Episode 84: Mastering Roth Conversions - Boost Your Retirement Strategy

Welcome to episode 84 of Accessible Finance for Retirement! Join Eric and Rachael Johns as they delve into the complexities of Roth conversions. Discover why Roth conversions are a powerful tool for managing tax brackets and maximizing retirement savings. Learn the fundamentals of Roth conversions, including the steps involved and strategic timing to optimize tax efficiency. They also discuss the importance of professional guidance and common pitfalls to avoid. Don’t miss this insightful episode to enhance your retirement planning strategy. Tune in now!

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Read the Transcript

Episode 84

Eric: Welcome to episode 84 of Accessible Finance for Retirement. I'm Eric Johns. 

Rachael: And I'm Rachel Johns. 

Eric: Let's dive in. 

Rachael: All right, so this is episode two in our three part episodes of, uh, Roth Accounts. And so we focused a lot on Roth contributions and some basic, um, Roth rules IRA functionality. Yeah, yeah. So today's episode is gonna focus on Roth conversions.

And particularly what kinds of strategies to implement to that end? So, um, the Roth conversion is one of the most powerful Roth strategies that are available. Um, and so the current tax rules, the law, there's a lot of reasons that this becomes particularly relevant. Eric, thoughts? 

Eric: Yes. 

Rachael: Why, 

Eric: why are Roth conversions relevant?

Yes. Because they are an amazing tool for manipulating your tax brackets and your taxable income and your marginal effective tax rate. 

Rachael: Beautiful. Um, and when we stay manipulating, um, we are talking about legal manipulation. Mm-hmm. But, um, it is a way to kind of. Uh, set yourself into certain tax brackets that you may not be in otherwise.

Correct. Um, alright, so let's first talk about Roth conversion fundamentals. Okay. What exactly happens in a Roth conversion? 

Eric: Got it. Um, real quick, we're gonna talk. We're gonna just change exact, like what you just said, said everything that I just said. Yeah. Yes. Okay. And I just very briefly want to say, if you take nothing else away, you know why I 

Rachael: organize anything.

Shouldn't. I really shouldn't. You should. You should understand 

Eric: that. I'm gonna wreck it all I do. Um, sorry. Uh, real quick, if you cake nothing else away, I would like it to be this, if you're trying to reduce your tax bracket for the year. You're thinking, I'm going to defer as much to a 401k plan. Mm-hmm. As I can, and I want traditional IRAs, that means I'm not gonna pay income tax now.

Mm-hmm. I'll pay ordinary income tax later when I take it out if you want. On the other hand, you're thinking, Hey wait, this is a pretty good year for us from a tax standpoint. Yeah. I'm in the 12% bracket. Yes. Should I? 

Rachael: I and, and that can be like, I retired this year, right? Yeah. Or it could be, I'm switching from full-time to part-time.

Sure. I'm easing my way into retirement or I'm starting a new business. Right. And it hasn't really 

Eric: absolutely gotten off the ground yet. Right. You might have losses. That's a perfect time to convert. Correct. Great Time to convert. Yeah. Um, so, right. So anyway, Roth is when you wanna increase your taxable income.

Yes. Right. Traditional is when you want to decrease it. That's it. That's all I got. And then, and 

Rachael: to that end though, I think that, um, and we've talked about this in previous episodes, but um, you may be hearing when you wanna increase your taxable income and you're probably like, what? Why would I ever Yeah.

Why would exactly ever want to do that? And at the end of the day, uncle Sam is going to get his piece of every single dollar that you have, right? And so realizing income through Roth conversion strategies is one way of. Telling Uncle Sam, like, I'm gonna tell you when you're like, when I'm paying taxes, rather than you telling me through RMDs or anything like that.

Eric: That's perfect. That's exactly right. We want to be deliberate Yes. And intentional about when we pay our taxes. Mm-hmm. Rather than having it thrust upon us in the form of RMDs or, um, just withdrawals from retirement accounts. So that ties in perfectly to your question, right? What exactly is a Roth conversion?

