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What Drives Value in a Roth IRA Conversion Strategy Thumbnail

What Drives Value in a Roth IRA Conversion Strategy

What is a Roth IRA Conversion Strategy

Most people have heard of a Roth IRA and understand their unique tax treatment, but many think they cannot open or fund a Roth IRA due to income limitations.  The ability to fund a Roth IRA in 2021 completely phases out at an Adjusted Gross Income limit of $125,000 if single and $198,000 for couples.   This is where a strategy known as the “backdoor Roth IRA” comes into play.  Any amount of IRA (or rollover 401k) assets can be converted to a Roth IRA in any year regardless of income level, so long as you recognize the withdrawal amount as income in the year withdrawn and pay taxes according to your marginal income tax levels.  The determination of how much and when to convert (if any) lies at the heart of constructing a Roth IRA conversion strategy.    

What Drives Value in a Roth IRA Conversion Strategy

A properly constructed Roth IRA conversion strategy can be a powerful retirement planning tool.  There are five fundamental economic drivers of value when considering a Roth IRA conversion strategy.

1). Marginal Tax Rate Differentials

The best time to withdraw funds from a pre-tax retirement account is when you are at your lowest marginal tax rate and would be taxed the least upon the withdrawal.  Recall, any withdrawal from a pre-tax retirement account is recognized and taxed as personal income in the year it occurs.  Claiming income and paying taxes when your marginal tax rates are lower is better than claiming income and paying taxes when your marginal tax rates are higher.  When an individual will be at their lowest marginal tax rate depends upon the prevailing tax policy and personal income level in any given year.  Today’s prevailing tax policy set under the Tax-Cut and Jobs Act is advantageous to taxpayers.  Today’s rate policy is set to expire at the end of 2025, after which marginal rates and income brackets revert to their previous higher levels.  Holding all else equal, people will be in a lower marginal tax rate environment now than will be the case after 2025.  Another time an individual may be fortunate enough to be at a low marginal tax rate would be shortly after retirement if a retiree chose to fund retirement expenses in some portion (or even wholly) with after-tax savings for a period of time. (See our Insight entitled "Roth IRA Conversions - Hedge Against Higher Future Tax Rates") 

2). Lower Required Minimum Distributions (RMDs)

An RMD is an IRS-mandated amount of money that you must withdraw from pre-tax retirement accounts after you turn 72.  Your RMD is calculated by dividing prior year-end account balances by a life expectancy factor in the IRS Uniform Lifetime Table.  As you get older, RMDs typically increase and can become larger than you need to support your retirement expenses, forcing you to be taxed on income that may not even be needed and that could push you into a higher marginal tax bracket.

Converting pre-tax retirement funds to a Roth IRA account will decrease the balance of funds remaining in the pre-tax retirement account, thereby shrinking the base the RMD percentage is applied to, resulting in smaller RMD requirements.

3). Transfer Capital Growth

We hold investments intending to realize gains over time.  The longer we hold investments in pre-tax retirement accounts, the larger those balances will grow.  Eventually, the entire balance will have to be realized as income, whether through RMDs or inheritance, and income taxes paid.  By not converting funds to a Roth IRA, you are, in essence, choosing to pay income tax on the current value of your pre-retirement account balance plus all the future capital growth the investments experience. 

By converting to a Roth IRA, you only pay income taxes once on the current balance being converted in any given year.  Once that balance is converted and reinvested, the capital growth from those investments is never again taxed.   

4). Beneficiary Economics

Any tax-favored account balance you leave to a beneficiary upon your passing has to be distributed entirely, and income taxes paid by your beneficiary at their marginal tax rate within ten years of your date of death.  The distributions do not have to be linear, meaning the entire balance can be taken in year ten.  In the case of a Roth IRA balance being passed, your beneficiary would likely maximize the economic value of the account by waiting until year ten to let the investments continue to grow and compound as much as possible and then take the balance.  This strategy is made economically possible because your beneficiary does not have to pay taxes on distributions from the Roth IRA account you left (you already paid taxes when you funded your Roth IRA or converted assets to your Roth IRA).

If you pass, leaving your beneficiary a balance in a pre-tax retirement account, two potential issues arise.   First, your beneficiary is likely working and may be in a higher marginal tax rate than you are being retired.   If this is the case, you could have passed on more wealth by converting to a Roth IRA and paying taxes at your lower marginal tax rate and then passing on a tax-free Roth IRA instead.  Second, your beneficiary will probably have to take a series of more linear distributions over the ten years to manage their tax situation.  Suppose your beneficiary allowed the balance to grow and compound for the whole ten years. In that case, a large proportion of the balance will be taxed at your beneficiaries’ highest marginal tax rate, making the strategy less economically feasible. 

5). Tax-Efficient Withdrawal Coordination

Tax-efficient withdrawal coordination is about finding the optimal mix of retirement funding from your various investment account assets so that you pay the least amount of taxes over your lifetime.  Let’s say you are married and filing jointly (in 2021) and have taxable income needs of $110,000 to fund your retirement expenses annually.  If your only source of income is from a pre-retirement investment account, you will pay 10% on your first $19,900, 12% on your next $61,150, and 22% on your last $28,950, leading to a total tax bill of $15,697 for the year.   If you had a Roth IRA account in addition to your pre-tax retirement account, and you could fund that last $28,950 of income needed from your Roth IRA instead and not pay 22% on it, you could save $6,369 (or 41%) in taxes every year.

How to Determine an Optimal Roth IRA Conversion Strategy

While many variables feed into creating an optimal Roth IRA conversion strategy, there is a mathematical solution given an individual’s financial situation and a set of market and tax rate assumptions.  At Thrive Retirement Specialists, we have specialized retirement income planning software that we use that is specifically dedicated to this task.  The mathematically optimal solution may not always be a person’s right solution, but it is a great place to start. A Roth IRA conversion may not make sense for every person in every situation, but to many, a carefully constructed Roth IRA conversion strategy can unlock many valuable retirement planning strategies.

Conversions Must Be Completed by Calendar Year-End

Contributions to an IRA or a Roth IRA are required by the end of the tax year, which is April 15th the following year.  For instance, the tax year for 2021 ends on April 15th, 2022. Unfortunately, Roth IRA conversions must be made before the end of the calendar year.  For instance, the calendar year for 2021 ends December 31st, 2021.  (See our Insight entitled "Don't Miss Your 2021 Roth IRA Conversion")

If you would like to learn more about how we can help you determine your optimal Roth IRA conversion strategy, you can schedule a date and time that is convenient for you here at this link: https://calendly.com/thriveretire/thriveretire-call or contact us here at any time.

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ABOUT THRIVE RETIREMENT SPECIALISTS

Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetireTM that goes far beyond what has traditionally been known as retirement planning.  ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible.  With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.


ABOUT ANTHONY WATSON, CFA, CFP®

Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.

Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.

EDUCATION:              

  • BBA in Finance, Walsh College
  • MBA, University of Michigan, Ross School of Business

CREDENTIALS:              

  • Chartered Financial Analyst (CFA)
  • Certified Financial Planner (CFP®)

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