Retirement: I’m 65 with $1.3M Saved. Should I Do a Roth Conversion?

You’re 65 with $1.3 million and the question is, should you do a Roth conversion? Now, instead of just answering the question, because we’ll go through the pros and the cons, but what I really want to do is to convey some of the considerations that go into whether it makes sense for you or not. Some of the things that need to be considered as far as how Roth conversions tie into the broader concerns you have for your own retirement.

It’s not just a black-and-white question. Some of the big variables that can impact whether it makes sense for you or not are how aggressive is your portfolio or how conservative? How much do you spend? What is the income withdrawal rate relative to the overall balance? If you’re taking smaller amounts out for income purposes, you should be able to expect your portfolio to grow to larger and larger amounts. Therefore, the tax problem, the future tax problem, could become bigger.

How healthy are you? How healthy is your spouse? Is one expected to live longer than the other? Then you introduce the risk of a married couple going from married filing jointly into the single tax brackets. You have to look at all of these considerations in order to calculate, so to speak, not just a math, not just a break-even point, but to calculate for you in your retirement, is a Roth conversion something that’s beneficial for you long term in your family?

How important are each one of these things to you in retirement?

What I’ve put on the board here is a general list, while not exhaustive, of retirement questions and risks and concerns, things that you have to decide how important are each one of these to you in your retirement and to your family. Now, when you make decisions in retirement, as far as when you take Social Security, how you invest the portfolio, whether you do Roth conversions or not, you have to look at it in the broader picture.

You have to understand, based on your priorities, how does that decision impact the broader picture of your retirement plan? Too often, and I get this in the comments all the time when I do Roth conversion videos, “Troy, the break-even point is here, and that’s all the analysis you need to do.” Look, I’ve sat with thousands of families over the course of my career, helping them build retirement plans, seeing those retirement plans through.

This is what we do for a living. We work with people in retirement or approaching retirement. I can tell you, every single decision that you make in retirement impacts another aspect of your retirement. This is one of the challenges with people who are finance experts or gurus on television and radio, or people who just focus on investment analysis, and they think they understand the financial industry.

While they may be experts in their particular field, understanding retirement planning requires a couple of things. Of course, studying and learning and understanding, but then it requires real-world experience, working with people day in and day out, putting plans together, seeing those plans progress, understanding how people’s priorities inevitably change over time, and adjusting plans, and then, of course, seeing those results and playing it through.

This is one of the most important things that I’ve learned in the course of my career is that every decision impacts another aspect of your retirement, so you can’t just look at things in the black and white all the time. You have to understand, “If I make this decision, does it improve, does it hinder? How does it impact other aspects of my retirement plan?”

Risks and questions to consider with Roth Conversions

Okay, so I want to tie some of these back to Roth conversions, but really, the goal is to get you thinking of how other decisions that you may make possibly impact your retirement. Now, of course, if you’ve never retired before, you’ve never gone through this, there’s a lot that you probably don’t know and don’t understand the relationship between some of these various risks, questions that you have to answer. The goal with the channel, as always, is to help educate you so you can make better decisions with your retirement.

Of course, the stock market and your investment portfolio. In regards to Roth conversions, when we have a more aggressive– let’s say we expect our portfolio to average 7%, 8%, 9%, 10%, well, that creates a bigger tax infestation in your retirement accounts, which means taxes could be a bigger problem later in life. If you have a less aggressive, more conservative portfolio, depending on how big your IRA is now, maybe it’s not really going to be a problem.

Sequence of returns risk. This is the combination of taking income out and suffering losses. One of the benefits, or possibly good timings to do a Roth conversion, is when your accounts are down. I did a video on this recently, had a lot of comments telling me I’m wrong. I’m telling you that when you convert, when your accounts are down, you’re converting a larger portion of your retirement account, a larger percentage, to a tax-free account.

