Episode 78: Managing Tax Impact on Retirement Savings: Roth Conversions and Tax Planning

In Episode 78 of Accessible Finance, we tackle the critical issue of managing taxes on retirement savings, specifically when most of your money is in pre-tax accounts like a 401k or traditional IRA. Hosts Eric and Rachael discuss strategies such as Roth conversion ladders to minimize tax impact and offer insights on effective tax planning before retirement. They emphasize the importance of diversifying savings buckets and planning withdrawal strategies early. Tune in to learn why balancing today's taxes against future liabilities is crucial for a healthier financial future. 🎙️ Have a financial scenario you’d like us to discuss (without giving personalized advice)? Send your questions to podcast@equilibriumfp.com—we’ll keep your information completely anonymous! 📢 Don’t forget to like, subscribe, and share with friends who could benefit from smarter retirement planning tips!

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Episode 78

Eric:  Welcome to episode 78 of Accessible Finance. Let's dive in. 

Rachael: Alright, Eric. Today's scenario is “I have been a diligent saver. Most of my money is in pre-tax accounts, like a 401k or traditional IRA. But now I'm starting to get worried about the tax bill when I retire. Mm-hmm. How can I manage this? So where should somebody in this position even begin?”

Eric: immediately convert all of it to a Roth. I'm just kidding. Don't do that. That's terrible. Uh, that's funny though, right? I mean, it's only funny if you're a planner. You understand what that means. Um, that would just mean paying a lot of taxes that you probably don't need to pay. So we've seen that though, correct?

You want to consider right, you tax brackets over time and what the fact that you have all of your savings or majority of your savings in tax avert accounts. Would look like over that timeframe. And what I mean by that is when it's time for RMDs, what do you project your balances to be? Right? If we assume some modest growth rate, assume maybe a five or 6% growth rate.

That's pretty reasonably conservative. Depends on how it's invested, right? But we can think about a 6% discount rate and star two extrapolate that out and then. Try to find out what your RMD is gonna look like and if you're comfortable with that and that tax situation. And the, the reality is you're probably not going to enjoy that too much, and you're gonna wanna consider what we would call a Roth conversion ladder.

Mm-hmm. Which means you're gonna wanna manipulate your income. And by manipulate we mean in this case, we'd be raising our taxable income in the years between retirement and RMDs. 

Rachael: And I just, I wanna touch on. What you're saying here, because when we say manipulate, we're not talking about doing anything.

Oh, for sure. Shady or illegal or anything like that. Correct. But it's timing when you're realizing that income and recognizing it for mm-hmm. Your tax purposes. Right. 

Eric: Um, the IRS says that we can. Um, practice tax avoidance, but not tax evasion. So the idea is we can try to pay as few taxes as we can using the IRS, uh, rule of law, right?

Yep. But we cannot try not to pay taxes that we owe. Okay, so we, you know, there's, there's a line there, right? We can, we can use legal means to try to minimize taxes. We, and these are, these are tools that they've given us. Should be, we should be using them. Correct. You ought to be trying to Yes. Do this kind of tax planning.

Rachael: Exactly. And that's the, the whole idea behind withdrawal strategies and tax planning. At its core. Right. So you've touched on, um, one of the major tasks, tax risks that somebody who has saved a lot in tax deferred would be hitting. Right. Um, we'd be remiss if we weren't saying like, great job on saving.

Right. That's already Oh yeah. Absolutely. So you've saved, you've done a great thing. Um, and it can be so disheartening, I think, for somebody who's worked so hard and has saved for so long to realize that they may not have diversified in the three buckets that we spoke about in a previous episode. Mm-hmm.

Or that they feel that they may have suboptimally. Right. You know, placed those funds, all hope is not lost. Right. There are things to do and so the first of the major tax risks. Wow. That is a tongue twister. Is it? For me, tax risks. Tax risks. It is kind of hard. Say it again. 

Eric: Tax risks. 

Rachael: Okay. I'm just gonna, you say it for me.

I won. I think I have won. I think you did too. I'm really 

Eric: proud of myself, guys. I'm really disappointed in my, 

Rachael: that's fine. Um, but I think that you touched on the very first one, which is RMDs, right? Mm-hmm. Um, so can you speak a bit to. How that is a risk, and then what steps we may be able to do to Sure.

Minimize that risk. 

Eric: Um, yeah. But what'll happen is your bracket will start to creep up. So RMDs increase over time. Mm-hmm. They start around 6% and then they'll get as high as, you know, 50% as you, as you're over a hundred of your account balance. Right. So does that, does that make sense? Yeah. So, um, what we wanna do, the way we wanna think about it is we want to try to.

