Episode #25- Developing a Multi-Year Roth Conversion Plan

Wealth Decisions Podcast Transcript for Episode #21- Does Your Portfolio Fit You?

Listen to this episode on Apple Podcasts or Spotify

Welcome to The Wealth Decisions Podcast, where each week I take 15 minutes or less to discuss crucial wealth decisions and mindset hacks to help you live a richer life.

I'm your host, Brian Muller, and I've been in the financial services industry for over 25 years, and I'm also a certified life and health coach.

Now I have a passion for helping people make better decisions around their money and their life.

So for the sake of time, let's dive right into it.

In today's episode, we're going to be talking about developing a multi-year Roth conversion plan.

So let's just start with the basics.

A Roth conversion involves moving money from a traditional IRA or 401k into a Roth IRA.

The big difference is that traditional IRA accounts or 401ks are funded with pre-tax dollars.

And then they're taxed upon withdrawal at whatever tax rate you are at that particular time, while Roth accounts are funded with after-tax dollars, but they grow tax-free.

So you might ask, why would I consider doing this type of strategy?

Number one, tax-free growth.

You know, once you've paid taxes on the converted amount, your money is going to grow tax-free in that Roth IRA.

And then when you want to take an income, all that income will come out tax-free.

Number two, there's no required minimum distributions.

Unlike traditional IRAs, Roth IRAs, they don't require you to take distributions at the current age, which is age 72, is when you have to start taking money out of an IRA account.

And also, number three, it gives you tax diversification.

You know, having all your money in a traditional IRA or 401k means that you're not going to have a lot of tax flexibility.

But if you have some Roth IRA assets and possibly some taxable investment accounts, it's going to give you more flexibility, you know, managing your tax burden in retirement.

And number four, there's also some estate planning benefits.

Roth IRAs are a great way to leave tax-free money to your heirs.

There's no required minimum distributions and there's no ten-year rule to take all of your money out if you inherit an IRA versus inheriting a Roth IRA.

Now, there's a catch to this, you know, when you convert money from a traditional IRA to a Roth, you're going to have to pay some income taxes on the converted amount in the year of conversion.

And this is why it's important to develop a multi-year Roth conversion strategy.

You typically don't want to do this when you're working, when you have a, especially if you have a higher income.

But this would be a strategy you'd want to implement early on in your retirement years.

To get more money in tax-free Roth IRA accounts.

And out of your existing IRAs and 401Ks.

It's going to be hard to ever balance it out.

Unless you've been contributing to a Roth IRA your whole life.

It's going to be hard to get the correct balance.

The optimal balance, which I think would be a third in taxable investment accounts, a third in 401Ks, and a third in Roth IRAs.

But the idea is to find a way to get more money into Roth IRAs early in retirement when you're in a lower tax bracket, so that you don't have as big of required minimum distributions and you have a little bit more tax control later in retirement.

A multi-year Roth conversion plan just involves, you know, strategically converting portions of your traditional IRA over several years, rather than all at once.

This is going to help you minimize taxes and potentially result in a lower overall tax bill down the road.

This type of strategy involves spreading out your conversions, so you can control how much additional income you're adding to each year, potentially keeping you in a lower tax bracket.

So you want to see how much room is in your tax bracket, and whatever that amount is, whether it's 15, 20 or 25,000 of room in that, in your particular tax bracket, that's how much you should consider converting each year.

And as long as your income doesn't change, you continue to do that strategy, as long as you're able to pay the taxes with outside money.

So you want to be taking advantage of those lower tax years early in retirement, before maybe your social security kicks in, and so you can do larger conversions in those years.

And all you're doing is just hedging against future tax increases.

When I ask people if they think tax rates are gonna be higher or lower, you know, 10 or 15 years from now, not very many people say they're gonna be lower.

So converting now and having a strategy to do that over time to get more money in Roth IRAs is gonna help you down the road later in retirement.

So here are the steps to develop this multi-year Roth conversion plan.

You first, step one, you want to assess your current situation.

You know, start by gathering information about your retirement accounts, the balance in your traditional IRA, your current income in tax bracket, your projected income in tax bracket in retirement, and then look at your overall retirement goals and timeline.

If you retire earlier than, say, age 65, say you retire at age 60, you're going to have a longer runway to be able to do this strategy until RMD age starts kicking in, which currently is at age 72.

That age level will go up over time, but it gives you a longer runway to be able to do this strategy to convert some of your IRAs or 401Ks to your Roth IRA.

And step two, project your future tax situation.

And this is obviously complex because we don't know where tax rates are going to be, but know your income sources.

For instance, if you have a pension, when you're going to take social security, all those things can impact your tax rate.

We don't know what tax laws are going to be in the future, but I have an inkling that rates are going to be higher.

Sometime in the future than where they are today.

You also need to look at what your income needs are in retirement.

If you need to take $7,000 a month from your IRA or 401K, then you're going to look at making sure you add that to your income situation.

And if social security hasn't kicked in, find out where that room is for you to do that conversion.

And step three is just to determine kind of the conversion timeline.

I usually do this over five to eight years for clients that are looking to extend their legacy in a better way or avoid some higher RMDs down the road because most of their money is in an IRA account.

And step four is just to set some kind of annual conversion target.

Divide your total intended conversion by the amount of years in your plan.

