Troy Sharpe: If you’re thinking about retiring before 65, or maybe you’ve already retired and you’ve figured this out, one of the biggest decisions you have to make is health insurance. Now, you also probably have another problem. You have a bunch of money inside that tax infested retirement account. The question becomes, should I do a Roth conversion and help to eliminate this tax problem I’m going to have down the road, or should I try to qualify and receive a subsidy so I don’t have to spend the $15,000-$20,000 a year for health insurance?
Troy: Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner professional, host of The Retirement Income Show and certified tax specialist.
This is a very, very interesting financial planning case study. It’s something that we do all the time for clients, but it is very powerful, the results for most people, when we look at the pros and cons of both decisions. Now, before I get into this, we have to talk about what the conventional wisdom is. Conventional wisdom is the advice that you’ve probably heard from your financial advisor, you’ve probably read online because it’s conventional. It’s kind of the easy recommendation, but when you actually dig down deep into the numbers and do the analysis, and have a real heart to heart conversation with what’s important to you, the client, oftentimes you come to a different decision of what the best course of action is.
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In today’s video, we’re going to look at a couple that’s 61 and 60 years old. The husband is 61, the wife is 60. They have about $2 million total, but as most of our clients and most of you out there, they have about $1.8 million inside that tax infested retirement account. Why do I call it a tax infested retirement account? Because all the money you’ve put in and all the interest gains that you’ve earned over the years, now, whenever you take the money out, you have to pay taxes.
What happens is if you let it defer until 72, or if you have any balance at 72, you’re forced to start taking money out, oftentimes far more than you need at that age and older. Then you have to worry about, “Are taxes higher? How much income am I forced to take out and pay taxes on an income that I don’t need?” It becomes a tax infested nightmare because it can trigger different taxes on your Medicare, different taxes on your investment income, all types of different taxes down the road. It’s like a domino effect. This is why I call it a tax infested retirement account. In this case study, they have a spending goal of $100,000 per year.
If we look at the average bare bones bronze plan, so I’m not going to get into a big health insurance discussion here. I do think it’s ridiculous that health insurance costs this much in this country. [chuckles] I’m not going to opine on that, just it does cost a lot of money to buy health insurance in this country and that’s unfortunate. If you look at an average bare bones bronze plan, I got this from the Affordable Care Act website. In early 2021, this was on the website, looked it up this morning, $17,000 per year, $8,500 for an individual is what the cost is for a bare bones bronze plan.
Now, you, you have to look at your personal situation. Do you need special treatments? Do you need to see specific providers? Will this plan cover your bills for the people you need to go see to take care of your health because health comes first? It could cost you $18,000, $20,000, $22,000 a year for health insurance. This is absurd, but it’s what it is. The question becomes, what should I do? This is a big cost. If I’m going to retire before 65, it’s one of the biggest determinants for many of you on whether you will retire prior to 65 or not. The conventional wisdom advice here is to spend your non-qualified money first. Now, this is true, not just for health insurance planning and tax planning as part of the retirement plan, it’s just generally true across the board.
If you go to any firm, most likely, they’re going to tell you to spend all that non-qual money first, let your tax deferred accounts continue to defer until you either need to take out, or you’re forced to take out because of required distributions. This is actually a real case study here. This is something we recently went through with a client. It’s a new client. They came to us because they said, “Troy, I went to my advisor and they said spend all my non-qualified money first, but I felt it was a lazy answer. I’ve watched a lot of your stuff and I hear you talk about conventional wisdom.” What we did is we actually built an analysis to help them decide what is the best course of action for them once they became a client. Now, we went through it, of course, before they became a client, but we really dive deep once people are clients. First thing I want to point out is for this particular situation, all they have is $140,000 in non IRA money.
You’ll hear me time and time again tell you to save money outside of that retirement account. Otherwise, your only choice– you have no tax diversification. Your only choice for income is that retirement account, so it creates a domino effect that you’re about to see. If they pull their spending goal out, this will be exhausted in about one and a half years, and then the remaining years until they hit 65, they’re going to have to pull out of the IRA. Then if they pull that out, that goes on the 1040, the tax return, they’re going to be stuck paying this anyways from age of 62 to 64, until they both qualify for Medicare. Lazy advice there to simply pull from the non-qualified first, we need to dig into the numbers.
When we start to dig into the numbers, what we want to do is just first and foremost see, “Is there a tax problem down the road if they do nothing else?” Because we want to start to eliminating possible choices or at least putting possible choices that we could make, we want to understand the consequences of them. Then we just look at each variable and go throughout that process, almost like the scientific method, just applied to finances. The first thing I wanted to look at here in this case with these clients, if they do absolutely nothing, if they do no Roth conversions, if they qualify for the subsidies, spend the non-qualified money first, what does their tax situation look like down the road? As we see here with this chart, this is doing nothing in the green.
