Troy Sharpe: When do your account balances catch up from doing Roth conversions because we have
to write checks to the IRS when we do those conversions? What are the various points to
consider? How do those things impact the different decisions that need to be made? We're going to run
through all these scenarios, and help you have a better understanding of whether Roth conversions
could be right for your retirement. [music]
Hi, I'm Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner, professional,
and host of The Retirement Income Show. This is a comment that we receive all the time on
the YouTube channel here, but it's not just the YouTube channel when we're sitting down
with clients, going through the tax planning that we do for clients or prospective clients;
when we're doing the tax analysis of your current situation versus what you
probably should be doing. This is something that comes up often. What do when I say,
when do your accounts catch up after doing a Roth conversion?
In today's example, we're going to look at someone that has $1.5 million in their retirement account
and $250,000 in their savings or brokerage account outside of IRAs and 401(k)s. If they do nothing
and assuming apples to apples that-- Let's say, both accounts are growing at 6% over time.
If we aren't doing converse, the non-conversion strategy or plan is going to grow faster
because in the plan where we're doing conversions, we actually have to write a check to the IRS.
We have less money initially to earn interest on. If we start out even,
hypothetically, two different paths that we could go so the fork in the proverbial fork in the road.
Before we make any decisions, let's say, we have 1.5 and 1.5. This strategy,
we decide to do Roth conversions. We have to write checks to the IRS, so when we both earn 6%,
this strategy, the hypothetical one where we're not doing conversions, we're going to
earn more interest on that account, so it will be higher after year one. Most things in retirement
planning; because your situation is so unique because you are different from the person next
to you or the person next to them. Everyone has their own circumstances. The answer is different
for everyone. Some of you spend more than others. If you spend more, where are we taking that income
from? Maybe we don't have to do Roth conversions. Maybe we can simply spend that IRA down.
Ultimately, what we're trying to do with Roth conversions is three main things. We're trying
to eliminate tax risk. We're trying to pay less taxes over the course of time with retirement,
and we're trying to improve the composition of our accounts. Meaning, down the road,
if we need to access a large sum of money and it's all on these tax-infested retirement accounts,
that's a poor composition because it's not even all your money. You have a partner in
that account, just like if you had a small business and someone had a 30%, 40%, 50% ownership
interest in that business. It's not all yours. By improving the composition, we buy our partner
out by doing these conversions over time, and we have a greater composition. Now, if you need to
access money, you want a second home, you want to go on vacation, you want to spend more, give more,
you want to pass money onto your children or grandchildren, that's a better composition
of assets. Those are the three main reasons. Now, before I get into the examples and looking at
different analyses and situations, I'd like you to take a second to subscribe to the channel. We're
delivering powerful content here that will help you make better decisions about your retirement.
I don't care if you're 30, 40, 50, 60, or 70, you will learn more by becoming a subscriber to
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the decisions you should be made in retirement. Basic parameters for the video. We're looking
at a married couple here, but it doesn't matter if you're married or single, but concepts are
still the same. Husband, 60; wife, 60. He has a social security check maxed out roughly around
$3,100 per month at his full retirement age. She does not have a social security check in
this instance. That is a good example of how your situation may be unique where you have income.
Does one spouse have a pension? Maybe he or she was a teacher, maybe one has social security,
maybe both have social security. That changes, not only the income plan but especially the tax plan.
The basic parameters, 60, 60; social security check of $3,100 a month,
and living until age 90. Basic parameters, $1.5 million in the IRA, $250,000 outside of the IRA.
The first scenario we're going to look at has to do with spending in this hypothetical
scenario with those parameters, we're going to look at spending $60,000 a year combined.
Adjusted up for inflations, so over time, we're pulling out 70, 80, 90. That is inclusive of
social security. The first question is and very simple to answer here. When do the accounts catch
up? That's a very interesting question in and of itself because are you talking about on a pre-tax
basis or on an after-tax basis? What that means is, if we're looking at just the account balances,
are we comparing them before taxes? If you have all this money in the IRA,
let's say, it's worth $2 million, but then you have $1.5 million in Roth. On a pre-tax basis,
this one has more money, but if we were to say, "Okay, if you actually needed to get that $1.5
million on an after-tax basis, that one's actually worth less. On a pre-tax basis, spending $60,000;
moderate growth here, we're assuming about 6% over time. We see the green line here. By the way,
this is the optimal conversion strategy for this scenario, for this particular couple
currently. We're going up to the $176,000 modified adjusted gross income level. That targets what
we call a IRMAA tier. If we go above that number, we're paying extra taxes on our Medicare premiums.
The base strategy is in blue. The targeted Roth conversion strategy is in green.
On a pre-tax basis, we can see here at 6% growth. We actually never catch up, but if we look at
it on an after-tax basis, it's much, much, much closer, and the line actually crosses over here
in the early 80s. Now, on a pre-tax basis, if we do nothing, we see the blue here is tax-deferred
money. All of our money, the composition of our accounts is inside retirement accounts.