But be prepared to adjust this based upon other income sources that might come into play that will force you to kind of lower that conversion amount in those years.

And step five is choose which assets you're going to convert.

If you have multiple IRAs or 401Ks, decide which accounts and which specific investments within those accounts you'll convert each year.

I sometimes will, if I own stocks in my IRA and they're down in value, I might use those particular stocks if I still feel really strongly about them to convert those particular investments to my Roth because they're down in value of less tax liability and more tax-free growth when that particular investment recovers.

Step six is to plan for your tax bill.

Remember, you're going to owe some taxes on the converted amount and you have to have the ability to pay those taxes with outside money, not taking it from your IRA conversion when you do that conversion to the Roth IRA.

Let's take a look at an example of the multi-year Roth conversion plan and how it might work in practice.

Let's say Bill is 62 years old and he's just retired.

He has about 800,000 in his traditional IRA from a 401k rollover and he wants to convert a significant portion to a Roth IRA over the next 10 years.

He does have a pension that he's begun to take, but he won't take Social Security until full retirement age, which in his case is age 67.

With his pension income and income he will take from his IRA to supplement his pension income, he has about 35,000 left in his tax bracket, which is at 12% currently.

Bill decides on a 10-year conversion plan, aiming to convert about 300,000 total from his IRA to a Roth IRA, which breaks down to about 30,000 per year.

However, Bill is going to adjust this based upon his tax situation each year.

If he has a year where he has to take out a little bit more from his IRA for a trip or an emergency or he wants to make some improvements on the house, he'll lower his amount.

Let's just assume that he takes out 30,000 a year for 10 years.

The idea is just to fill up your current tax bracket as much as you can without spilling over into the next one.

At a 12% tax bracket, the next tax bracket up bumps all the way up to 22% currently.

Bill also plans his conversions towards the end of the year, when he has a clearer picture of his overall income and tax situation.

By spreading out these conversions over 10 years, he's going to save a lot of money in taxes, compared to converting it all at once.

Now, if we project this out over 10 years, at the end of the 10-year conversion, assuming an 8% return, Bill would have about 500 in his Roth IRA, with all the conversions and that growth, tax-free growth.

And his IRA, because he was taking distributions and taking money and converting it to a Roth, would be worth about $750,000.

His tax bracket at age 72 is now 22% because of Social Security, his pensions, and his distributions from his IRA.

And he only needs about $2,000 per month from his IRA to complement his pension and Social Security.

But his required minimum distributions from his IRA at age 72 would be about $3,000 per month.

If he had left his IRA alone and never converted some of that to a Roth using the 10-year conversion plan, his IRA would have potentially grown to about $1.2 million, and his RMD would have to be about $4,800 per month when he only needs $2,000.

This is why you should consider a multi-year Roth conversion plan, especially if you retire a little bit earlier and you have a longer runway to be able to do this strategy.

It's a proactive approach to help minimize those forced withdrawals later in retirement that you'll be taxed on, and it helps to create a more tax-efficient income down the road.

But it's important to note that the strategy requires some careful planning and on-going management.

You'll need to reassess your plan each year based upon changes in your income or tax situation, market performance over your investments, maybe any changes in tax laws and your overall financial goals.

So here's some final tips just to keep in mind as you develop this multi-year Roth conversion plan.

Number one, consider your timeline.

You know, if you're close to retirement or already retired, you may want to be more aggressive with your conversions to maximize that tax-free growth timeline.

Number two is be aware of Medicare premiums.

You know, if you're converting a large amount, this is going to increase your income, which may result in higher Medicare premiums a couple years later.

Also, number three, don't forget about state taxes.

You know, some states treat Roth conversions differently than the federal government, and make sure you understand the state rules.

Obviously, in the state of Minnesota, we have a higher state tax, but that needs to be factored in to the equation when you're doing these Roth conversions.

Number four, you know, consider your overall asset allocation.

I like to take the more growth-oriented investments in my IRA and convert those to a Roth, because that means that the more they grow, the more tax-free growth I'm going to have.

So it's an opportunity to take investments that are more growth-oriented and move those to your Roth IRA.

I typically suggest people be a little bit more aggressive with their Roth accounts.

Number five is just, you know, obviously keep good records.

You're going to want to keep track of your conversions and the taxes paid for future reference and with tax filing.

And number six, obviously, you're going to want to stay flexible.

Be, you know, prepared to adjust this plan as circumstances change.

And number seven, definitely consult with a professional.

Because this is a somewhat complex strategy, it's definitely worthwhile to check with a financial advisor or tax professional to make sure you optimize this strategy.

So Roth conversions can be a really powerful tool.

They're not right for everyone.

If you expect to be in a much lower tax bracket in retirement or if you don't have funds outside your IRA to pay the conversion taxes, this strategy may not be beneficial to you.

But a good financial advisor can do a Roth conversion analysis to see if it makes sense for your particular situation.

So that's it for today's episode, developing a multi-year Roth conversion plan.

Listen to this episode on Apple Podcasts or Spotify


-Brian D. Muller, AAMS® Founder, Wealth Advisor

Momentous Wealth Advisors in a fee-only fiduciary advisory firm

Disclaimer: This material is for informational purposes only and should not be construed as investment advice. Past performance is not indicative of future results. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

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