I’m 62 With $1.5 Million How My Investment Strategy Affects My Tax Plan (Part 4)

Troy Sharpe: Today, we’re going to look at how different investment strategies or how aggressively versus conservatively your portfolio is invested, how that can impact your overall tax plan.
In the last video in this series, we looked at how different levels of spending can impact your tax plan. One of the big takeaways there was that if we’re spending a high amount relative to our overall portfolio size, those extra withdrawals act as de facto Roth conversions because we’re pulling more money out of that IRA, which is keeping the balances down, so as the RMD percentages increase over time, it’s not as drastic of a scenario, but what about the investment strategy? How does that impact the overall tax plan?

Then in part five of this series, the next video, we’re going to tie it all together, look at different investment strategies, spending levels, life expectancies, all of this to provide a real-world application for how and what this might look like.

Troy Sharpe: Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner professional, host to The Retirement Income Show, and also a certified tax specialist. Today’s video, like I said, we’re going to look at different investment portfolios because that can change your tax strategy.

In the last video we looked at, in this series, we looked at different spending levels. I just want to remind you that if we have a higher spend relative to our portfolio balance, so we’re talking 4%, 5% here, especially in the beginning years, that can act as a de facto Roth conversion. Now that money’s not moving into a tax-free bucket but by spend ending more, we’re keeping those IRA balances down, so once we hit 72, 75 age 80, when those RMD percentages begin to rise, pretty significantly, we don’t have as much of a balance inside that tax infested retirement account. Spending a little bit more now or spending a higher amount over time does, in fact, keep that tax problem in check to a certain extent.

I just want to remind you of that because, in this video, we’re going to look at investment growth. If we have a more heavy allocation to equities, we should expect long-term higher growth inside our retirement account balances.

Those two concepts are similar because if we’re growing more and we have more inside the portfolio, especially if we’re growing more than that RMD percentage is increasing, then we’re going to have higher and higher balances and need to take more and more out for required minimum distributions. All of this means that it just simply alters our tax strategy.

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Okay. The first one we’re going to look at is a very conservative portfolio. This is about 25% equity, 75% bond or bond equivalence. One thing to keep in mind here is that if we’re only 25% in equities, we probably shouldn’t expect significant growth over time. Realistically, 3%, 4%, maybe 5%, we’re not going to see a lot of volatility, so that type of portfolio would have a lot of guardrails around it where we don’t see a lot of bouncing, of course, but we shouldn’t expect 7%, 8% returns if we’re only 25%, 30% stocks.

What’s interesting about this case is that all of the tax strategies have ultimately resulted in us targeting the 22% bracket as the top or the most optimal strategies. Now, that is not always the case. I don’t want you to think that you should just target the 22% bracket because it’s come up so frequently in this case. That’s primarily a function of how much money this hypothetical couple has saved outside of your retirement account.

As a quick refresher, they have 1.25 money in retirement accounts, 1.25 million, and then 250,000 in non-IRA accounts. If they had more money in non-IRA accounts, it’s quite possible that the optimal strategy would be a bit more aggressive, but when you have more money inside IRAs and less money in non-IRAs, once the non-qualified money or non-IRA money is exhausted, you have to pay the taxes on IRA withdrawals, which makes the conversion strategy more costly, which sometimes can push us in the direction of only going up to a certain limit.

What’s unique here is even though we’re targeting the 22% bracket in most of the different spending level scenarios, and even in the different investment portfolios, one thing I didn’t touch on in the last video that we’re going to dive into today in this video and the concept we were saying before, I just didn’t get into it, is even though we’re targeting that bracket up to the 22% threshold, the schedule is different. Okay, I’ll show you what I mean.

Here’s the schedule conservative portfolio, and also I plugged in spending $80,000 a year. That 80,000, it’s a bit high initially at about 5.3% of the overall 1.5 million but again, I’m comfortable with that because social security has not turned on yet. Once social security turns on the percentage they’ll withdraw from the portfolio drops to a very, very manageable amount.

Conservative portfolio we see in bar graph form here what that Roth conversion strategy looks like. Now, we see a decrease in these years right here for a couple of reasons. Under current tax code, the Trump tax cuts expire after 2025, so we’re going to have a different tax environment at that time assuming between now and then that the tax code doesn’t change.

