Roth Conversion Case Study

More than five years ago I wrote a newsletter titled “The Reality of Roth Conversions” because far too many people consider it a viable strategy.  In most cases it doesn’t make sense and people ask me about it all the time.  Scare tactics surrounding increased tax rates are a common pitch for investment and insurance advisors who want to schedule you for an appointment.  My goal is to provide value to anyone who asks for my help so answering this question definitively can clear up confusion for a lot of people in retirement.

I ran through a few simple examples in the past newsletter that cover probably 95% of all scenarios but this week I’m going big on one case study.  This couple responded to a newspaper ad promoting bonuses on indexed annuities and the topic of a Roth conversion came up as one of their primary concerns.  They have a healthy amount of IRA assets and they are in their late 60s.  Once they collect social security all income needs will be met so they don’t really need money from the IRAs.  Once required minimum distributions come in a few years they will be taking funds they don’t need and paying taxes they’d rather not pay.

Please remember, this is a general exercise and not tax advice for anyone.  A plan like this would have to be blessed by your CPA but I can assure you that I’m qualified enough to do some simple math and think through complex problems.  I’m going to make several assumptions because certain variables need to be fixed and I’ll offer disclosures where things might change in the future.  Looking well into the future is helpful to get an idea of the big picture but Roth conversions are a different animal.  In practice these conversions are something that changes on an annual basis which could have a significant impact on the outcome.

Here are the details:

$2.1M in total IRA assets between both people but for simplicity purposes I’ll consider it only one account.  This will be different in practice.

Husband and wife are 68 and 69 years old respectively but I will assume they both need to take RMDs at the same time.  Only six months separate the two so the actual numbers will be a bit different but this is close.

There is currently a $60K annual income gap for these guys and they haven’t taken social security yet, which will more than cover the gap.  With the numbers quoted I assumed taking social security now but they may well wait until age 70.  At this point it doesn’t make much difference and I’ll run both scenarios for them.

I used a 6% static investment return for the IRA and Roth IRA going forward.  Variable rates of return may change these numbers considerably and that’s one reason why conversions need to be adjusted annually, not to mention potential changes in marginal tax rates.

It is assumed that personal income will top out the 12% tax bracket so any conversions will happen at the 22% or 24% Federal bracket.  Anything more is unacceptable to these guys and it’s probably a bad idea as well.

One of the biggest problems with conversions in general is that you need to have money available to pay the taxes.  Whether you do it with non-qualified cash or additional IRA distributions this is a significant cost and probably the determining factor that will indicate if the conversion is a good idea.  For this couple, taxes will be paid with excess cash flow from social security and additional withdrawals from the IRA.  This is where the complications arise in the calculations but I did figure out how to do it.  I’ll explain it here but go into the actual numbers in the podcast because a visual aid is quite beneficial but it’s too much to post a bunch of graphics on this post.

If all personal income tops out the 12% bracket then this couple could convert an additional $101,299 in the 22% bracket and $173,450 in the 24% bracket.  With more than $274K available to convert at an acceptable tax rate we first need to figure out how to pay the taxes.   Since they have already converted some to Roth this year my calculations will start in year two.  It’s easy enough to determine that between the two brackets, taxes due for the maximum conversion is $63,914.  This considers Federal taxes only and state taxes would require further adjustment.  $23,544 in the first year of conversions on my spreadsheet is surplus income from social security so that goes to pay taxes first then a distribution from the IRA needs to be made to cover the remaining $40,550 due.  So the first year they do this will result in $234,199 converted to Roth IRA.

On the spreadsheet I figured that in the first three years they will need to take IRA distributions to pay taxes.  Then RMDs need to be drawn first and that will provide cash to pay taxes.  Both will reduce the amount that can be converted and both are fully taxable and factored into the total combination of distribution and conversion that top out the 24% bracket.  All in all it would take this couple just 11 years to get the full IRA converted to a Roth.  The eye catching part is that it costs a total of $618K in taxes to get it done.  This is why I claim that in most cases the Roth conversion is certainly not the cheapest way to do things.

Now, this assumes the maximum conversion and they may choose to do less.  That’s fine but it won’t change the long-term cost. They will still pay taxes in a similar bracket and it’s just spreading the cost over time.  To really determine whether it’s worthwhile, why don’t we analyze the numbers to see if they would be better off leaving it all in an IRA.  Of course I did that too.  Since they don’t really need the money it can just grow until distributions are required in a few years.  I used the same spreadsheet to calculate taxes due on RMDs and over the same time period they would only be out of pocket $117K to just leave it alone.  Here’s a good question: Do you want to never pay taxes again or pay the least amount of taxes possible?

Accumulation of funds over time, whether taxable or tax free should also be a determining factor.  With a full Roth conversion the account accumulated to just over $3M during the period so they end up with more money and it’s tax free.  The IRA accumulated to just $2.8M but RMDs would have been available for reinvestment after paying taxes.  Using the same growth rates, the after-tax distributions would accumulate an additional $736,762.  This of course doesn’t factor in taxes on growth or dividends with non-qualified assets but regardless it’s a pretty dramatic difference.  This couple needs to decide whether they’d rather have extra cash for reinvestment or send it all away to the Federal government.

In order to effectively convert assets to tax-free you have to minimize taxes wherever possible. If you are jumping into a higher tax bracket to convert then it’s a waste of time and money. If you are converting in a similar bracket it’s a wash. Then you’re just making a bet on where tax rates are headed. Some people, as does this couple, have non-qualified brokerage assets so down markets may provide the opportunity for tax loss harvesting which will create a deduction that can offset taxes due on the conversion. This would make it more tax-effective and is another reason why conversion strategies will likely change from year to year.

Legacy wishes are a core motivation for some who consider converting assets to tax-free.  Roth is far better as a wealth transfer tool than the IRA but tax brackets for the beneficiaries is an important factor.  IRA assets need to be distributed over ten years so it could create a tax problem for the next generation.  Maybe the Roth strategy isn’t the best for maximizing accumulation but each person will have to decide if that’s more important than making it easy on your heirs.  There is no benefit without cost and a Roth conversion has a pretty steep price of admission.  Each person will differ in regards to who they think should bear the cost.

My guess is that this couple would be well suited to adopt a more moderate conversion strategy that uses surplus income to pay taxes or harvest market losses from non-qualified accounts.  The result would be some middle ground between the two options for simplicity, taxes, accumulation and legacy.  It’s almost never a good idea to go all or nothing on a strategy and a combination of the two makes sense to me and will likely be more appealing for this couple as well.  I may have left a few things out but I’ll do my best to cover it all in the podcast.  For another run at this and a lot more detail go check out the video.

Have a great weekend!

Bryan

Podcast Episode: Roth Conversion Case Study

Download The Podcast Episode: A Roth Conversion Case Study on Apple iTunes

Last Updated on May 31, 2024 by Bryan Anderson