, and who should and shouldn’t be considering them. To summarize at a high level, Roth Conversion Planning can be a powerful strategy to potentially save many thousands of dollars in taxes for individuals who have sizable pre-tax accounts. But it can also be a strategy that can result in paying more tax if not executed properly.
Careful consideration should be given on an annual basis. There are criteria that need to be met to make sure this strategy is worth pursuing.
This post will take you through a specific example of a couple who should be considering Roth Conversions. It also covers the criteria in which they should be using to determine how much they should convert every year.
Roth Conversion Planning Disclaimer
It’s important to note this is a fictional case study.
While we’ve helped many couples retire (from FirstEnergy and otherwise), we’ve changed the information presented in this case study to help protect anonymity.
The couple presented in this example are merely meant to reflect a prospective case.
The projections used are also used as of current tax rates and rates of return, inflation rates, and all other projections are assumed.
Any strategy involving Roth Conversions should be vetted by a professional. This includes, but is not limited to, a financial planner and CPA/tax professional before implementing.
Assumptions
It’s also important to note we use a number of assumptions in this example. You will see a set of facts below, but we have also used the following assumptions:
- Inflation will rise at an annual 2.51%
- The Retirement Accounts are invested in Growth & Income Funds inside the Traditional IRA at 6.99%. The Roth IRA is invested in the same funds earning the same 6.99% return.
- This is not necessarily how we approach how these funds should be invested. The example is used to show a comparison based on a tax-strategy.
- Mr. Harris lives until age 92, and Mrs. Harris until age 95.
- We also assume the Tax Cuts & Jobs Act, which is set to sunset after 2025, will indeed do so. As a result, the case study reverts back to the previous tax brackets.
- We assume these tax brackets until both Mr. & Mrs. Harris reach their age of death.
Case Study Background
As discussed in our prior video, there are criteria that need to be met for sound Roth Conversion Planning. To conduct an analysis that would be helpful to determine if this couple should consider the strategy, we must first meet them.
Both Mr. & Mrs. Harris have executive positions at FirstEnergy Corporation.
Of note, Mr. Harris would like to retire at A65, and Mrs. Harris would like to retire at A63. She told us that she thinks health insurance is too expensive, and thus would also plan to work until 65. However, she would retire earlier if they can find an alternative.
For reference, COBRA premiums from FirstEnergy would cost Mrs. Harris approximately $1100/m.
This couple has stated that they plan to use their retirement savings plans (which were Traditional FirstEnergy 401(k) plans that have been rolled over to Traditional IRA’s in each of their names) to help supplement their pension in retirement as needed.
They were unsure of when to collect Social Security.
Other Considerations
Both Mr. & Mrs. Harris are in excellent health. They have longevity on their side, as the parents on both sides of their families are living in their 90’s.
They do not expect any type of significant inheritance from their parents, and let us know to plan as such.
The Harris’s also have shared they have a moderately aggressive risk tolerance. They have both admitted that they feel very secure in the amounts they have saved respectively.
The Harris’s plan to travel and spend time with their children. They don’t currently have any significantly larger expenses planned, such as a vacation home.
Lastly, it’s important to them to help their children. They want their three children, Jack, Jimmy, & Joe to inherit the wealth they’ve built at their passing.
They’ve stated they’re open to helping them while the kids while they are living.
However, being that the children have stable jobs and are considered in solid financial standing, they don’t view that as necessary at this time.
Focusing on Tax-Smart Roth Conversion Planning
If you’re familiar with our planning, you know that we focus on the key areas of financial planning.
But our focus today is going to work with the Harris’s and see if Roth Conversions can be a potential part of this strategy. Let’s first make sure they’re candidates.
Healthcare Costs
As Mr. Harris reaches age 65, he is going to enroll in Medicare.
Until then, Mrs. Harris is in a position that she would need to continue working for health care coverage. Based on her findings, she would need to go onto a plan through the Healthcare Marketplace.
However, after analyzing her situation, Mrs. Harris could retire at Age 63.5 and utilize the COBRA coverage through FirstEnergy. While the premium is not cheap (~$1100/m), she has an HSA balance of $24,000, which will more than cover the premiums for the next 18 months.
This will allow her to enjoy an early retirement with Mr. Harris, without having to worry about healthcare premiums. As a result, we do not need to plan to stay within an income threshold to qualify for coverage.
If she would not be utilizing COBRA to cover her healthcare, our planning would potentially revolve around these income thresholds.
However, since she has enough funds in her HSA to cover the COBRA premiums, she can avoid worrying about ACA subsidies altogether and enjoy early retirement with Mr. Harris.
It has been discussed with both Fred & Joan that IRMAA thresholds are a consideration. This is something we would need to plan for should we utilize the Roth Conversion strategy.
That said, with the potential RMD the clients will be facing starting at Mr. Harris’s age 73, IRMAA surcharges may be seemingly inevitable.
State Taxes
The Harris’s are residents of Pennsylvania. They are in the fortunate position of not having to worry about state tax on their pension or retirement income.