Functionally, what happens? What does that even mean? Correct. What does, yeah, what are the steps? What does look like? So I'm taking money from a tax deferred account. Typically a traditional IRAA rollover IRA or a 401k. One K, right? Mm-hmm. And then I'm moving that money to a Roth IRA. All right? When I move that money, it is a taxable event, and I pay ordinary income tax at the federal and state level.

On the total amount of the conversion. Mm-hmm. I don't pay FICA taxes, but I do pay income taxes on the total amount of that Roth conversion. Right. So it's called a Roth conversion because we're taking tax deferred amounts or, or I'm sorry, tax deferred, uh, funds. Mm-hmm. And we're converting them into a Roth account, so we're taking a tax, like a traditional IRA and converting it to a Roth IRA.

It doesn't have to be a total conversion though. It can be any part of it. 

Rachael: Okay. So let's say that I have a. A traditional IRA that has $200,000 in it. Got it. I decide I'm gonna convert 50,000 into a Roth. 

Eric: Got it. 

Rachael: That on my tax return then means that I realize $50,000 more of income. Correct. 

Eric: Exactly.

Correct. 

Rachael: And so I'm gonna pay, like if I'm in the 24% tax bracket. Yep. Right. I would essentially pay 24%. Well look, we're to assume every dollar is in the 24% tax bracket. Yep. And we're saying 12. I would pay 20, I would pay $12,000 on that. 50. Yep. Right. But. If I'm in the 24% tax bracket now and I expect that down the line.

Right. I'm looking at some pretty large RMDs down the line. Sure. Um, I think I'm gonna get pushed up into the lower thirties. I'm may be comfortable paying at the 24% tax bracket. 

Eric: Exactly 

Rachael: right. So it becomes something where. And the fact that you can do partial conversions rather than all of it leaves a lot of strategy on the table.

Because you can essentially nearly like down to the dollar 

Eric: control Exactly. Where the marginal dollar last marginal dollar is being paid. Right, exactly. Yeah. Yeah. Exactly. So that's, that's frankly what we do. Yeah. Right. Like so we'll pull up tax software and we will look at exactly where you are. Mm-hmm.

And think, Hey, maybe this year we should take a little bit off the table because we just. You know, some of it is pushing us over this threshold or into this higher bracket, or over this IRMAA limit, right? So. That's, that's exactly what you're doing. You're calibrating, right? Mm-hmm. So this is Roth Conversions are a tool to calibrate your taxable income.

We know that deferrals are the way to turn it down, right? Mm-hmm. By deferrals, I mean you are deferring your salary into a 401k to the tune of 23 and a half, up to $31,000 a year if you're 50 or older, right? Which will lower. So that's way you can lower your tax income. Yeah. The 

Rachael: income you're reporting on your return, right?

So 

Eric: Roth conversions are a great way to. Increase your taxable income mm-hmm. In years, like you mentioned mm-hmm. That your taxable income is artificially low or just simply lower than you believe it will be in the future. Mm-hmm. 

Rachael: Correct. And it's, it's important. I mean, we have interacted with people who have been quite excited and quite proud of the fact that there have been years that they have been in these zero or 10% tax bracket.

And while that is a wonderful thing, it causes financial planners. Or professionals who understand the value of Roth accounts to salivate because of the amount of planning opportunities it allows for and the amount of space it allows for. 

Eric: Correct. 

Rachael: To convert 

Eric: a Roth. Because the issue is this, right? You avoided paying tax in the zero or 10% bracket.

Mm-hmm. But now what happens? You have all of your money in tax deferred accounts. And then those RMDs are required. Minimum distributions are substantial. And you might be paying tax in the 22 or 24% tax bracket when you could have paid. That's a whole lot more than zero or 10 or 12, correct? Correct. So we could have filled all the way up to the 12 and been.

Doubling. Yeah. Right. Like we would've been having the amount of taxation we're gonna have on those accounts at the least. 

Rachael: Yes. And one of the things we use, I think that makes this point really salient for people we work with is a visual that kind of shows, um, the estimated tax brackets based upon what I mean, you, you can look at what the RMDs are gonna be, there's calculators and things available, right.

