How To Take Advantage of Roth Conversions

hey everybody i'm james canole the founder of root financial partners and i'm here to teach you what you need to know to create a secure retirement now in today's video we're going to go through a case study because if you're like most people you've probably heard that you need to have a tax strategy in retirement and you need to have a withdrawal strategy and you need to have an investment strategy which is easy enough but tying everything together is where most people get overwhelmed so what we're going to do today is look at a case study break it down piece by piece to show you how can you apply all these strategies to one particular case so that you can make a more informed decision about your own retirement now real quick before we jump into this today i want to give a big disclaimer that none of this is intended to be investment advice or planning advice this is just designed to be for illustrative purposes only but when we use an actual real life example and you see how we apply different strategies my hope is that you can take something away from that to see what might be able to be applied to your own personal situation but let's do this so i have a podcast it's called ready for retirement and on that podcast people will submit questions when people submit questions i like to address them and flush them out in different episodes and i'm going to pull one of those questions from the ready for retirement podcast so that we can use it for a case study on this video here today to start let's read through the question that was received so this is a question from the from the podcast website for the ready for retirement podcast it says hello i've just started retirement at age 61. my wife and i have 1.9 million dollars in traditional iras 700 000 in taxable savings and 130 thousand dollars in a roth ira we are currently living off a pension and our savings electing to defer social security until age 70 for the maximum benefit my concern is that we have a lot of money in the traditional iras and would like to bring this more imbalance with roths by doing strategic ira withdrawals or roth conversions now while taxes are historically low we would also like to reduce future rmds that could push us into a higher tax bracket the roth will be invested for long-term growth while we draw down the traditional ira and our taxable savings to meet our near-term living expenses so my question is this does it make sense to draw down the traditional iras to meet our living expenses or should we do roth conversions and use our taxable savings for our living expenses my pension income is 65 000 per year and we would like to max out the 22 federal tax bracket with our ira withdrawals we live in florida which has no state income tax so that's the question and again we're going to address this and as i do it this is not tax advice this is just for illustrative purposes but let's start by looking at this example and seeing where we'd go from here now as we do so a couple things to note number one this individual lives in florida which has no state income taxes if you're watching and you're not in florida you would need to add in state taxes to this calculation and they're going to be different depending on the state that you live in number two i don't know this individual's living expenses i don't know if it's 80 000 per year 100 000 per year 200 000 per year i just know income and portfolio assets so we're going to take that in mind as well and then number three i have no idea their risk tolerance which would determine how they're going to be invested in each of those accounts so with those three disclaimers here's what we do know number one we know that he has a pension of sixty five thousand dollars per year i'm going to assume that that pension is fully taxable meaning it's not some type of a government pension or a military pension where maybe portion of it could be tax free i'm making the assumption that it's fully taxable number two we know that he's going to collect social security at 70 both he and his wife and number three we know that there's a total of about 2.8 million dollars in investments between roth ira's traditional iras and brokerage accounts his question is this is he says we know we're going to be in a higher tax bracket in the future so he's asking should we do roth conversions today to avoid that or should we draw down our ir iras today to avoid that i love this question so let's let's look at this let's start with an example though let's make the assumption that he doesn't spend any of his iras they don't draw down their iras or do any conversions but instead they live on their pension and their brokerage account and i'm going to assume their brokerage account they're able to make a lot of withdrawals from that without paying anything in taxes which of course would depend upon any potential gains but let's look at this let's assume that this individual lives on their brokerage account their savings and their pension and that's able to cover all their expenses from now until age 72. so they meet their needs their brokerage account is spent down over that time but it gets them to 72. now that's 11 years away for them based upon their ages today so if they have 1.9 million dollars today in traditional iras if that money grows for the next 11 years before they spend it well if they get 7 percent per year growth which is an assumption i'm going to make that ira value would grow from 1.9 million dollars all the way to 4 million dollars so and growth is never a bad thing there's nothing wrong with that but here's the challenge that 4 million dollars of growth is now or that 