We want to have real, we want to keep a 

Rachael: tax risks. 

Eric: Yeah, I won. Exactly. Yeah. Touche, touche. Well played. Thank you. Um, we wanna try to keep our tax effective, marginal tax rate actually marginal, effective tax rate relatively equal over time. Yeah. And the reason I transposed those words, I've talked about it before and I know I talked about it on the last episode.

Yeah. But the point is that we're trying to fill up the, the smaller bucket. Right. Or I say smaller, the lower rate buckets, like we don't want any year to pass where we don't pay a single dollar of tax at 10%. Okay. Or 12%. So to make this, I was gonna say, I think as a general, yeah, general, where's your threshold?

A general rule? I would say always fill up the 10% bracket. Always fill up the 10, 12% bracket. To the extent that you're not, you probably pay too much in the past or you're wrong. Mm-hmm. Because you will be paying more in the future. Right. Those are very low brackets, super low hanging fruit. They should always be filled.

Okay. So our point is we, we want to fill up the lower brackets. That's how we're trying to think about this. And RMDs are gonna make it to where. Whatever bracket we're at today, we could potentially be going much higher in the future because the RMDs are going to increase over time and then our tax account balances could potentially increase over time.

Yep. We might have social security that's gonna be increasing over time, right? Like there are way there and then the earnings on the accounts themselves. Mm-hmm. So we talked about RMDs increasing over time. What we mean is they take a larger percentage of the total. December 31st prior year balance of all of your tax deferred accounts.

And they say you must withdraw this percentage, and that percentage goes up, it goes from six to 12. You know, it goes up over time. Yeah. 6, 7, 8, 9, whatever climbs. Okay. So that percentage is going up. But also typically, if these accounts are invested, well that's a stock, then they will have to, uh, then they'll grow, right?

Like you'll have some rate of return on these investments and that's going to be going up over, so, so the balance is going up and the percentage that you have to withdraw is going up. So these RVs could potentially. Put you in higher brackets over time, and that's what we're referring to when we talk about, um.

You know, your tax bracket creep over time. 

Rachael: Yeah, perfect. Exactly. So you know, the RMDs kind of cause this tax bracket creep right to happen. And then in addition, one of the downfalls that we talked about, or the cons that we talked about to that tax deferred account is the fact that you, every withdrawal that you make is ordinary 

Eric: income.

Correct? No exceptions. 

Rachael: Correct. And so you leave yourself with very minimal flexibility. 

Eric: Couple exceptions. Oh 

Rachael: well 

Eric: Qds, right. So I guess technically it's not you withdrawing the, the amounts, but you can write a check essentially straight to charity from the account called a qualified Charitable distribution.

If you're 70 and one half or older. So age 70 and a half or older. Um, 'cause they didn't change the wallet's kind. Is that interesting to you? Because it's interesting to me. 

Rachael: Well, I just, they 

Eric: updated Secure Act and Secure Act 2.0. I find it 

Rachael: fascinating that 

Eric: increased RMDs. 

Rachael: We like to live not 

Eric: QCD age in 

Rachael: ages that are half years uhhuh.

And it's, I mean, well, if you feel like the tax, 

Eric: yeah, it wasn't complicated enough, let's start using fractions that's gonna help everything, that makes it all more clear. 

Rachael: So yes, please know you're not alone in being like, what the heck is all of this? 

Eric: Right? 

Rachael: Um, 

Eric: so if you are charitably inclined, qcd can help with this a little bit, but again, but only to the extent of, um, ooh, 103,000 a year.

Oh man, that's another number that I haven't memorized. But, um, it's per person and I believe it's around 103 grand. I think it started with secure Act in its index to inflation. It's 2025. 

Rachael: Okay. All right. All right. Did they go down? Um. 

Eric: No, I'm just wrong. It's 108. I was wrong. It's 108,000, not 103. Sorry guys.

Rachael: Maybe 2023 was, its rough. It's brutal. It was 103. 

Eric: I failed us. Um, tax. But anyway, anyway, yeah, so you can write a QCD from the account. 

Rachael: I'm gonna, I'm gonna get it. I'm gonna get it actually. Pretty funny. Okay. Well played, 

Eric: well played. 

Rachael: All right. So, okay. If somebody's coming to us again in this situation saying, look like I've saved my whole life.

I have everything in my tax deferred account. It's what my job place told me to do. And to be honest, that is literally like. The majority of people are just kind of differing and putting stuff in their 401k and calling it a day. 

Eric: Right. 