When the market inevitably rebounds, if you believe it will, which we do, then all that money is now growing back tax-free. Yes, you may have the same dollar amount, whether you converted or did not convert, but everything else, the domino effect, how everything is impacted in your retirement often will be improved by doing that conversion when the market is down. Now, it doesn’t mean that you don’t do conversions when the market is up, because we can never time the market.

Just being aware of that concept can maybe help you not procrastinate those Roth conversions until the end of the year, and maybe doing them in the beginning of the year or when the market hits its inevitable 5%, 10%, 15%, 20% correction. Taxes. This is really a no-brainer. This is what the singular topic that most people look at when it comes to Roth conversions, but there are so many others.

Longevity. Longevity ties in because, one, if you take control of when you pay taxes and how much you pay taxes now, if you have a longer longevity, not only will the black-and-white math work out better for the Roth conversion, but you’re likely to pay a heck of a lot less tax over time because you’re incrementally doing it now, and it’s likely that your Social Security benefits will incur less taxation over time.

Of course, your IRA distributions, you’ll have smaller required minimum distributions. This can have a domino effect throughout other areas of your retirement. Running out of money require minimum distribution. At age 73 and 75 or 75, you have to start taking money out of your retirement accounts. Roth IRAs do not have those RMDs. By doing Roth conversions, you minimize your future mandatory distributions.

Taxes, looks like I put it in here twice. I guess that’s just to maybe point out subconsciously how important the tax decision is in retirement. What is your health? If you’re not very healthy, maybe a Roth conversion doesn’t make sense for you. If one spouse is healthy and one is not, it could have an impact because, well, for multiple reasons. Your legacy, you’d much rather pass on tax-free money than tax-infested money. Long-term care concerns.

Interesting dynamic here because some long-term care expenses can be tax-deductible. If you have a big concern about that, Roth conversions could be beneficial in one way, but in other, you could be losing out on potential future tax deductions if long-term care is a big concern. Of course, how much income you take, your withdrawal rate, where you take that income from, all of that is impacted by whether or not you do Roth conversions.

Your Social Security, asset protection, trusts, giving, all of these considerations that you have in retirement, they’re all interrelated in one way or another. Making any one decision can impact a lot of other aspects of your retirement. Really, what I want you to do is just start thinking about your retirement as a bigger picture, not just the black and white of, “Does this make sense or not?”

Case study parameters for $1.3 Million saved

Okay. Now, we’re going to look at the case study. We have a married couple, both 65 years old, with $1.3 million in total investable assets. Of that $1.3 million, $1.1 million is in qualified retirement accounts or, as we refer to them, tax-infested IRAs, and about $200,000 in non-IRA accounts, or non-qualified accounts. The Social Security for them both combined is about $65,000 a year at full retirement age, which is 67. They want to spend about $80,000 a year in retirement.

We’re looking at a conservative portfolio here, averaging around 6% a year over time, a moderately conservative portfolio, but about 6% is the average growth rate here. As you might imagine, there are thousands and thousands, if not millions and millions of possible combinations of when to take Social Security, when doing Roth conversions, the amount that you do them, the increment, the timing, all of that, where you withdraw your income from. There really are an unlimited number of scenarios of how you can go about retirement.

What this software does is it simply ranks the top 100 based on the total value created. Looking at Social Security, whether to do Roth conversions, which accounts to withdraw your income from, and it simply ranks them. Now, it’s important to point out that this is just a snapshot in time. Of course, you have to make assumptions. All of the assumptions need to be identical. In the real world, not all of those assumptions are actually going to play out, so things need to adjust.

They need to be looked at pretty consistently over time. Plans are dynamic. There’s a lot of adjustments that take place if you want to continue to optimize your income, tax, and distribution strategy in retirement. Okay, so what we’re seeing here is it’s– we’ll just focus over here. The total Roth for the number one ranked strategy is going to be about $775,000 of that $1.1 million in IRAs converted over time, but the max Roth in any one year is $169,000.