This is one big tax infested nightmare because if you want to put a down payment on a second home,
if you want to go on a vacation, if you want to take the kids and your grandkids and spend money
and enjoy the memories that you can create with them as opposed to just leave it to them. Let's
say, you want to spend $25,000. It's going to cost you $30,000, $35,000. You need to pull more out.
That can trigger Medicare taxes. That can trigger other dominoes such as Net Investment Income Tax,
which can increase under current law up to 3.8% additional tax on your investment income.
There are dominoes in the tax code. It can cause social security possibly to be more taxed.
Long story short, there are a lot of tax traps out there. The composition, when we're looking at
doing nothing versus doing conversions, the gold here with this strategy represents your tax-free
accounts. Over time, this is a much better composition. You have eliminated the tax risk
in your retirement. If taxes go well up, if Medicare taxes go up, if these things-- Wherever
you take your income from, it's not going to impact or trigger those other potential dominoes.
Now, doing nothing in this particular scenario. This is a good chart to look at. This is
why I say, "Eliminate tax risk," because if you believe taxes will be higher in the future,
if you do nothing with your retirement accounts, this is major tax risk
required minimum distributions. You are forced to start taking money out at 72.
Your first RMD estimated to be $107,000. For someone who's only spending $5,000 a month
in today's dollars, you have social security. In this particular example, $3,100 for the husband,
half of that for the spouse, for the wife. Let's call that $45,000 in today's dollars plus 107.
Now you're at 100, and let's call it $52,000 of income. You don't spend anywhere near that. You're
paying tax on the majority of that income. As time goes on, your RMDs get up to 180,
228, 267. This is tax risk. If taxes are higher in the future, you're forced to take that money out
of the account, pay taxes on it on potentially higher rates, tax risk. Now, it's important to
point out here that we're looking at the optimal tax conversion strategy versus doing nothing.
We could consider all these different tax scenarios based on the parameters
that we've talked about earlier. I'm going to change some of these parameters, so we see not
only the optimal tax conversion strategy change but the impact of when we catch up.
176, we could go over the 32% bracket. We could go up to 222. This is another IRMAA threshold.
Roth tax 32, up until 2026, and then having an income plan where we take from multiple accounts.
A lot of different strategies, this is the ranking of them. Just because this one is ranked first,
it may still not be right for you. Everyone's circumstances are different. This is why we
require relationships with clients because even year-to-year, typically, our spending changes,
our willingness to take risk changes, which alters our assumed growth rates moving forward, which can
alter the tax strategy, but also, the individual tax code itself is going to change over time.
How can we ever put a plan together just once and say, "Here you go, take it".
Good luck over the next 25 years. It doesn't work like that to optimize. That's where most of our
clients are-- They're in the optimization stage where the decisions they make,
year after year after year after year, compounding good decisions leads to a more optimal outcome
or at least a greater probability of a more optimal outcome. The first strategy we just
looked at was spending $5,000 a month in the optimal strategy. All things being equal was to
convert up to about the 176,000 modified adjusted gross income threshold. Now, I've changed the
spending to $84,000 a year or $7,000 per month. First and foremost, on a pre-tax basis, we still
don't catch up. Although it does look a little bit better towards the end. On an after-tax basis,
we catch up again in our early 80s. Something very important to note here. Require minimum
distributions. When we have a larger spending goal, we don't typically always have to convert
the entire IRA balance to Roth. For a lot of you, that never makes sense anyways. Because
of inflation, we need to pull more and more out of our accounts when we're targeting specific tax
brackets depending on the tax law, depending on your spending needs. We could have a go-go plan
in place where we're spending more in that first 10 to 15 years and spending less after that.
The tax plan, the investment plan, the income plan, all of that needs to be working together.
What we notice is that we don't get fully converted. We can see the green here
is, by the way, the strategy has changed to the 24% bracket. Let me just get
that out there. We still have required minimum distributions. This is the green
because when we're spending more, it's okay to have a little bit more in there.
That estimated or required minimum distribution is targeting roughly our need at that time. We can
pay less tax today on these conversions by not doing as many or not doing-- by doing as
much because the estimated RMD at that point will help to fulfill the need that we have, and also,
stay within our targeted tax bracket. Again, doing nothing, we see the same
RMDs as before. They get to be pretty scary once we get out here later in life, but I want to show
you the ledger here. This is the optimal for this particular spending level, again,
living until '90. If I change the life expectancy, that's going to change the strategy. If you're
invested more conservatively or more aggressively, those two are going to change the strategy.
This is why it's so unique, your circumstances, your position in retirement is unique.
This is just one example. I'm trying to convey concepts to help you understand
not only when do Roth conversion account balances catch up but everything you need
to understand and how it impacts the decision that you make, whether you do these or not.