Rachael: Um, and 

Eric: that's what your employer's matching? Yes. That's what you've heard about the most?

Yes. 

Rachael: Well, and a lot of times not gonna 

Eric: really push the Roth options that much. Some, some 401k don't even have it. Don't offer. Yeah, I was gonna 

Rachael: say a lot won't offer them. Um, I will say I do think that starting to become more common, but it's not even something that, like I will tell you, when we had our benefits, people come, that was not.

What they felt comfortable talking about, right? Like they're gonna talk and push the things that they know. Um, and a lot of times people who are participating in a workplace 401k believe that they're working with a financial planner because they have a guy who told them that the target date fund is the best fund for them and that they're done.

Um, 

Eric: Ooh, we gonna get to go on a little tirade about the planning industry or the finance industry. It's 

Rachael: could be, it could be a caveat. Definitely 

Eric: not the planning industry, but I, I wouldn't call it that, but 

Rachael: I, no, but I, I mean, we've had a number of people come to us, tell us that they're working with somebody.

Because there's a finance guy that will come and talk to them annually at their job. 

Eric: Correct? Correct, correct. 

Rachael: Um, but I will say this is not somebody who's gonna help you figure out your withdrawal strategy or figure out your tax planning when it comes time for your RMDs and things like that. So all planning is not equal.

Investment management is one. Correct. Their 

Eric: job is to increase deferral so that there's larger a UN that they get to collect on. 

Rachael: Yeah. 

Eric: That's the answer. Well done. 

Rachael: Okay. So we've talked about kind of those, the, the traps or the, the hidden things that are there that can come to, um. Fruition if you only have funds or money in tax deferred accounts.

Um, so what is something that they can do now, um, to reduce the future taxes? You've already kind of spoken to some of those, but I think kind of tying it with a bow would be really lovely. 

Eric: Yeah. So what we're trying to do is we're trying to increase. Our tax brackets today, our taxable income today mm-hmm.

In an effort to decrease it in the future. So when we convert, like when we execute Roth conversions, what we're doing is we're converting the tax deferred balance to a tax free balance and paying tax on the amount that was converted. Does that make sense? So for example, 

Rachael: right, so for example, um, I have. I don't know, 500,000 in my tax deferred account.

Okay. I know RMDs are gonna happen down the line. Mm-hmm. Right. So they're gonna tell me that I need to take like 16% of that 500,000, right? 

Eric: 6% in the first year. Yeah. Six. 

Rachael: I thought it was 16. 

Eric: No, it doesn't start at 16. That'd be really high. 

Rachael: It was high. I thought that's what you said. Well, okay. 6%. Right. So, um, I end up having to realize.

A significant amount of money, right? 

Eric: Sure. 

Rachael: Okay, so I'm having to take thousand. You raised me 

Eric: to life table. Hmm, 

Rachael: no, you can wanna start you life expectancy all day long. 

Eric: Oh, you're talking about the divisors? I was talking about the percentage. 

Rachael: Oh, well there we go. 

Eric: Sorry. Yeah. It is 16.4. At age 73. However, that's the divisors.

You divide that account by that, which is about 6%. 

Rachael: Okay. So then I'll say, I'll take about, like I had half a million. Um, I'm gonna take about 30,000 then, right? Yeah, 

Eric: sure. 

Rachael: Okay. Um, so I'm taking 30,000 so on. I'm recognizing 30,000 of income. I now have to pay whatever my tax bracket would be in that. Right?

But then my next year, it's not gonna be 30,000, right? My account has gone down by 30,000, but that's not a huge amount in. Correct. For half a million. Correct. Right. So it goes up from 6% to something else. 

Eric: Right? Higher. 

Rachael: Right. And so it'll continue to go up and up and up. And so I am soon starting to realize like numbers that are.

You know, a hundred thousand. 

Eric: Right? 

Rachael: And so I'm now in a significantly higher bracket. 

Eric: And frankly, the, yeah, frankly, the, the balances are gonna be higher than that. Or we would say don't retire. Like if you only have $500,000 in a tax deferred account, you're probably not retiring. Fair. 

Rachael: I picked it just for ease of numbers.

Eric: Sure. Um, 

Rachael: but yeah, we're probably, I mean, you're talking something million North, right? Yeah. So you're talking large numbers. Right. And the reality is that if I have the opportunity. To start taking some of that million that's in that pot and say, okay, I'm gonna start. Real, instead of you telling me that I have to take a hundred thousand, right.