You can. Plan out estimated conversions based upon the information you have available, and the name of the game is essentially to try and make that. Those tax brackets or the tax brackets, you're in your marginal, effective tax rate. Um, 

Eric: now we're talking, 

Rachael: you're trying to make that line as flat as possible.

Correct. Rather than, you know, uh, being mountainous. 

Eric: Correct. 

Rachael: And so you're kind of tweaking all these levers everywhere trying to, to make that line really flat. So if there is a year where you're paying in the 10, but you know that later on you're gonna be paying, you know, 24, 28. Yeah. Lower thirties. We'd love to see that go down and be happy to pay, you know, beyond fill up that 10 bracket for sure.

Exactly. 

Eric: Correct. 

Rachael: Um, okay. So, excellent. So the Roth conversion allows you to kind of titrate like where, like to really nail down mm-hmm. Exactly what bracket you wanna fill. 

Eric: Right. 

Rachael: And um, like you said, you can do that in. Portions. It doesn't have to be the entirety of your, like traditional ira. It should, 

Eric: right.

It's something that should be continuously evaluated. It's not a like all or nothing strategy. Yeah. And it's not a strategy that even when you implement it, you're not gonna say, okay, we're gonna convert $50,000 to a Roth from our traditional every year for the next 10 years. Mm-hmm. That's, that's, that's frankly nonsense.

Like there's no way that things are gonna be that. Like stagnant. Correct. Does that make sense? Like there's gonna be movement in the accounts. Um, there's gonna be movement in your earnings more than likely. 

Rachael: Yeah. 

Eric: You might have raises that, you know, make it less viable to convert 50. Maybe now it's 40.

Rachael: Correct. 

Eric: Right. 'cause I got a $10,000 raise and I was comparing to a specific, 

Rachael: the amount. Change purposefully, right? From year to year. You should 

Eric: calibrate it on a ongoing basis based on changes to tax law, changes to your situation. Right. Changes to the account balances and the markets, so. 

Rachael: Right. And something important that we touched on in the last episode is the fact that there are no RMDs from Roth accounts.

Yes. So if you are worried about getting hit with a huge RMD like balloon down the line mm-hmm. You can essentially lower what those are gonna be by. Forcing those distributions now converting them into a Roth, and then no longer having to 

Eric: correct deal with RMDs from that account. Correct. One of the things that's actually, that's super helpful, right, is not only with a Roth conversion, are you reducing the amount that's subject to the RMD.

Those funds are no longer growing in the tax deferred accounts. Now they're growing in a tax free account. So you're not going to have to pay taxes on the growth. Right. Does that make sense? So instead of experiencing the compound growth that we all love 

Rachael: right 

Eric: inside of a tax deferred account, it's still fine.

It's still good. It's not incurring the tax drag. You still like tax deferred accounts. They absolutely have a purpose and they're fantastic 

Rachael: for sure. 

Eric: Um. We might not like love it when the RMDs are gonna increase every year by the time it feels a little painful then. For sure. So as you age, your RMD increases just because of the, um, decrease in the denominator of their formula, right?

Correct. So what I'm saying is simply like if your account, you're gonna start on in year one, it's 73. Paying, you know, 6%, then it's gonna go to 8%, 10% of your total IRA balance. Right. So that's increasing as you get older. And then also those accounts you can expect are gonna be growing as well. Yeah.

Because they're likely invested in markets, which we hope go up into the right 

Rachael: and history tells us that's what happens. That 

Eric: do. Correct. 

Rachael: So it, I mean, I think the biggest takeaway and what we've kind of really been touching on is the fact that the, um. S strategic timing is critical here. Mm-hmm. Um, and so it allows you to optimize that situation.

So if you are retiring at 62, but you're collecting Social Security at 70, you may have eight years of this kind of artificially low income. And so it's a wonderful time to plan out. Roth conversions. That's 

Eric: exactly right. 

Rachael: Um, and so you referred to them as like Roth conversion ladders, right? 