Neither plan to continue working, so there is no indication they will have any earned income after Mrs. Harris’s retirement. Thus, while the state income taxes on their IRA distributions, Social Security, or pension will cease, they could still owe taxes on capital gains, interest, and dividends.
It’s important for them to be mindful of these potential tax liabilities as they plan their retirement finances.
Living Expenses
Based on the Retirement Spending Plan we provided to the Harris’s (can be downloaded here), it was discovered that the Harris’s had essential expenses of $6k per month, and discretionary expenses of $4k per month.
They had not indicated any type of large purchase (beach home, recreational vehicle, etc.) is in their immediate plans.
The Harris’s are in position that the pension income covers the essential expenses and nearly all discretionary expenses.
IRA withdrawals in their early years could help supplement some of those discretionary expenses as needed.
Social Security
Based on the living expenses of the Harris’s, they’re currently in position that each of their pensions will cover their $10k/month living expenses.
To cover the full amount per year, they likely need to withdraw a negligible amount each year from Fred’s IRA to cover any discretionary expenses. As a result, it’s recommended they continue to delay. In this case study, we’ll show them waiting until age 70 to take Social Security, to get the guaranteed 8% increase each year.
Delaying does prove flexibility in their income to allow for potential tax planning. That said, we would be focusing on a strategy to optimize Social Security Benefits in conjunction with the Roth Conversion Planning.
The “Do-Nothing” Strategy
Using our planning software, we’re able to plot what cash flow will look like for the Harris’s. You can see a breakdown of the income plan in the screenshot below, and the accompanying chart for a more detailed look.
Thankfully, the pension income, Social Security, and retirement savings the Harris’s accrued should more than cover their living expenses in retirement all the way to their life expectancies.
When it comes to running out of money, that is a problem the Harris’s should not have, barring no drastic lifestyle change or major long-term health event.
Future Tax Projections
But when we take a deeper look, the Harris’s do notice a potential issue. The issue is the amount of tax they will owe.
We can see from the chart above that the Harris’s will have significant taxable income starting in the year 2032, when Mrs. Harris begins collecting her Social Security at Age 70, and Mr. Harris begins his RMDs.
As you’ll see from the charts below, this can create a problem when their income tax will more than double between the years 2031 to 2032, and again significantly increase in the year Mrs. Harris begins her RMD.
Again, a more detailed look can be found here.
These increases in taxes represent a substantial increase. Income tax due jumps from $25,509 owed in 2031 to $86,503 owed in 2036!
The Harris’s are pushed to the limit of the 28% tax bracket once Mrs. Harris begins her RMD. They eventually find themselves in the 33% tax bracket starting in the year 2038.
Thankfully, planning can be done to decrease their lifetime taxable liability significantly. The planning you’ll see in the example below shows how the taxes can be spread out over time.
It may help alleviate the tax liability shown in the later years for the Harris’s.
Take 2: Roth Conversion Planning
Rather than allowing the RMD projections to continue to balloon, the Harris’s can consider taking action. Roth Conversion planning can help avoid the tax tsunami headed their way due to the RMDs.
By executing a series of Roth Conversions in the years prior to Mr. Harris’s Social Security election, the Harris’s are able to lower the amount needed to take out for the Age 73 RMD (all other things being equal).
However, we don’t just want to pick an arbitrary number. The Harris’s still do need to pay the income tax due on the Roth Conversion.
By focusing on converting a set amount, up to the known 22%/25% marginal tax rate for the Harris’s, we can project a significantly lower lifetime tax liability (detailed version found here), as shown in the example below.
Upon review, we see that there are more withdrawals taken in the early years. The subsequent increase initially in taxes, which lead to a substantial decrease in taxes paid, just under $400,000 in the cumulative years.
Better yet, the Harris’s stay within the 28% bracket based on their current projections over the long term.
Additional Considerations for Roth Conversion Planning
As mentioned in the beginning of this post, we did use a number of assumptions. This is a hypothetical example. It is simply meant to illustrate how Roth Conversions could potentially benefit an individual or couple.
In this hypothetical example, health insurance premiums were not a factor. But could be for couples who would plan to retire early, Roth Conversion Planning may be secondary to health insurance planning.
Equally important, any couple should account for IRMAA surcharges when planning for a couple’s Modified Adjusted Gross Income.
Improper Roth Conversion Planning could trigger an increase in MAGI, which could trigger an additional IRMAA surcharge.
These tax savings can look quite attractive. But the Harris’s would need to stomach the increase in taxes in the early years. It requires discipline and a commitment to this strategy to execute it properly.
Roth Conversions can be a valuable tool in retirement to lower the lifetime tax liability for a couple or individual.
However it should only be executed with the help and after careful analysis of a financial planner and tax professional. It’s unlikely that this hypothetical couple, or couples with a substantial amount of pre-tax retirement savings will convert all their pre-tax funds to a Roth asset.
Instead, the goal should be balance and a focus on a reasonable tax strategy that minimizes their lifetime taxable liability.