4 million dollars in the ira is now all subject to required minimum distributions i mean they're going to be forced to start withdrawing that over the course of their lifetime starting at age 72. rmds go up the it's a it's a percentage of your account that you're forced to take out each year and it starts at one percentage and it goes up over time but the initial starting value is around 3.9 percent in year one at age 72. so just to use a round number 3.9 percent of the ira must be withdrawn now if there's an ira value of 4 million dollars and 3.9 percent of it has to be taken out that represents 156 000 of withdrawals just that first year and that number is going to continue to climb by the way but year one of rmds there's a hundred and fifty six thousand dollars of ira withdrawals that are fully taxable there are sixty five thousand dollars of taxable income and pension there is social security which could be another ninety four thousand dollars if they fully max their benefits now not all that's taxable but portion social security the majority of it certainly would be in this case so it's very feasible that they might have about three hundred thousand dollars of taxable income at that point now today in 2021 that would put them in about the 24 federal tax bracket if that bracket goes up so if current tax rates expire if tax brackets go up it's likely that bracket will go closer to 28 to 33 if brackets revert to where they were before tax law changed in 2017. so if we look at 2016 brackets for a reference that would put them squarely in the 33 percent tax bracket also and this is never fun to talk about but if a spouse passes away well those tax brackets that we have is married finally jointly those tax brackets get condensed and you start pushing up into higher tax brackets with lesser amounts of income if you're single as opposed to married filing jointly now you might say well that doesn't really matter because if i'm single my expenses will be lower well true but your required distributions might not be lower your rmd would still be the same in this case if you're both the same age the pension if there's a joint survivor benefit would be the same social security would have the little bit of reduction because you would take the survivor's benefit but it would still be a decent amount so what happens is at a minimum this might push the the combined tax bracket up into the low to mid 30s but if there was a single tax bracket at that point if one spouse or pre-deceased the other that jumps up much higher it'll put you in about a 35 tax bracket if we look back at 2016 thresholds so bottom line in this example they'd probably have a lot of money to last for the rest of their lives but what they did is over the next several years from now until age 72 paid a very low amount in taxes probably in the what would today be the combined 10 to 12 bracket so relatively low amount but then at 72 and beyond pushed up into the 30 to 35 tax bracket depending upon where rates are at that time so what you can see here is this created a great tax situation for the first decade plus of retirement but then a much less than ideal tax situation from 72 and beyond so the question is how can we get around that how do we avoid paying really low taxes today but then much higher in the future can we even that out a little bit can we normalize that a little bit to lower our overall tax bill that we can expect to pay over the entirety of our retirement now there's other options for doing this that's not the only way that it can be done another option is don't live on the cash and brokerage accounts today can you start to withdraw down your ira today and what that does is it creates more taxable income today but it manages the balance of the ira if there's 1.9 million dollars in iras today and you're withdrawing that to supplement your pension today it's keeping that balance in check so it doesn't grow out of control and create really significant required distributions in the future so what that does is that is one way of spreading out the taxes you're paying more today but less in the future when required distribution start but there's another option and this is an option that i see being very favorable depending upon your situation or the specifics of any client details but using roth conversions as an option is a very significant option or a potentially really impactful option so what do we know today well we know that today tax rates are historically low compared to where they've been in the past and there's a good chance they're going to go up in the future so what we can do is we can also look at this individual's overall situation he has iras pension roth ira and he also has a brokerage account so let's take a look at this let's look at what we do know his fixed income sources are so he hasn't collected social security yet and we know that he has 65 000 per year coming in from a pension well the standard deduction in 2021 it's about 25 000 just rounding for simplicity here once you turn 65 that standard deduction goes up by 1300 per spouse but for today 25 000 so if if they have a pension of 65 000 what that actually means is their taxable income is only 40 000 if that was their only income source so far so 65 000 from the pension reduced that by the standard deduction their taxable income is only 40 000 well if you're married finally jointly in 2021 you're gonna pay ten percent in taxes on the first about twenty thousand dollars of income that you have and you're gonna pay twelve percent taxes on amounts up to about eighty thousand it's really eighty thousand two fifty but i'm just going to round to 80 000. so in this example this