Eric: Correct.

Correct. Roth Conversion ladders is simply the. Term used to indicate that it's incredibly likely, like we said, we're going to evaluate and calibrate on an annual basis. Correct. But it's incredibly likely that if you retire and you're expected to have almost no taxable income mm-hmm. From, you know, your early sixties through RMDs or through Social Security elections at 70 or RMDs that started maybe 73 or 75.

Yeah. That's gonna be a time where you're almost certainly gonna wanna pursue some kind of a Roth conversion strategy. Mm-hmm. So the Roth conversion ladder just means you're gonna do conversions over a number of years instead of just front loading a boom, pulling the trigger. I'm gonna knock myself up to the 37 plus percent bracket.

Yeah. And pay taxes all the way up to the top. That's almost never the right play. You're all almost certainly going to want to do it in a measured way over time. 

Rachael: Correct. Because like we were saying, you know, imagine if you're imagining tax brackets like buckets, right? You wanna. Fill up that 10% and then every drop over that 10% spills over into the 12, right?

And every one over the 12 spills over into, 

Eric: because if you can think about it, it like we spoke about earlier, there are clients that you know, or you know, individuals that we, that we've encountered that didn't take advantage of even the 10% or 12% brackets. You can think about it this way. Maybe I convert a million dollars in a year and I shoot myself up to the 37% bracket.

Okay? So now I'm paying taxes at the 32%, 35%, 37%, 24 even. And then the next year. Where's my taxable income coming from? We just said I'm retired. Yeah. I have no earned income. 

Rachael: Now I'm in the zero. Now I'm in the 10. Now back the 10 or 

Eric: zero, I might not even be able to fully utilize the standard deduction. Yeah.

I've really left some money on the table. Correct. 

Rachael: And I think, um, you know, as you're planning out these Roth conversions, it's a really delicate situation. Um, because every dollar you're able to get into a Roth. Has huge upsides, right? But then every dollar that you go over, um, you know where this limit is.

Mm-hmm. Incurs either, um, a new IRMAA, um, 

Eric: correct 

Rachael: charge, right? Or kicks you up, kicks that dollar and all future dollars above that into the next tax bracket. Right? So being able to really hone in on where your. Um, comfortable converting up to and having a rationale behind that is really important. 

Eric: Right.

And one thing, don't wing it. I know we're talking about Roth conversions here. Yeah. And that's not Medicare. I do however, wanna say that once you hit age 63, assuming you're gonna get on Medicare at 65, we wanna start thinking about IRMAAthresholds. Yeah. Because those have cliff. Limits. Yeah. Which means if I'm a dollar over, then I pay the entire increase in the premium.

And it's usually about a hundred dollars per increase. You know, it starts at about, let's say 180, 1 90, and then it'll go to, you know, 2 80, 2 90, um, and then it continues to go up to about 500. So. The thought is, Hey look, let's think about very carefully if we, how much we can squeeze into the years before maybe 63.

'cause IRMAA has a two year look back, right? So when you're 65, they're looking at your tax return from when you were 63. Mm-hmm. Okay. And then when you're 65, when you're 67, they're looking at your 65. So you get the idea. So you're looking 

Rachael: at a bit more aggressive pre, correct. 

Eric: Correct. So all us equal, you would, and you want to think about, you know, maybe I can go up a little bit in this year and then avoid IRMAA.

Premiums in the next year. That's what, when we say the term, when we use the term marginal effective tax rate, that's largely what we're talking about. Mm-hmm. You can use your marginal tax rates for conversion, um, analysis, and that's fantastic. We're just saying also consider things like IRMAApremiums, net investment, income tax, social security, taxation.

Yeah. Those kinds of things are what we're talking about when we're talking about effective tax rate. Yeah. We're talking total taxes, paid and credits lost by increasing your taxable income. 

Rachael: That can be. Very, very tricky. Um, we are fortunate to be in a business that has, where, you know, we are very familiar with planning software and how to use it to be able to help identify where each of these cliffs are.