Here is really, really, revealing profile. This is the optimal. The optimal for this situation is
also deferring social security a little bit later, so here in the conventional wisdom, the base,
we have social security at 67. Over here, we have it deferred, but look at the total taxes,
this is what this column represents in the two scenarios. Right now, we could get away doing
no conversions, of course, and pay less tax, compared to over here, we're paying more tax.
Once we get out about 71 years old, we see 22,029 taxes that we're paying overtime
increasing relative to where we're at over here. Now, this is tax risk. What if taxes are higher
in the future? What if additional excise taxes are introduced? Excise taxes are, for example,
IRMAA. IRMAA did not always exist, it's an acronym. It stands for Income Related Monthly
Adjustment Amount. If your modified adjusted gross incomes falls in between certain thresholds,
you paid more tax on your Medicare premiums. The Net Investment Income Tax, it's an excise tax.
This did not exist forever. This came about in the healthcare legislation back 2008, 2009.
Congress can always introduce these additional taxes, which they're doing right now with this
pending tax legislation, The Build Back Better Act. They can introduce things that if you have
income that falls in these certain thresholds, you now have to pay additional tax. That is tax risk.
My main point here is we are eliminating-- Part of this is eliminating tax risk.
That's one of the things we want to consider when doing Roth conversions.
This scenario, we're going to look at increasing that spending up to $9,000 a month or about
$108,000 per year in today's dollars, adjusted for inflation. First thing we notice, for the
first time, we don't see the chart going up, we see the chart actually going down. The Roth tax,
this is up to the 24 tax bracket but a different length of conversions in a different timing.
Strategy has changed, although we're targeting the same tax bracket. We see that the crossover
point is a little bit later in life on a pretax basis. On an after-tax basis,
it's low mid-'80s right there, but we do see, again, there's a bigger divergence here.
There's an emotional thing we have to consider here. If we're into retirement
and we're spending a high amount relative to our asset base, are we comfortable doing conversions
if it's projected that our account balances are going to go down? That's a discussion to be had.
This is a very interesting one because now required minimum distributions are not as
scary. It's $60,000, $70,000, $80,000 if we do nothing. When we look at the ledger,
taxes, pretty similar here to the last one that we looked at because we're targeting that same
threshold. Then moving forward, because we're spending a larger amount of money, it changes
the taxes down the road because we're spending more in the earlier years. That's less in there.
That means there's less money down the road that we need to take out. We compare that to over here,
we see this is a much bigger amount. Then we look at the total
taxes, 1.187 versus 494. Let's call it almost $700,000 of additional taxes paid,
not doing this versus doing that. Is one right or wrong? No, one's not right or wrong. One,
we pay a lot less tax over time. We eliminate tax risks. We do have a better composition of
assets if we look at that. This is doing nothing. It's all blue. If we want to spend more money,
we have only one place to choose from as far as where we get it. Composition is much better here.
Getting back to the spending level here, we do see that with the base strategy, doing nothing,
we feel more secure in the early years of retirement, but we are less secure in the
later years of retirement. Still, if we decide to go down the path of doing the
conversions and targeting the optimal range, then we also have to be okay with seeing the
accounts down lesser or down to a greater extent when we're younger than they would be otherwise.
We have to mentally be prepared for what that looks like. Again, that's a conversation to have.
Now, let's say we have a go-go plan in place where we're spending more over the first 5 or 10 years.
That needs to be accounted for in here. I'm going straight spending all the way through.
If one of us will live longer than the others, that's a huge part. If one spouse
is in bad health or less than optimal health and has poor longevity, genetically speaking.
When one spouse predeceases the other, the surviving spouse goes into the single tax
brackets, but we still have to take those required minimum distributions.
If there's a pension involved, if there's social security involved, a lot of times,
that can us into a much, much worse tax situation. That conversation needs to be had possibly.
I hope you're getting the point that all of these various factors, this is why I say your situation
is unique. This is why we require relationships with clients because year to year to year,
things are going to change. Our investment risk tolerance will change most likely over
time. The tax environment. All of these things, we need to do this analysis typically a couple
of times a year, make sure that you're connected to your money, and you understand where you are.
Then we need to have those conversations, so as a team, we can make the best decisions.
I hope you're able to take away a lot from that video. I didn't cover all the scenarios I'd want
it to because I'm trying to keep these videos a little bit shorter, but this is why I want you to
subscribe to the channel because we're delivering powerful content, and the goal is to educate you.
If you are not talking about these things with your advisor, reach out to your advisors, say,
"Hey, do a tax analysis. What's going on with my retirement? Should I be doing conversions?
How does my income plan and my investment plan, how does that impact my tax plan?"
Here at Oak Harvest, we fill your investment plan, your income plan, your tax plan, your estate plan.
down below. I try to personally respond to the comments. I don't get to all of them, of course,
but I try to personally respond. If you have something to say, please, say it down below,
and hopefully, I can get to your comment. [music]