If we go down here, so the third-ranked strategy, more money into Roth and a higher conversion to $210,000 in its biggest year. Down here, we have less money going into Roth. Of course, with less money into Roth over time, the annual maximum Roth contribution is a lot smaller as well. Incrementally, though, this one may not be that much better than this one as far as for you and your retirement.

The point is these are ideas. These are ways that we can go about it. It leads to deeper discussions in uncovering what’s really, really important to you. All software, all tools, all technology is really just a part of the solution. It helps us to crunch numbers a lot more quickly and do comparative analyses a lot more effectively, which, of course, leads to better discussions.

Taking a closer look at the top ranked strategy

Okay, so we’re going to just look at the top-ranked strategy for this one, and I’m going to point out a few key things. The base strategy, we have this set up as what we would typically see when someone comes in to meet us for the first time. They’re retiring at 65. Typically, they’re going to want to take Social Security at that point because that’s how we’ve been conditioned over many, many years. You retire, you turn on your Social Security income, and conventional wisdom in the financial industry has been to continue to let those retirement accounts defer, pull out from your non-IRAs.

This is taking Social Security soon. The rates of return, everything is the same. Longevity, living until age 90. They’re 65 today. Everything’s the same, except for the Roth conversion and distribution strategies. Just a quick summation here, so we have total taxes paid this way of about $357,000 versus $161,000. Almost an estimated $200,000 in potential tax savings. Then we have a higher ending value over here, $3.4 million versus $2.9 million. This is the top-ranked Roth conversion strategy. This is the base case.

Impact of Required Minimum Distributions

 

First thing I always like to point out is the impact of required minimum distributions, because if you have concerns about taxes in the future being higher, you have to understand what your retirement accounts, the required minimum distributions that come out of them, how they will impact not only your income, but also your taxation. The green here is the base strategy, not doing any conversions, following a conventional wisdom path.

We see on the y-axis here, $50,000, $100,000, $150,000. The x at the bottom, we have ages and years. We can clearly see that doing no conversions, the green bars, we have RMDs that start at around $73,000. They get up to $99,000 to over $100,000, $130,000. These are forced distributions from your account that will go on top of your Social Security, go on top of any pension, or real estate income, or dividends and interest.

Without doing conversions, when you have large IRA balances, oftentimes, you can find yourself in retirement in your 70s and 80s, having a much higher income than you ever did throughout your life. It’s something to be aware of, because this has domino effect throughout your other aspects of retirement. I’ll show you what I mean in a second. Okay, so here we have, on the right, we have the base strategy. On the left, we have the Roth conversion strategy. I want to point out the first column, Social Security, the base strategy.

We’re taking Social Security as soon as possible. Then on the Roth conversion strategy, what we’re doing is we’re deferring until age 70, because that’s going to leave more room to do conversions, because Social Security is a taxable income. If you’re doing conversions and taking Social Security, up to 85% of your Social Security will be subject to income tax, as well as the tax on all of the Roth conversion, because we’re taking money out of that IRA and putting it into the Roth.

Typically, what we’ll do here is we’ll leave some room. We’ll defer Social Security. This has additional benefits we’ll cover in a second. That gives more room for Roth conversions. Then we can spread that tax hit out by doing the conversions incrementally over a series of years. Here, we’re doing them over about a five-year span. One, two, three, four, five. Then see what happens to our total taxes from that point forward.

They may even be spread out a little bit more. Look what happens to the total taxes. Once we get up here to our RMD age, our taxes are negligible throughout the rest of retirement. Again, if you think you’re only going to live to 80, maybe this isn’t as beneficial for you. Just something to consider. Whereas over here on the base case, look, we could pay no taxes for a very long time. All we’re doing is we’re choosing to defer those taxes and pay them later in retirement.

Then we see here as we get down to once taxes actually kick in, $13,000, $15,000, $16,000. Pretty big taxes. Of course, we don’t know what taxes will be in the future. That’s part of the tax risk that you carry when you have large IRA balances. What will taxes be in the future? If you think they’re going to be higher, doing conversions could help to mitigate some of that risk by taking it off the table.