Um, but for the average person, like knowing where the IRMAA thresholds are, knowing when that investment, I mean, it is incredibly complicated. 

Eric: It's quite tedious. Yeah. And quite complicated. 

Rachael: It's a lot. Um, so. Don't be shy about reaching out to a professional if these are things that you are worried about.

Eric: You would also, nevermind. I don't wanna, I don't wanna derail us into tax legislation, but you would think that they would make efforts to simplify the tax law. Oh no. The latest changes did not do that. 

Rachael: No. Well, that's true actually. 

Eric: Either above the, above the line deductions or below the, below the line deductions that are now, it's crazy.

You can take sta Oh, sorry. It's, I 

Rachael: mean, we had a long conversation about this not that long ago. I don't remember what it was. Um, but about the fact that the. Tax code is just wildly inaccessible, um, to the general public and also is often misinterpreted by professionals in the industry, which is really problematic.

And so there were no steps taken to help clarify that. Um, which is great. So it's okay to be a bit gun shy. I think about, it's just 

Eric: a bit confusing. Is is my only point here converge? It is. And it's not getting any better. It's not 

Rachael: a bit, I think it's quite confusing. 

Eric: Yes. Um. 

Rachael: And so being very intentional about the conversions and understanding the implications of, you know, what we like to do with clients is essentially say, look, here are three options that we think are good.

Here are the pros and cons of each. And then finding kind of what they're most comfortable with, because typically there's not one right answer, but there are definitely plenty of suboptimal choices. Mm-hmm. Um, okay. So the Roth conversion ladder. Eric, I know last episode we touched a bit on some of the restrictions with conversions mm-hmm.

That, um, contributions don't have. Can you refresh our memory with conversion? 

Eric: Sure. Each conversion will have a five year clock until you can withdraw the contribution. Um, tax and penalty free. Right? Um, actually it's just penalty free because you've already paid the tax. Correct. You would just pay the penalty.

Right. So when you convert from a tax deferred account to a tax free account mm-hmm. Like a traditional IRA to a Roth IRA, you pay ordinary income tax on the amount that you've converted. Right. Then there's a five year clock on this conversion. However, if you're over 59 and a half, you can ignore that. Um, and then you can just, you can convert and then withdraw the funds from the Roth.

You've already paid the tax. There's no penalty incurred there. 

Rachael: Excellent. Um, and so when you're talking about a, like conversion ladder mm-hmm. For example, very important to keep records of how much you're converting each year, and then knowing when those contribution or the conversion amounts, um, are available for withdrawal.

Mm-hmm. Um. So that's the, the five year rule, which we touched on in the last episode. Correct. Um, alright. Any like common pitfalls come to mind when it comes to conversion strategies? 

Eric: Probably the, the largest is to try huge conversions or outsized conversions immediately, rather than taking advantage of small conversions over time.

Mm-hmm. Right. Um, and also, yeah, that's, that's the largest I would say, but also. Under utilizing it, not realizing that it exists or is even as a tool that you can use because of the complexity surrounding it and kind of, you know, if you're, if you're not familiar with this stuff, if, if you're unsure, you know, when you press.

Can, well, when you try to move money from your traditional IRA to your Roth, IRA, there's big red boxes that come up and it says, did you take your RMD this year? Are you sure you wanna do this? Right? And like, how much federal tax do you wanna withhold? 

Rachael: They scare you 

Eric: and right. And if you're not not sure, then you might say, Hey, I wanna withhold 20% federal tax.

And if you're under 59 and a half, well that was a distribution from your traditional IRA and now you have 

Rachael: Yes, a 10% 

Eric: penalty. 

Rachael: That's a really good point. So, 

Eric: right. If you're not. You know, in retirement or if you're are retired and you're under 59 and a half, that's something you actually should contend with.

So, mm-hmm. There are logistical, I guess, barriers and perceived barriers to doing, to executing the conversions that are kind of intimidating for a lot of people, um, as they well should be. 'cause if you make mistakes, like we said, you, you can't really roll it back. Right. So in, in many cases, you're just kind of stuck with your actions and you'd have to deal with it.