individual will be paying 10 taxes on the first 20 000 of taxable income and 12 taxes on the next 20 000 of taxable income so that's very low and that's very nice for today and as i mentioned if he just lives on cash on top of that you're staying in that tax bracket but that sets you up for much higher tax bracket in the future so how can we look to fill up some of the tax brackets how can we say we'd gladly pay 12 to fill that bracket up maybe even gladly pay at the 22 bracket to fill that up in order to avoid much higher tax brackets in the future well one way you could do that is through conversions so could you potentially convert so going back real quick 40 000 of taxable income so far after taking out the standard deduction could this individual convert about 41 000 from an ira to a roth ira so rather than spending that money to fill up the tax threshold they're spending their cash or spending their brokerage account which is managing their tax bracket and keeping it low and then convert ira to roth ira so shifting assets from pre-tax to after tax whatever that conversion amount is you pay taxes today but it saves you from ever paying taxes on those assets again in the future so in this example what if this individual were to convert 41 000 from iras to roth iras well in doing that pension would be 65 000 ira conversions would be 41 000 so for a total income of 106 000 dollars if you back out the standard deduction of 25 000 again i'm slightly rounding these numbers you get a taxable income of 81 000 which maxes out the 10 tax bracket maxes out the 12 bracket but doesn't yet put them into the 22 bracket and beyond so what they're doing here is they're saying we'll gladly pay tax at 12 to avoid taxes at 30 32 35 potentially beyond in the future think of it as like tax arbitrage or tax insurance of i'm going to pay insurance on what i have to avoid a much more costly tax bill in the future what they could also look at is potentially converting the 22 percent bracket now this is going to be the case-by-case basis if you don't have as much in your ira there's maybe not a need to convert as much but the more you have in your ira the more your required distribution will be in the future the more it might make sense to convert at the lower thresholds so what thresholds do we want to fill up to manage the future liability of all that now the goal is not to convert everything from iras to roth iras all people talk to me sometimes how do i get all this money in my 401k or all this money in my ira over to my roth my first response is you don't you don't want to do that because the cost of that would likely outweigh the benefit of having everything in a roth ira long term what we want to do is get enough into roth iras that it fills up the right tax brackets today and doesn't push you into the highest tax brackets in the future so it's this balancing act between how much do we want to pay today in taxes and how much we want to pay in future in taxes if we don't do enough roth conversions the scales might tip too much taxes in the future where this is a lot of money if we do too much conversions today the skills might flip in the opposite direction we're paying too much taxes today and really not much at all in the future the goal is to find that balance where we can stay underneath certain thresholds both today and in the future so can you convert enough to fill the 12 bracket for many people that's a great place to start we might not see tax brackets that low for a very long time of course this depends upon your situation talk to your cpa talk to your financial planner but that might be a good place to start if you have significant amounts in your iras or pre-tax accounts or significant income you know will be coming to you in the future that's maybe you when you might want to consider converting a little bit more so the goal is make sure you're not overpaying today make sure you're not overpaying in the future but understanding roth conversion strategies understanding income and withdrawal strategies understanding how everything interconnects with one another that's really the goal of good retirement planning not looking at one question on a one-off basis but really understanding how does everything tie in to impact one another on an ongoing basis thanks for watching again this is james canoll with root financial partners if you enjoyed this video or if there's anyone that you think could find value in this video and creating a more secure retirement please share this video with them also please be sure to like this please be sure to subscribe if you haven't already so that you don't miss future videos just like this in the future and if you want more tips and strategies about how you can create a better more secure retirement be sure to check out the ready for retirement podcast weekly episodes full of information full of strategies that you can apply to your situation to create a more comfortable retirement and if you are interested in our services and how we help people create their own retirement strategy please be sure to check out our website at root financialpartners.com [Music] you

Channel: James Conole, CFP®

Views: 56,450

Keywords: roth conversion, roth conversion taxes, ira to roth conversion strategies, roth conversion strategies, roth ira, roth ira conversion, retirement investing, how to retire, how to invest money, passive income, retirement planning tips, roth conversion rules, roth conversion explained, roth conversion ladder, roth ira conversion 2021, retirement planning, retirement planning at 50, retirement planning at 60

Id: ET3cJ0hQxBo

Length: 16min 3sec (963 seconds)

Published: Sat Sep 25 2021