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Is a Roth Conversion Right for You? Exploring Options For A 100% Pre-Tax Nest Egg (Case Study)

Is a Roth Conversion Right for You? Exploring Options For A 100% Pre-Tax Nest Egg (Case Study)

By
Jake Skelhorn
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September 11, 2024
If you're like many people who have saved for retirement, you probably have most, if not all, of your money in pre-tax accounts like 401(k)s, 403(b)s, or traditional IRAs. As you approach retirement, you may be wondering if you should convert any of this money to a Roth IRA.

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In this article, we'll take a look at Tom and Camille's retirement plan to see if Roth conversions make sense for them, and at what pace. With Roth conversions, there's often a sweet spot—you'll see here in just a minute that there comes a point where it doesn't make much sense to convert more.

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Understanding Roth Conversions
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Before diving into Tom and Camille's case, let's briefly discuss what a Roth conversion is and why it might be beneficial.
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A Roth conversion involves moving funds from a pre-tax retirement account (like a traditional IRA or 401(k)) into a Roth IRA. When you convert, you pay taxes on the amount converted now, but the money then grows tax-free, and qualified withdrawals in retirement are also tax-free.
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Factors to Consider When Deciding on a Roth Conversion
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There are several factors to consider when trying to decide whether or not a Roth conversion makes sense for you:
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  1. Current vs. Future Tax Bracket
    What is your tax bracket today, and what will it be when you withdraw that money?
    If you expect to be in a higher tax bracket in retirement, converting now could save you money in the long run.
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  2. Required Minimum Distributions (RMDs)
    Traditional retirement accounts like 401(k)s and IRAs have RMDs when you turn age 73 or 75 (depending on your birth year). If you have a large enough pre-tax balance that continues to grow, your RMDs can be significant, potentially pushing you into a higher tax bracket.
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  3. Impact on Social Security and Medicare
    High RMDs can affect how much of your Social Security income is taxable and can also lead to Medicare surcharges known as IRMAA (Income-Related Monthly Adjustment Amount).
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Beyond just saving money on taxes, these are other factors that we consider when doing a Roth conversion for clients.
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Tom and Camille's Situation

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Tom & Camille's "Financial Blueprint"

Let's look at Tom and Camille, both age 60, who are hoping to retire at age 62. They plan to live on about $5,000 per month in income. Here's a quick snapshot of their net worth:
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  • Camille's 401(k): $250,000
  • Camille's 403(b): $310,000 (current job)
  • Tom's Rollover IRA: $450,000 (from a previous job)
  • Tom's 401(k): $500,000 (current job)
  • Primary Residence: Paid off
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Total pre-tax retirement accounts: Approximately $1.5 million
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Notably, they have:
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  • No money in Roth accounts
  • No money in a brokerage account
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Everything is in pre-tax accounts. This is very common for people who are saving for retirement.
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Assessing the Benefits of a Roth Conversion for Tom and Camille
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To determine whether a Roth conversion will make sense for them over the long term, let's take a look at their tax situation to visualize where the savings would come in, if any.
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Visualizing Tax Brackets and Future Income
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We can use a graph that shows:
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  • Colored Lines: Representing different tax brackets, which adjust over time due to inflation and legislative changes.
  • Dark Blue Filled Line: Their Adjusted Gross Income (AGI) according to their current plan.
  • Green Line: Their AGI with a Roth conversion, since a conversion is added to taxable income.
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Note: The Tax Cuts and Jobs Act is set to expire at the end of 2025, which may cause tax brackets to change unless extended.
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Finding the Sweet Spot for Roth Conversions
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We start by seeing which tax bracket would make sense to "fill up" based on their income.
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  • Filling Up the 10% Tax Bracket: Minimal benefit over their lifetime.
  • Filling Up Higher Tax Brackets (e.g., 22% and 25%): Significant benefits, with over $1.6 million in tax-adjusted ending wealth by age 90.
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Income & long-term benefits with Roth conversions (green line) vs. No conversions (blue line)

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However, beyond that, the benefit starts to dwindle. Converting too much in a given year can lead to paying a large amount of taxes out-of-pocket, reducing the overall benefit.
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The Sweet Spot for Tom and Camille is the 22% tax bracket.
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Implementing a Withdrawal Strategy
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The next step is to determine which accounts to withdraw from for their living expenses.
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Default Assumption: Pro-Rata Withdrawals
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  • Taking some funds from Roth, some from traditional, and some from a brokerage account.
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Optimized Strategy: Taxable, Tax-Deferred, and Tax-Free Sequence
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  • Let Roth Money Grow: Since Roth accounts grow tax-free, it makes sense to let this money grow as long as possible.
  • Withdraw from Taxable Accounts First: Then tax-deferred accounts, and Roth accounts last.
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Implementing this strategy increases the benefit over their retirement.
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Avoiding Medicare Surcharges

We need to ensure that their Roth conversions won't lead to Medicare surcharges (IRMAA).
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  • Modified Adjusted Gross Income (MAGI) thresholds determine IRMAA.
  • For example, if their MAGI is over $233,000, they'd start to pay surcharges.
  • In their case, their AGI with the conversion is about $225,000 in the first year they're eligible for Medicare, so they avoid additional Medicare costs.
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Even with Roth conversions, income will be below the first IRMAA threshold

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Visualizing Cash Flows
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For those who prefer numbers in black and white, we can look at their cash flows in a table format.
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  • Current Plan:
    • Income for two more years while working.
    • Living expenses and taxes owed.
    • Net flows indicate how much they need to withdraw from their portfolio each year.
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  • Observations:
    • Zeros in Net Flows: Indicate when income drops off upon retirement.
    • RMDs at Age 75: They have large RMDs, requiring them to withdraw over $70,000 they don't need, leading to unnecessary taxes.
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  • Proposed Plan with Roth Conversions:
    • Higher portfolio withdrawals initially (to pay taxes on conversions).
    • At Age 75, surplus is now zero, avoiding unnecessary RMDs.
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Increasing the Probability of Retirement Success
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The best part of the Roth conversion analysis is that it actually increases their probability of success in their retirement plan.
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  • Introducing the distribution proposal (Roth conversions up to the 22% tax bracket and optimized withdrawal sequence) increases the odds of their retirement plan working out long-term.
  • Less Chance of Cutting Spending: Reduces the likelihood they'll have to reduce spending at any point in retirement.
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Real-Life Impact: More Money to Spend
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Ultimately, this translates to them probably being able to spend more money.
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  • They could potentially take an extra vacation each year without hurting their plan.
  • For example, spending an extra $500 a month in retirement might bring them back to where they were pre-Roth conversions in terms of plan success.
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Implementing these changes can give them more money to spend, pay less taxes, and keep more money in their pocket.
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Is a Roth Conversion Right for You?
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In Tom and Camille's case, it makes sense for them to do Roth conversions up to the 22% tax bracket over the next decade or so.
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However, this does not apply to everyone's situation.

  • Individual Factors: Your tax bracket, income needs, RMDs, and other personal factors play a significant role.
  • Potential Downsides: In some cases, Roth conversions can result in less money over your lifetime or more taxes owed.
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Conclusion
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Don't take this as specific advice for your situation, but more of an insight on how to help determine this for yourself.
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  • Consult a Professional: It's crucial to analyze your individual circumstances.
  • Plan Ahead: Understanding when and how much to convert can make a significant difference in your retirement planning.
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If you're wanting help determining whether or not Roth conversions make sense in your own retirement plan, schedule a free consultation with us, and we'd be happy to talk with you.

Thanks for reading, and we look forward to helping you achieve a confident and clear retirement.

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