That doesn't change the fact that these tools are fantastic, they're wonderful, and they're an excellent way to increase your taxable income in a way that's viable for your long-term savings because you're putting the securities that will grow in tax-free accounts. 

Rachael: Yeah, for sure. And you know, in the example we discussed earlier where you've retired at 63, um, but you're not.

Um, going to be looking at Social security till 70. Mm-hmm. If you, I mean, you either have the option of those seven years of conversions, like Eric was saying, so you can repeatedly refill that 10% and 12% bracket, um, or. If you wait to try to convert or don't even realize that's an option for you till you're 68 or 69, you're left with one or two years, um, in which case you're either paying at much higher rate than you would, or you convert less than you would've otherwise.

Um, so being proactive, understanding what it is as early as possible. 

Eric: Mm-hmm. 

Rachael: Is crucial. And I think, you know, one of the, the groups that we really like to work with are those who are looking at retiring in a few years because it allows us to kind of get all the ducks in a row to really take advantage of those.

Prime years where there's so many planning opportunities to take advantage of. 

Eric: Exactly. There's a lot of tax complexity. Mm-hmm. And that's, that's interesting, frankly, to me. So I like it. 

Rachael: It is, and it, it ha quite frankly has, I think, some of the biggest impacts in long-term. Mm-hmm. Um, you know, savings of any of the things that, that we do.

Um, okay. Excellent. So. Nothing else comes to mind for me for Roth conversions. Do you have anything else that we may not have hit on? 

Eric: No. There are times where it's more advantageous to do than others, right? Like down markets are good. It's kind of like buying stock at a discount. Mm. Because you can get more into your Roth and if the expectation is reversion to the mean, then you can expect that if stocks go down and you expect 'em to come back up, then if you convert them when they're down, then you have more of the tax, more of the growth or the, the rebound, the bounce back inside of a tax free account.

So that's good. Um. No, I don't. I, I think that's about it. Right. Okay. So you just want to carefully consider, I think one of the largest things that we try to convey on every episode is we want to be intentional. Yeah. About when we're paying taxes and why always. Like, why is our rate this today? Should we make it higher?

Should we make it lower, or should we leave it this same? 

Rachael: And I think that that is one of the most powerful things because. I know certainly growing up, both of my parents were involved in tax preparation. Mm-hmm. Um, so growing up I definitely feel like I was more exposed to just the tax world in general, but it feels very, um, helpless.

It feels like you're just stuck in whatever bracket you're stuck in. It's whatever the number is on your tax return. And so it can be really empowering too. Realize that you can use Roths, you can use traditional IRAs, you can use these tools to kind of play around with those brackets. It doesn't have to be, I made this much money this year.

My tax bracket has to be this. Mm-hmm. There are definitely options and, and ways to creatively. Manipulate what that number is. Um, okay. So then the main takeaways that I have, um, to kind of wrap up for us are that, um, the Roth conversions allow you to transform those tax deferred savings into tax free retirement assets.

Right. So you're choosing when you're paying the taxes on them and changing that classification. Um, like we said in last episode and this episode, the ideal time to convert, um, would be when your current tax rate is lower than your expected future tax rate. 

Eric: Mm-hmm. 

Rachael: Um, strategic partial conversions over multiple years.

So the Roth conversion Ladder, um, often provides the best tax efficiency mm-hmm. Because you're. Able to repeatedly fill in those lower brackets. Right. Um, the pre RMD window, um, offers a really unique opportunity for those conversions as we would expect the majority of people's income to be lower between retirement and those RMDs.

Exactly. And then, um, proper planning and professional guidance, um, where needed could help maximize the benefits, um, and minimize the tax impact because you. Really only get like one shot at that, at that window and doing it correctly, as correctly as possible. Agreed. Um, alright, well I have nothing else.

If you guys have any questions, comments, stories, anything relating to Roth at all, but particularly for this episode, anything relating to conversions, please don't hesitate to send them to podcast@equilibriumfp.com. 

Eric: Thanks guys, 

Rachael: till next time.