The effect on Social Security taxation when eliminating RMDs

Okay, so I want to point that out. I also want to go back here and look at the Social Security. Not only do we have higher Social Security income, but look at our taxation. We have $108,000 of Social Security, and we’re only paying $625 in taxes. How is that possible? It’s because when you eliminate the required minimum distributions or a big portion of them, now you can take advantage of the preferential tax treatment of Social Security.

Doing conversions not only helps us pay less tax over the course of retirement, but part of the reason it does is because it reduces the tax on our Social Security. When we look at $108,000 of income, a simple rule of thumb I go by is multiplying it by 20. This can work for pensions. It can work for annuity income, anything that’s a secure source of income that you have coming in. When you multiply it by 20, what you’re ultimately getting is the asset base, roughly, that it would take to generate that amount of income.

Having $108,000 of lifetime income from Social Security is similar to having about $2 million, $2.1 million inside an investment account. When you start to change your perspective a little bit in retirement and understanding that income, whether you have that asset base or not, is virtually the same thing as having that large asset base as it pertains to the total value that it provides to your retirement. Of course, there’s no death benefit. There’s no lump sum to pass on. As far as the income and the security and the overall value that you receive, it’s a general rule of thumb that I like to follow, and also I like to make sure that you understand.

Here, we have a great tax situation. We have a really, really good income situation. Oh, and we also have a significant amount of money in the portfolio. This is the before-tax balance. This is the after-tax balance. All that means is here’s the value of the retirement accounts in their current state. Then if we were to simply look at what is the effective after-tax value that we have, that’s what this column represents.

Now, if we do a quick comparison here, so $1.6 million versus $1.9 million. Yes, $1.9 million here, so I’m just going across. Yes, if you do the Roth conversions, you’re taking money, moving it to the Roth IRA, and you have to pay taxes. Ideally, you pay that money from your non-IRA accounts, but you are paying taxes. Therefore, you have less money in your accounts. For some people, this is a really big deal.

How the SECURE Act and Account Composition could affect your children

You have to keep in mind, the value of the two different sources of lifetime income. If we’re looking at this on an after-tax basis, this $1.9 million, you’re probably not going to distribute it during your life, but the SECURE Act requires your children to fully distribute that account within 10 years. Right now, this is the after-tax balance, the true value of what you actually have.

I don’t want to get too deep in the weeds here, but understanding that you’re creating, a lot of times, more security when you have less tax risk, more income from Social Security. Then when we start to look at, of course, the RMDs, you’re in a much better situation with your required distributions, but then we start to look at the composition of your accounts. The gold represents your Roth IRAs, the tax-free portion. The blue represents the tax-infested part of your retirement. We see here with the Roth conversion strategy, we’re not completely getting rid of all of the IRAs. We’re still strategically keeping a certain portion.

We’re going to have an RMD from that, but it’s manageable. Mostly, our assets are in this tax-free account. When we pass that on, it can grow tax-free for another 10 years, and then it does have to be fully distributed. If you’re in a high-tax state or federal taxes are much higher in the future, your kids are going to be much more grateful to receive an asset that’s tax-free and can compound for 10 years before they take it out, as opposed to not doing it, receiving this tax-infested asset, allowing that to compound, and then fully distributing it, and paying tax across the board.

Looking at the whole picture to decide if a Roth Conversion is right for you

As I’ve went through and illustrated here, the Roth conversions may or may not be right for you. There are a lot of considerations. The big takeaway is understanding how every aspect of your retirement is impacted by every decision that you make, as far as, do I do Roth conversions? Do I not? When do I take Social Security? Which accounts do I invest in? Which accounts do I withdraw from? How much do I withdraw? How much do I spend? All of these decisions are interrelated. Hopefully, this video helped you to think a little deeper, to dive a little bit more into just pondering your retirement and the decisions you have to make. I look forward to seeing what you guys have to say in the comments. Maybe we’ll do a follow-up video.

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