This is the required minimum distributions. If they do nothing, as far as Roth conversions go and they just spend the non-qualified money first, qualify for the subsidy until those funds exhaust. Once they hit 72, they have required minimum distributions starting right around $100,000 per year, a little bit less. Actually, $83,000, but we see the very clear scale of how they increase over time. Social security would go on top of this income, so they’d have income of $125,000 to $175,000, somewhere in that range, depending on if we decided to take social security at full retirement age or age 70, it’s a whole another planning discussion there, but it does integrate into this decision as well. Right away, we know if they do nothing, they’re going to have social security plus require minimum distributions of $100,000, $120,000. This is going to put them up to $175,000 to $200,000 of income later in life.
Do you think taxes will be higher or lower later in life? Well, most people would say higher. We don’t know for sure, of course, because they very well could be lower and chances are, we will have that political pendulum swing to the right, swing to the left, taxes may be higher taxes may be lower. The key thing is we want to have flexibility, so when taxes are higher, we have choices. We don’t have to pull $150,000 out of our IRA because we’ve done no planning up to that point. Yes, we do have a problem if we do absolutely nothing. If we want to look at the total taxes paid here, when we talk about the cost of health insurance being about $20,000 a year, we see if they do absolutely nothing that once they hit about 67 here, now the blue, this is a Roth conversion strategy.
Lots of different Roth conversion strategies we can look at, but the blue is an aggressive targeting the top of the 24% bracket for Roth conversions. It doesn’t mean we have to go that route. This is just the example I’m looking at because it happens to be one of the top ranked strategies for this couple and their particular circumstances. I just want you to focus on the green. The green is doing nothing, qualifying for the subsidies, spending the non-qualified money down, deferring the retirement accounts until that’s exhausted and we’re forced to take our spending needs from those retirement accounts. Health insurance, as I said, cost about $17,000-$20,000 per year until they hit Medicare age. I look at health insurance and taxes as a cost. If we have to pay it, it doesn’t matter necessarily who we’re paying or what we’re paying, it’s a cost. It’s as simple as that. It’s a financial cost because it’s money that’s coming out of our pocket that we’ll no longer have anymore. Once they hit about 67, we see here this is about 66, they have costs in the range of $17,000 per year forever. As we go out to 28,000, to 31,000, and then we start to see this later in life, the annual taxes are obviously increasing.
Now, we look at the blue down here. The blue, again, is a little bit more aggressive, Roth conversion strategy. Not saying it’s the right strategy, it’s just one of the top ranked strategies when we’re looking at ending account balances and also taxes paid throughout retirement. We obviously can see a huge distinction between the green and the blue. The question becomes do I want to pay costs now, whether they’re in the form of health insurance or taxes or do I want to pay costs later? Then what is the difference between paying them now and later as it impacts my security, my family’s security, my account balances, all of those factors? Doing nothing, we’d absolutely have a tax problem where down the road, we’re going to be paying a significant amount of taxes and this is just looking at today’s tax code. If taxes are higher, these numbers will all be a lot higher. If you don’t want to spend $17,000 or $20,000 a year in taxes today– excuse me, in health insurance cost today, do you want to spend $30,000, $40,000, $50,000 per year every year in taxes in the future? No, probably not, so we have to have this context when making that decision of do we qualify for the subsidy or do we take money out to the IRA either to spend or to do Roth conversions.
First variable determined yes, there is a tax problem. Now, that we know we have a tax problem, the next thing we will want to look at is, do we have a health insurance cost problem? Of course, the answer is yes but let’s put some numbers to this. I told you what the cost is for the bronze level bare bones plan, about $17,000 per year, based on the Affordable Care Act’s website. I’ve seen it as much as 21,000 a year for a couple, so every state is different. Make sure you know these numbers. Now, this is from healthinsurance.org. It is an estimate. There’s a couple other websites out there that can provide estimates. They are never exactly the same but it’s pretty close. This is our zip code here in Houston. 61, 60 year old, husband, wife.
By the way, if you go to this website, you have to hit the plus sign to bring up this other box. Household size, two members. Modified adjusted gross income assuming there’s some dividends, maybe IRA distribution something like that, I put it at $24,000. That provides a monthly subsidy of $1,600. This couple, if they decided to get the bare bones bronze plan, keep their modified adjusted gross income which is your adjusted gross income plus adding back any what we call above the line deductions and also tax free income from municipal bonds, for example, creates a monthly subsidy of about $1,600. This family could get health insurance for about $100 a month. That’s a pretty good deal, but if they do that they have to keep the MAGI low. That means the IRA defers and we have that tax problem down the road. We can slide this up real quick just to show you. At 36,000, we’re looking at 1,500 a month. At 72,000, we’re looking at 1,100 a month. There could be some type of balancing act here.