Eric: That's the idea. I'm 

Rachael: telling myself, I'm gonna take this much, I'm gonna pay taxes on this much. And so then even when the RMDs kick in and they're giving me, you know, I need to withdraw 6%. I'm not withdrawing 6% on a million. Mm-hmm. I reduced a million because I started realizing things earlier. 

Eric: Correct.

And then a couple, a couple caveats that we talk about a lot when we're talking about Roth conversion ladders and retirement. Um, the Irma brackets are also known as the Medicare premiums. The additional Medicare premiums that you will incur when your modified adjusted gross income is. Exceeds thresholds, right?

Those are things that we want to plan for. And so you would rather all else equal, you'd rather have higher income when you're younger or lower than 65. Really lower than six, lower than 63, because there's a two year look back on Medicare, um, and well on the Irma provisions in Medicare, within Medicare, right?

So it's so complicated. I know it is complicated, but the idea is we'd rather realize more income when we're younger than older, and we'd rather try to get some of this money out of, we wanna get. Some of the money outta the tax deferred account. You'll hear people talk about it, you know, like the tax time bomb, right?

There's, there's clever and, uh, little phrasing for it, but it, it will, you know, if you have multiple millions of dollars in a tax deferred account, it, it can potentially blow you up, right? Yeah. You're gonna have a large tax liability associated with that if and when you live long enough, right? So you want to try to think about.

Um, reducing your tax bracket later by converting the money, right? Yeah. So like Rachel talked about, if you have a large tax deferred balance, you convert some of that balance, it now grows tax free and you never have to pay tax again. Okay. You've hopefully boosted your tax bracket or you're paying taxes.

Um, and filling the lower buckets, right? Like we talked about the, so you filling the 10%, you're filling the 12%, you might be filling the 22 or 24. Mm-hmm. And then later you might not have to pay any taxes at 32, 37. Right. 

Rachael: Exactly. And I think, you know, it's something like Eric had mentioned that you can kind of math out.

It's also a situation I think where, um. Diversification as soon as possible is gonna be very, very important. If you are currently tied up completely in your tax deferred accounts, you're looking to really start filling up that tax free bucket. And so you want to keep that income as artificially low as possible so you can get more conversions.

And so that would factor in with a delay of social security. Yeah. One 

Eric: one point I'd like to make there is while we talk about. If you're earning, if you're in your earning years and your tax deferred account is the only account, let's assume you don't even have a Roth account yet. Yeah. Okay. You don't even have it.

You just have a taxable and you have a tax deferred. Right. And you're making, you're in the 37% tax bracket. You're earning, you know, $750,000 a year or something. You're earning lots of money. Okay. We might still say keep pumping the tax deferred bracket. Okay. We might say that, but there's gonna be a plan, there's gonna be an exit strategy where we're not just gonna have 10 million plus dollars in a tax deferred account.

Right. Waiting to just kick out RMDs of, you know, 400,000 plus. 

Rachael: That's a great point. Does that make sense? 

Eric: So like. There, there might be a world where we're, we're completely content to still, um, put money in the tax deferred while pursuing something like, Hey, we're gonna keep stuffing our taxable account because we know we're gonna retire at age 50 and that gives us, you know, 25 years potentially of Roth conversions.

Mm-hmm. So we're gonna carefully calibrate how we're gonna get this $10 million of tax deferred savings out of there. So we're not super, we're still happy to pay less taxes at 37%, but we wanna have some kind of a viable strategy. As to how we're gonna not pay in the 37% forever in perpetuity. Yeah. And pay with pay in the 37% with more dollars.

Does that make sense? 

Rachael: One, I think that's the biggest thing here is that. It's really easy to think of the financial planning process as, okay, I'm retiring. This is my change in life. I just need you to like help me over this hump, right? When in reality, it is a complete lifestyle planning process and it can begin as soon as people are willing and able to begin the process.

I mean. We have plans with clients who are, you know, in their twenties and thirties. Mm-hmm. We have plans with clients who are widowed and have been retired for quite some time, but the planning process doesn't ever stop. Right. Right. So, as involved in proactive as you can be on the front end, it can set you up for making really great decisions now so that you're not in a position.

Where you find yourself with everything in your tax deferred accounts. 

Eric: Right. We would say if you do have substantial balances in tax deferred accounts, you probably do wanna start thinking about, we had mentioned, we talked, uh, you know, in prior episodes about how long till you should maybe think about, you know, working with an advisor Yeah.

Or potentially like a planner. I, I, I like to make the distinction because typically advisors are gonna tell you it's a difference where to put your money. Yeah. Right. I, I think of advisors as like. We're gonna just tell you where to put your money and that's it. Right? And then we say, you know, good luck.

