What are Roth conversions—and how can they save you millions

One of the most powerful tools in the financial planning toolbelt in terms of tax strategy is called a Roth conversion.  It is simply moving money from your pre-tax retirement accounts to your tax-free (or Roth) retirement accounts after you have stopped working and when you are in a lower income tax bracket.  Let’s review how it works.

Nest-egg buckets

As you save, invest, and grow your retirement nest egg, there are three possible destinations, or buckets, where those assets could end up:

1.       The taxable bucket: this is everything that you have saved and invested outside of a tax-advantage retirement account including, for example, your bank accounts, CDs, individual brokerage accounts, private real estate holdings, etc.  Usually, any alternative investments are found in this bucket as well, like cryptocurrency, angel or private investments, and options trading accounts. These investments are taxed at capital gains rates when you sell them and the dividends or income that they produce are taxed yearly as well. 

The advantage of this bucket is that it is always accessible.  You have already paid income tax on this money before you invested it, so there are no specific rules about when you can use it.  You just need to be aware of the capital gains tax consequences on the growth when you sell.

2.       The tax-deferred bucket: this is where all your pre-tax retirement account funds are housed, including your 401(k)s, your SEP-IRAs, your traditional IRAs, your 403(b)s, and your 457(b)s. The reason that it is called tax-deferred, or pre-tax, is that you chose to deduct this income on your federal return in the year that you invested and take the tax break.  However, you eventually have to pay taxes on that money.  The IRS allows you to defer that tax liability until you take it out of the account after you retire.  That is when you pay the tax—at your ordinary income rate at that time.   

The advantage of deferring is that you will likely be in a lower tax bracket after you retire than you are when you are working, so that you will pay a lower percentage of tax on that money.  And the money is allowed to grow tax free in the meantime. The disadvantage is that the government controls when you are allowed to distribute it (must be after age 59 ½) and when you must start distributing it (starting at age 73 currently). The latter is called a required minimum distribution or RMD, and we’ll take more about it in a bit.

3.       The tax-free (Roth) bucket: this money is also in a tax-advantage retirement account.  The difference here is that instead of deferring the taxes when you invested, you paid them. And since you already paid them, you are not required to pay taxes on them again when you take the money out.  Like the tax-deferred accounts, the assets in Roth accounts are allowed to grow tax-free.  The other big advantage is that for Roth accounts, there is no RMD, and your heirs will inherit the money tax-free to them as well.

Which bucket should you choose for your retirement money?

The answer to this question is: it depends.  If the goal is to pay as little taxes as possible on each dollar that you earn over your lifetime, it makes the most sense to pay the taxes when your tax bracket is the lowest. 

First, it is almost always the right decision to put as much of your investment dollars as possible in a tax-advantaged account, whether it is tax-deferred or tax-free. Why?  The tax-free growth.  That is a lot of year-to year taxes that you avoid paying where your money can be working for you instead.

The government limits how much you can contribute each year to your tax-advantaged accounts though.  If you reach that limit and still have money to invest, your only choice is a taxable account.  Many high-income doctors who are good savers end up with a lot in their taxable account by the time they retire—and that is okay.  Even purposefully directing money into this account rather than into a retirement account makes sense if you anticipate needing to use it before the age of 59 ½ when the government allows you to use your retirement account money without penalty.

The decision of pre-tax vs Roth for your retirement account, however, usually comes down to what your current tax bracket is and what you expect your tax bracket to be in the future.  If you expect to be in a higher tax bracket in your future years, including your post-retirement years, it makes sense to choose Roth accounts earlier (if you have the option).  If you are currently in a high tax bracket and expect that to be less after you retire, it makes more sense to defer paying taxes until later.  So, for doctors that are done with training and making a full salary, taking the tax break at the time of investing is usually the right choice. 

What is a Roth Conversion?

First, a few points to review. 

1. The goal is to pay the taxes when you are in the lowest tax bracket

2. If you earned high income during your working years, most of your retirement  money will be in a tax-deferred account. 

3. The government requires you to start distributing tax-deferred money at age 73. (This is currently set to go up to age 75 in 2033.)

4. When you distribute that pre-tax money, you pay taxes on it at your ordinary income tax rate at the time you take it out.

5. Distributions from your pre-tax accounts count as taxable income and can put you back into higher tax brackets again if your account is large. 

   
   

The Roth Conversion window

Given all that, it means that you will likely have a little window of time when your tax bracket is going to be at the lowest that it has been since residency—it is after you retire and before your RMDs kick in at age 73 (or 75).  The idea is to pay the taxes on the dollars in your pre-tax accounts when your tax bracket is the lowest.  You can do that and still keep the money growing tax-free in a retirement account by converting the money from pre-tax to Roth—hence, a Roth conversion.

