HOW ROTH CONVERSIONS CAN SAVE HUNDREDS OF THOUSANDS OF DOLLARS ON TAXES

by Kevin Lao CFP® RICP®

If you have been saving into retirement plans for a couple of decades or even longer, chances are the bulk of your nest egg sits in what I like to call a “taxdeferred” retirement account (401k, 403b, IRA, TSP, 457b etc.). These accounts allow for tax deductions on contributions but are fully taxable as ordinary income when distributions are taken.

Roth conversions allow retirement account owners to “convert” some or all of their balances to Roth IRAs. For those of you who don’t know, Roth IRAs allow for tax-free growth and tax-free distributions (if certain rules are followed). Additionally, when you pass these accounts to your beneficiaries, they can also benefit from tax-free distributions.

The “Retirement Distribution Hatchet”

This illustrates a temporary drop in income during the early years of retirement. Once you quit your day job, your W2 income will go away. Required Minimum Distributions (RMDs) may not begin until age 73 or 75 for most account owners. This temporary period of low tax brackets is known as the “Retirement Distribution Hatchet,” and is the time frame when Roth conversions can really move the needle. By filling up certain tax brackets in the hatchet you can benefit from reducing your RMDs later in retirement. And believe me, RMDs are one of the biggest tax traps for these traditional 401ks and IRAs.

Run the Numbers

This is not a one-size-fits-all approach. Of the last dozen or so clients I have analyzed Roth conversions for, about 50% would benefit and 50% would not benefit. Factors like age, life expectancy, marital status, beneficiary status, and other sources of retirement income all come into the equation. However, the most recent analysis illustrated a saving of over $400k in taxes throughout their retirement years. Here’s how.

Example

A client we recently started working with is about to enter the Retirement Distribution Hatchet. He is 65 and his wife is about the same age. Therefore, we have approximately 8 years until RMDs begin. We illustrated “filling up” the 22% tax brackets with conversions for the next decade. The result is their entire $1.1mm 401k and IRA balances will be converted to Roth accounts. Their breakeven point happens around age 86, but they both have longevity in their family history and could very well live well into their 90s. If we projected they lived until 95, they would save $427,533 in taxes throughout retirement!

Other tax benefits of Roth conversions

Not only will this client save hundreds of thousands in taxes during their lifetime, but it will also make their Social Security more tax efficient. Additionally, they will avoid Medicare premium penalties known as IRMAA. And finally, the assets they pass on to the next generation won’t get eaten up with huge tax payments.

Great time to act NOW

Even if you are pre-retirement or have already retired, it’s worth running the numbers. The Tax Cuts and Jobs Act is expiring after 2025, so tax brackets will go up for most taxpayers. Additionally, the market has been quite volatile, and Roth conversions during a downturn provide those shares with tax-free growth instead of tax-deferred growth! Make sure to consult with your tax planner or reach out to us if you would like to discuss your situation!

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As a therapist, I help clients from all walks of life feel, function, and communicate better; teaching them the skills they need to access their own resiliency and strength, empowering them to be their own best advocates and to mindfully create the lives they desire.