Now, because of a law passed due to the COVID pandemic, the amount of subsidy that you can receive has been changed for 2021 and 2022. As I’m recording this video, we’re in the beginning of 2022 right now. It used to be if you had income that exceeded 400% of the federal poverty level, you don’t qualify for a subsidy. In 2022, that 400% threshold has been removed, but in 2023, it is coming back. When we’re planning over the next 2, 3, 4, 5 years depending how old you are and when you turn 65, we have to keep that into consideration. One basic rule with financial planning is we make decisions with the best information we have available today with the context of how those decisions impact the future. We’re aware of that, but we don’t have to make those decisions until next year. We know what our subsidy is. If we keep the income at a certain threshold, this is an option we could go.
Now, what if we say, “You know what? If I do that and I put $20,000 in here,” this is a time value of money calculator. It is assuming you want more than the bare bones bronze plan. $20,000 payment for five years from 60-65 because in this example, the wife is 60 years old. If I kept that money, got the subsidy– so I didn’t pay for health insurance, I received the subsidy, that would be $20,000 I could keep in my pocket. If I earned 7% on that money over the next five years and received essentially free health insurance from the Obamacare exchange, how much money will I have in the future? Well, I hit this future value button. It’s $115,000, so essentially, you’d be receiving a subsidy that, to you, when we look at the time value of money, is worth about $115,000. That’s not a small chunk of change. The question then becomes– okay, this is the benefit today. Let’s say I just invest that money. I never do any Roth conversions and I invest this $115,000 around 7% for the next 20 years, well, it’s going to turn into $445,000. That’s the time value of that money that you would save by receiving the subsidy today, keeping the $20,000 a year that you would otherwise pay for health insurance in your account. Absolutely, that’s a viable path. Your situation is different than the other person watching this or someone else watching this. This is why the analysis and going through and having someone to work with this is so important.
Let’s keep these numbers in the back of our head now. We would save about $115,000, when we look at the time value of the money over a 20-year period that could turn into $445,000 if we receive the subsidy. Now, we have to look at the next variable. What are the savings or what is the cost from doing a Roth conversion versus not doing a Roth conversion? Why does this– Let me back up a little bit here.
If we do Roth conversions from 60-65, that means we’re taking money from the IRA and putting it into the Roth IRA. When we do that, we create income that goes on our tax return, which increases our modified adjusted gross income and disqualifies us from receiving a subsidy. The question becomes, do we receive the subsidy or we do tax planning and Roth conversions? Again, everyone’s situation is different, but in this particular case, if we look at spending $100,000 a year, 60-61 years old today, estimated future value, we’re looking at a moderate rate of return here, not a super aggressive portfolio, not a conservative portfolio, $3.8 million ending value, versus over here, not doing any conversions, and ending value of about $2.7 million. A little more than a million dollars in more value, more account balance at the end of life by doing the Roth conversions versus not. The taxes, $432,000, paid over the course of retirement estimated versus $1.3 million. This is a big one. This is about a million dollars in taxes over the course of time.
Okay, so that’s a pretty big savings, but do you remember that $445,000 number that I talked about earlier? Well, let’s go back and look at that. We have to make sure these timeframes are congruent, and we have to do the correct calculation. In the tax analysis, I had the couple living until 95 years old. When we looked at the different account balances and taxes paid, that’s until 95. Here, they’re 60, 61, we’re going to calculate this out 35 years to get them to the same 95, look at the future value of that $115,000. This is a great example of just the power of compound interest and the time value of money. That $115, 000, if we don’t touch it, and theoretically, we wouldn’t touch it, we probably would spend it out of our non-IRA, but it would be inside the retirement account an equivalent dollar amount. The power of compound interest shows us that at 7% over a 35-year period, the $115,000 turns into $1.2 million.
Now, if we go back and look at this and ending balances, well, guess what? This is about $1.2 million difference here. When you look at it through that lens, okay, maybe the decision is about equal. Now, obviously a lot of variables, interest rates, timeframes, health, all of these things come into it. This is why retirement planning, it is an imperfect science. We simply have to have discussions and make decisions about what’s best for us at any given time. Having these types of planning discussions with your advisor is a very, very powerful tool that you can have in your retirement box to help you make better decisions in the moment today.