The government allows this conversion as long as you pay the taxes that you would have owed on your pre-tax money at the time that you turn it into Roth money.   Remember, once it is in the Roth account—no more taxes and no RMD.  So, moving money from pre-tax to Roth during this low tax-bracket window accomplishes two things:

1. You pay taxes on the money at a lower tax rate.

2. You decrease the amount of money in your pre-tax account which lowers your RMD and may prevent you from bumping back into a higher tax bracket when you do start distributing.

   
   

Any money in your Roth account is accessible and tax-free, whenever you need it (with some nuances, see the 5-year rule below). Or you can just leave it in there and let it grow.

How much should you convert?

You need to remember that when you move the money from your pre-tax bucket to your Roth bucket, the amount that you move is counted as income in the year of the conversion, just like it would have had you distributed it directly from your pre-tax account to your wallet.  If you convert too much of it all at once, it puts you back into a high income tax bracket and defeats the purpose. 

So, the best way to do it is to convert just enough each year to keep you in a reasonable tax bracket without pushing you into a higher one.  For example, you might do just enough to keep you in the 22% tax bracket, or the 12% tax bracket, or whatever makes sense based on where you think you will end up after RMDs start.  It might take you many years of conversions to maximize the tax benefit and get most of your money into Roth.

Paying the taxes

When you make the conversions, you are paying taxes on that extra “income”.  In order to let your Roth money to continue to maximize growth, it makes the most sense to pay those taxes out of your taxable account rather than out of the conversion itself.  Use your taxable account to pay them.

How much could this strategy save you?

Let me try to demonstrate it all graphically.  The graph below is from a hypothetical client—a 55-year-old doctor and his spouse with high income and $2.6 million saved in a tax-deferred 401k.  He plans on retiring at age 60.   

The shaded dark blue area is his taxable income, and the horizontal lines are the tax brackets.  The top orange line represents the 24% bracket.  Before he retires, he is in a higher bracket, over 30%. When he retires at age 60, he drops into the 10% tax bracket.  Because he has a large pre-tax account, once RMDs start (in this case, age 75), he jumps back up into an even higher tax bracket than when he was working and stays there until he dies. 

Now, compare that to a graph that shows what happens with Roth Conversions. 

From age 60 to age 75, he converts enough of his pre-tax money to fill up the 22% tax bracket (green shade).  You can see what happens to his taxable income after age 75 (darkest blue shade.)  It is much lower, and he stays in a reasonable tax bracket while he continues to spend down his pre-tax accounts.  That is because his RMDs are getting smaller.  If you are able to convert all of your pre-tax account to a Roth account in this way, your RMDs will be erased completely, and your tax liability will be at a very low level for the rest of your life.   

In this hypothetical, but realistic scenario, Roth conversions alone saved him $1.3 million in lifetime taxes.  If he coupled that by spending down his taxable bucket and pre-tax bucket first and leaving Roth to the very end, his tax savings jumped to $4.4 million with almost $10 million more in lifetime assets. Amazing, isn’t it?

The 5-year rule

Something else to be aware of with Roth money is that the government requires it to be in a Roth account for 5 years before you can access the investment growth on the money without penalty.  The basis (the money that you invested and paid taxes on already) can be accessed at any time.  For each Roth conversion, the 5-year window resets for that subset of the account, so you have to keep good records on how much you converted and when.  This is another reason to leave your Roth money alone for as long as possible.

Leaving a legacy

I mentioned this earlier, but it is worth emphasizing. Another advantage of spending your Roth money last is that if you have anything left behind for a legacy, your beneficiaries get to inherit Roth money tax-free.  If it is pre-tax money, they pay taxes when they distribute it to themselves at their individual tax rate.  If they are in a high income tax bracket, then a much higher percentage of your legacy is going to the government than if you had paid it as a Roth conversion.  So, if you expect to have money left over, you are doing your kids a favor by turning it into Roth. 

Conclusion

Okay, that was a long post but an important one for you to understand.  Now you know why Roth conversions are one of the most powerful tax strategies that we have available to us.  A little immediate pre-and post-retirement financial planning can literally save you millions. 

If you are interested in learning more about becoming a client and walking your through your own Roth conversion scenarios, check us out at www.targetedwealthsolutions.com. 

Disclaimer: the material in this blog post is intended for general educational purposes only and should not be considered specific financial advice. You should always consult with your personal financial advisor to see how it might fit within your personalized financial plan.