President Biden tried to change the tax code last year, President Biden and Congress, but they weren’t able to get that done. It looks, in my opinion, unlikely they’re going to be able to get it done this year, simply because there’s so much going on in the world right now, they still are not getting concessions from Joe Manchin and it just doesn’t look like the tax changes are going to take place although they could.

Also, we’re looking at social security at age 70 here. If you remember back to the previous videos when we were looking at the Roth conversions, there wasn’t a huge difference in ending value if they took social security at 67, full retirement age, or 70, but because those two were so similar and I have both life expectancies going out to age 90, I’m going with the age 70 strategy here because the difference is it’s about $2,000 more per month in guaranteed lifetime income by deferring social security till 70.

Even though they end up with about the same amount of money and the composition is fairly similar, meaning how much is in Roth versus traditional IRA versus non-IRA at life expectancy, the 70 is more secure because it has more guaranteed lifetime income, but the difference, even in the tax plan, it doesn’t change it that much for this particular couple.

We see an increase in Roth conversions out here once social security turns on just simply because social security, there are some tax advantages to how that’s taxed so we have a little bit more room in the tax bracket so we can convert a little bit more, but we see this tax schedule, it goes all the way out to about 2036 with a small conversion there in 2037.

Just want to show you the composition of accounts here. This visually shows us that the blue is the tax-deferred, it’s a gradual Roth conversion strategy. Again, the accounts aren’t growing that aggressively, so we don’t have a huge tax problem down the road. We can gradually start doing these conversions. Also, we’re starting to pull a little bit out of the IRA to live off of, and ultimately everything gets into the yellow or the gold here which is the tax-free Roth IRA.

You see the little green building up here, that’s just simply required minimum distributions. They’re very small at that point, they’re going into our non-IRA account, savings, bank account, et cetera. With this strategy, the schedule stretches out over time because it’s a conservative investment portfolio and most of the money ends up inside tax-free Roth IRA.

If legacy is important, this is a lot of tax-free money to pass on. Ending balance here is about 3 million inside the retirement account, estimated 293 inside the non-IRA account. Now we’re going to look at the more traditional 60/40 type portfolio. This means 60% in stocks, 40% in bond or bond alternatives compared to the last one which was 25% in equities.

Here, we see we’re still targeting the 22% tax bracket as far as the optimal, and just so you’re aware, the software here is running, in this particular case, it looks like there’s 10 per page. We get onto page– so it’s called 70 different iterations of, so the top 70 distribution and Roth conversion strategies and we have them ranked here.

Still targeting the 22% bracket, but we see here it says 2032 conventional wisdom, so that means we’re actually stretching these out only through 2031, and then 2032 the optimal strategy is to withdraw from our accounts with what we call the conventional wisdom sequence, which is taxable accounts first, then IRAs, and then Roth IRAs.

One thing to quickly point out. More aggressive portfolio, we’re still spending the same amount of money, 80,000, adjusted upwards for inflation. Ending balance is about 4.7 million versus about 3.3 in the more conservative portfolio.

Here’s the difference with this one. We’re still targeting that 22% bracket, but ultimately it makes more sense to leave some money inside the retirement account versus pulling money out of the retirement account, doing conversions, and then using that money to pay taxes as well. We still have the same little quirk with social security here, but we’re only going through 2031 not 2036 per the previous plan.

If we look at the overtime spending in Roth conversion strategy, ultimately, we have the Roth conversions here, all the way coming up through 2031. Then what happens is based on having social security and our spending need, we can moderate our taxable income or what goes on the tax return by lining up what our required minimum distributions would be according to our spending need as well as how that optimizes our tax bracket.

Ultimately, what that means is we can hit our spending need on top of social security by making these withdrawals from the tax-deferred accounts very, very modest withdrawals here. This is fulfilling our RMD obligation in these years and not throwing us into a very high tax bracket. Because we’re getting more growth with a little bit more aggressive portfolio, it makes more sense to leave some money inside that IRA as opposed to taking it out, paying taxes, and doing the conversion.