Like I tell 

Rachael: you what buttons to push. Yeah. 

Eric: You say, I need a hundred thousand. I say, here's what we're gonna sell, and now here's your a hundred thousand. Right? Yeah. Like, that's that. I, I look that like, that's, that, that to me is, is myopic. That's too, it's too small, right? Like we don't, we wanna be broader than that.

We wanna be doing tax work. Do you? I do. Good, thank you. I do. But the point is, I think about five years is probably the minimum, um, to work before retiring. 'cause you're gonna need to accumulate taxable account balances so that you can A, live on them and B, execute conversions. Probably I. Um, during that timeframe, but also if you're retiring at 50, you probably need a, you need a pretty solid plan because you're gonna have a long time to be drawing on your portfolio before social security kicks in.

So we need to really calibrate your spending and make sure, and see what that looks like in different, um, environments. I 

Rachael: have, I mean, the planning on RMDs and Social Security alone. Mandates, I think almost a five year window there to plan that withdrawal strategy. Particularly 

Eric: if you're just stuffing it in tax deferred and your taxable balances are not particularly high or just, we don't know how much we're gonna have to convert.

And it could be a significant amount of taxes, right? If it, if the stars align for you and you're really interested in, you know, like a estate planning, you have considerations where you want your beneficiaries to inherit Roth accounts, you think they're gonna be high earners too. So you don't wanna stick them with $10 million of tax deferred income that they're gonna have to dump within 10 years under current rules.

Rachael: And that's what's so interesting. There's so many things that are triggered without us even, I mean, without the general public, right. Even knowing that they exist. Mm-hmm. Um, and so being able to even just have a thought partner and talk with somebody about like, Hey, this is my current situation. Lay out my options for me.

Right. Just to even know what they are. Right. Like it's overwhelming. And I will tell you right now, if you're looking on like chat GPT or AI stuff, it's just wrong. It's wrong a lot. Um, and to be quite frank, the, the changes in. Um, laws and all of that stuff as well. It's just, it's so hard for people to keep up with, um, for AI to keep up with.

Eric: They still thought that there were, um, RMDs from Raw 4 0 1 Ks. 

Rachael: Yes, exactly. Not true one. That's the thing. So I, it's, it can be really, really easy in this day and age to feel like, um, we can know all the things, right? I mean, I'm totally guilty of going on like WebMD and stuff to try and make self-diagnose.

Eric: Oh, absolutely. I'm 

Rachael: totally that person. 

Eric: Everybody does 

Rachael: it right. Um, it's really dangerous to do that with your money, so I'm just throwing that out there. Um, so Okay. Just, but yeah, 

Eric: if you're looking for broad takeaways, you're looking to, and you have a huge tax deferred balance, we know that the RMDs are gonna be unsettling, and we know that when we withdraw that money, we're gonna have ordinary income tax consequences on all of the money that we need to pull out, right?

So in to avoid situations where you're pulling out money and paying tax, and then. Pulling out more money so that you can pay the tax on the money that you pulled out, and then paying the tax on the tax. It's, and it's unpleasant. It's dog chasing a scale, right? To avoid those kinds of situations, you want to have a strategy, right?

So likely you're gonna be trying to increase your, um, you're trying to decrease your tax deferred balance is by realizing that income a little earlier, you're gonna pull forward some of that taxable income in the form of Roth conversions usually. Right. So you're 

Rachael: looking to pay a little bit of taxes now to avoid paying a lot of bit of taxes later?

That's exactly right. Okay. And again, um, those brackets that we're really looking to fill are. You know, 10, 12, 10 and 

Eric: 12 I think are absolutely, should be filled almost. Mm-hmm. I I, and 

Rachael: depending on your situation, maybe it's very rare. I'm sure there's 

Eric: some cute situation that somebody could contrive that that might not be true, but almost, almost always, I have yet to see a 10 or 12% tax bracket that we weren't super happy to fill.

Rachael: Yeah, exactly right. I love it. All right, so big takeaway for today is that. Your tax deferred account's great to save in, but you need to be planning your withdrawals. You need to be diversifying in those three buckets. 

Eric: Correct. Alright. Alright. Thanks guys. 

Rachael: If you're sitting on a mountain of pre-tax savings or wanna a personalized tax strategy, we'd love to help.

Please email us at podcast@equilibriumfp.com if you have any questions or suggestions. 

Eric: Thanks guys. Till 

Rachael: next time. Tax. What was it? Risks? Tax risks. Tax risks. Got it. 

Eric: I did it.