Here’s something I do want to point out, when we talk about having the same amount of money, it’s not quite the same amount of money because we have to look at the composition of our accounts. Would you rather have $3.5 million inside that tax infested retirement account, or would you rather have $3.5 million inside a Roth or outside of any retirement account? Obviously, the answer is we would much rather have that money outside of the tax infested retirement account because if it’s in there, we don’t really have that much money, do we? Plus, we’re forced to make these big required minimum distributions at that point, which we’re going to pay massive amounts of taxes later in life. Even though the dollar amounts may be the same, let’s say 3.8 and 3.8 in the analysis, the composition of your accounts and the income taxes you’re paying at that time are much, much, much different. Here’s a quick run through. This would be the 24% Roth conversion target. We see the majority of the money gets into the gold, which is the tax free account. Whereas, over here, if we do nothing, we have all this money inside our tax deferred accounts. We would add another $1.2 million into here from that time value of money calculation that I just did over a 35-year period, but we see that this is a whole lot more money. What that would actually do is increase the taxes you’re paid, which isn’t accounted for in this analysis, because I’m walking through it conceptually with you.
If you have the $1.2 million, you’re looking at about another $40,000 to $50,000 to $60,000 distribution from that account in your 70s and 80s, which then you’re paying more taxes. Second thing to note here is if it’s important to you to pass money onto your kids and grandkids, then all of this money that you would pass onto them, they have to distribute it within 10 year years. Those distributions go on top of their income. If they’re working, if they have jobs, if they’re married and both spouses are working, those distributions could easily hit the 30%, 40%, 50% bracket, maybe higher if you live in a state with high estate taxes down the road. A lot of things consider here. You can see it’s not a very, very black and white, but I’m trying to help you understand what the choices are and what variables you need to consider when making these decisions. This is just one decision. This is just healthcare versus Roth conversions. This is important but the last thing I want to go through with you today. What we have is we have a tax return from this case study of last year input into this column over here so I said they’re retired. $4,300 in wages, $21,000 in IRA distributions, no wages this year. We just carried over the dividends from last year. No IRA distributions right now, but ultimately, what I want to get at is now this Roth conversion, so let’s say we looked at doing $100,000 Roth conversion. $100,000 Roth conversion, total income will jump up to 102,000 because of the dividends. You have a standard deduction of 25,900, taxable income of 76,000, total tax of $8,500. Most of you probably aren’t aware that you can to do $100,000 conversion if you don’t have any other income and the taxes would only be $8,500. Now, that’s a pretty good deal and this is why we’re big proponents of Roth conversions. Now, everyone’s situation is different. Marginally, the next dollar they took out of the tax of their IRA would be taxed at 12%, so maybe we want to go up and max out that 12% bracket. Maybe we want to target the 22 and effectively our income taxes would be around maybe 14%, 15%. Either way, what I wanted to show you here is the modified adjusted gross income. They can still do all of these different things. They can make it– well, they’re not working so they can’t make the Roth IRA, but the big thing here is the modified adjusted gross income with the Roth conversion for 2022 would be $102,000. We come back here, bring this out to about $103,000. This family could still do a Roth conversion of $100,000 and still receive a monthly subsidy of $891 which is about 10,800 per year. Still reduce that health insurance costs from 17,000 or 20,000 by $10,000 a year, and do the tax planning with the Roth conversion. To me, that’s exciting, but again, is this the exact right way to go? No, probably not. Maybe it’s doing 120,000 or 130,000 conversion. My point is I just want with these videos to help you understand the type of financial planning that really needs to go into making these types of decisions.
There usually never is an exact right answer, but there are better answers than others. Should you take the subset or should you do a Roth conversion? Well, the answer is you need to do financial planning, but as we went through various scenarios here, if you have a lot of money inside that retirement account, not doing a conversion does create a pretty big tax problem down the road. Receiving the subsidy today, if you’ve taken into account the time value of that money, the savings over time is much greater than what maybe you save out of pocket today. Additionally, you have to take into consideration the composition of your accounts no matter which kind of fork in the road that you choose. If you do the conversion, you’re going to have a lot more tax free dollars and more tax flexibility down the road in case taxes go up. If you go the healthcare subsidy route, you’re going to have a lot more or tax concentration inside that retirement account, a lot less flexibility, and probably a bit more precarious situation if taxes are higher in the future.
What should you do? Well, you should talk to your financial advisor. If you have questions, you can reach out to us. We do this for clients. We don’t do this for people who aren’t clients, but we have these conversations with you. The point is you want to find someone you trust, you want to make good decisions, and ultimately, you want to understand the context of those decisions that you’re making so you can feel comfortable and sleep at night and know that you’re on the path to a more secure retirement. If you like this video, make sure you to subscribe to the channel. That’ll keep you connected to us and help us keep you more connected to your money. If you want to comment, please do so down below. Love to hear what you think. If you you’ve made this decision, done the analysis yourself, then of course, share the video with a friend of family member that you think could benefit from this content.