The schedule with this particular portfolio, we’re still targeting the 22% bracket, but we’re doing conversions over a less number of years. We see this takes us out all the way through age 90, year 2050 for this hypothetical couple and that’s very manageable. With a more moderate invested type portfolio, what we see is more money left inside the retirement accounts actually makes a little bit more sense. Here’s what that looks like over time.

The gold again is the tax-free, the blue is the tax-deferred, so we’re doing these conversions, then once we get to 2031, we stop doing those conversions and we really just maintain a relatively modest balance there because as the account is growing, we’re also taking RMD, so the account doesn’t balloon to such an extent where we have a big tax problem down the road. Of course, we have more money because, over time, we’ve invested more aggressively.

Now I want to look at how a very aggressive portfolio, heavily tilted towards equities, can impact the tax strategy. This may not apply to many of you, but still, it’s important to understand the concepts because the primary difference in all of these investment portfolios, how they impact the tax plan, is the schedule is changing, not the tax bracket that we’re targeting. I think that’s a mistake that a lot of people make or are overlooking when they’re trying to figure this out. We only look at, okay, there’s two mistakes I see.

Someone just says, “You know what? I’m just going to do $50,000 converted,” or someone says, “You know what? I’m going to target the 12% or the 10% or randomly the 22% bracket.” There’s really no rhyme or reason between why and where people are choosing to do conversions up to. One of the things that absolutely gets overlooked is it’s not just the bracket that we’re targeting, it’s the frequency, how many years over time are we doing these conversions?

So let’s jump into it. Heavily aggress– this is 100% stock. We see that we’re going up to the 22% bracket. All right, so the schedule here is extended out over many, many more years than either the previous two scenarios. It’s more similar to the conservative portfolio, believe it or not, than the moderate portfolio, but we see here visually, we’re doing Roth conversions all the way up through life expectancy here and this is because, with a more aggressive portfolio, those IRA balances are increasing over time more so than the previous two versions, but if we didn’t continue these Roth conversions, we would simply have higher required minimum distributions than that 60/40 portfolio which would force us to pull more out, pay taxes, and then that would be less optimal.
Dollar-wise, we’re still doing the big conversions in the beginning of the years, but then we’re stretching these out over time where each year, we’re essentially putting money over here into the Roth IRA, so we keep those balances in check as opposed to allowing them to balloon and then be forced to take a lot of money out.

Now, let’s say you don’t do these conversions and you are forced to take a lot of money out. You still will have that tax liability, but instead of the money going into the Roth being tax-free, it would be go into your non-IRA account and be subject to annual taxes on interest dividends and any capital gains that you incur.

We much rather, if we’re going to have an aggressive portfolio and that account is going to grow over time, if we’re going to pay taxes because we’re forced to take it out, why not get ahead of that, elect to take the money out so then we can put it inside the Roth IRA so it will be tax-free forever. You still have required minimum distributions here. These are Roth conversions on top of RMDs and you cannot take your RMDs and put them into a Roth IRA. I do get that question a lot as well.

Again, just to show you visually what this looks like, we’re obviously getting a lot of money into the Roth IRA here and we do see, from required minimum distributions and the extended Roth conversions, we’re really keeping the blue, the tax-deferred accounts, we’re really keeping that in check and eventually it goes to zero and we’re passing on all of the tax-free money.
We have about 6 million there in tax-free and about 700,000, so it’s called 6.7, 6.8 million in total assets to pass on to the next generation. Now that may bring in an estate planning scenario where we would have to look at a different structure but still, the point is the Roth conversions as we can see with a conservative portfolio, a moderate portfolio, or an aggressive portfolio, the tax bracket that we targeted didn’t change and that’s primarily because of how much money they had saved outside of retirement accounts. Only 250 versus 1.25 million in retirement accounts but what changed was how long, how many years we did those conversions over.

When you’re doing your calculations, when you’re trying to figure out, “Should I convert? Should I not convert?” One, don’t just do a random conversion. I understand your investment plan, your income strategy affects your tax plan. Then it’s not just trying to figure out, “Okay, what bracket do I target or what number do I target as far as converting?” It’s we need to have a plan where we’re looking out into the future and identifying what makes the most sense over time.

Part five, we’re going to look at different variables and start to show you some real-world applicability to everything that we’ve been looking at in theory. Make sure to share this video with a friend or a family member, subscribe to the channel, and comment down below.