Roth Conversion & Tax Planning Impact – In My 40’s with over $1 Million In My Retirement Account

Troy Sharpe: You’re in your 40s, done very well for yourself, and you’ve saved over a million dollars in your retirement account, or maybe you’re watching this and thinking about your children. Maybe they’re doctors, engineers, attorneys, either way, they’ve done a good job saving. How important are Roth conversions and also what is the impact that tax planning can have on your future?

Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified tax specialist, certified financial planner, professional, and host to the Retirement Income Show. A good rule of thumb is, the younger you are, the healthier you are, and the more money you have in retirement accounts, the more likely it’ll be a positive thing for you to do Roth conversions for any age. Tax planning is extremely important. Hey, just a quick interruption here. If you could take one second to subscribe to the channel and hit that bell icon, that’ll keep you connected to us, help notify you when we upload new content, and the goal is to help you stay more connected and make better decisions with your money.

I want to look at a couple different scenarios here, doing big conversions, doing little conversions, doing no conversions, and compare the outcome. Now, it’s important to understand that just because in the time title of this video, I say, are you in your 40s and you’ve done well saving. You could have a million, a million-five, $500,000, you could be 38, you could be 52, 45. The general concepts apply to you. Everyone’s circumstances are different.

I want to look at the impact of doing conversions based on this hypothetical scenario and if you’re somewhere range and you’ve done a really good job saving and you have a large amount of money in your retirement account, the general rule of thumb is, the younger you are, the healthier you are and the longer you’re expected to live, the more of a positive impact Roth conversions can have on your retirement.

They can really reduce your tax bill over time, they can give you more money to spend in retirement, and they can also eliminate a ton of risk out there associated with future tax implication. If you’re 60, 65, 70, it doesn’t mean that Roth conversions aren’t still right for you, but typically, the older you get, the less benefit you’ll get from Roth conversions during your lifetime. There are other variables to consider or other factors to consider. Let’s say it’s very important that you pass money onto your children. If you’re in that older age demographic, then Roth conversions can still make a lot of sense for you. I just want to make the point clear that you don’t have to be exactly within these parameters for you to get a lot out of this video.

In today’s hypothetical video, we have a husband and wife, 47 years old, and if you’re not married, this can still apply to you. I get a lot of comments about doing these for single people. It’s the concept. Remember, that’s what’s important. We’re looking at a 47-year-old couple, have $200,000 of gross annual income, spend about $100,000 dollars a year, and they expect that to continue throughout retirement adjusting for inflation, and we’re going to have them live until age 95. I’d rather plan for too long than too little, but everyone circumstances of course are different.

The first thing I want to look at is the number one rank strategy versus not doing any Roth conversions at all. Now, when I say the number one rank strategy, keep in mind, all we’re doing is isolating all the variables such as age, spending, longevity, income, account balances, and the software is analyzing different conversion scenarios. Meaning what if we convert this amount or that amount, or this amount, follow this schedule, or that schedule, or this schedule. Those are the variables that we are exploring with the software in order to determine what is the number 1 rank strategy, the number 10, the number 100.

Keep in mind that this analysis has to be done every year because the strategies will change. Account balances won’t average exactly 6% per year forever. This is a living, breathing, fluid type plan. If you embark down this road, it’s something that you need to do every single year, adjusting all of the variables that have changed from year to year.

Now, doing the Roth. In this strategy, number one ranked has an ending balance of $12.9 million versus the non-Roth strategy, which is ranked number 92 of $10.2 million. First and foremost, this couple here, they have $1.5 million in their IRAs today, 47 years old. They have about $250,000 outside of their retirement accounts. That’s about $1.75 million. They’ll be saving a little bit, of course, heading into retirement, but this has to last until they’re 95 or the money will last until they’re 95.

Most people who are in this net worth range right now, or at least liquid net worth, investable, I don’t think a lot of them really truly understand how much $1.5 or $2 million in your 40s, late 40s, how much that can turn into by the time your 85, 90, 95. Compound interest is extremely powerful. This is just averaging about 6% with the spending numbers that I outlined before. Long story short, though, we’re looking at $12.9 versus $10.2, so big difference. We’re talking $2.7 million in additional value provided simply from the Roth conversion strategy versus the non-Roth conversion strategy.

Of course, your ending balance is very important when it comes to deciding whether the Roth conversion is right for you, but that’s not the only thing that matters. We often talk about the composition of accounts, eliminating tax risk. If you have all of your money inside that retirement account, what happens if taxes go up to 40%, 50%, 60%, federal and state. You’re in a pretty bad spot there. If you put all your money into Roth and then the market tanks, that’s a pretty bad timing and that’s going to suck also.

Now, we’re going to look at this number one ranked strategy versus doing absolutely nothing, all variables are the same, $12.9 million, the ending value versus $10.2. Taxes paid $1.2 million versus $3.9 or almost $4 million, so we’re looking at the difference essentially in ending value is the amount of taxes paid over the course of retirement.

Now, we’re going to look at a few important things. One, account balances. When do your account balances catch up? Trust me, when your account balances catch up, should not necessarily dictate whether you do a conversion or not, but it is one thing to consider. Required minimum distributions is the second thing we’re going to look at, and then also annual taxes, doing the conversion versus not doing the conversion.

Okay, so here we go. The blue is the number one ranked strategy. By the way, this is going to get all done immediately doing the whole account or almost the whole account as a Roth conversion. We see that account balances dropped, but if you’re in your 40s, you can’t touch that money until you’re 59 and a half anyways, so it’s not the worst thing in the world to do a very, very aggressive Roth conversion. Talk to your CPA about your particular situation or your financial advisor, of course, but I just want to convey the concepts. We see the account balances don’t necessarily catch up until later, but as I said, that should not dictate your decision, it’s just a piece of information to know.

Here’s where it really gets interesting. Require minimum distributions. If we do the aggressive Roth strategy, we don’t have any force distributions once we hit age 72. If we don’t do the Roth conversion strategy, again, this is just growing at 6%. We see our require minimum distributions $209,000 on top of Social Security, on top of any other income you have. Social Security here could easily be $80 to $100,000 a year for this couple, depending on if they took it at full retirement age or 70. I’ll show you that in a second.

Here’s the challenge, as we go throughout retirement, the RMDs are increasing. You don’t want to be 76, 77 years old probably and have $250,000 of force distributions plus Social Security, plus any dividends, interest, maybe real estate income. This is where not doing the Roth conversions becomes a problem, because you get into a situation where you are forced to take that money out of the retirement account and pay taxes at whatever income tax rate federal and state they say is appropriate. When I say they, it’s the government, is appropriate for having this level of income.

Now, here is what it looks like. No conversion, the most aggressive conversion. You would pay taxes of about $484,000. For many of you, that’s too big of a pill to buy and I’m not telling you to do this. What I am trying to convey, of course, is the pros and cons of this strategy and then next we’re going to look at a reduced strategy, meaning we’re not doing it all at once, we’re spreading it out, targeting a lesser tax bracket.

For the most part, income taxes while you’re working in these two comparative scenarios are not going to change that much, because in those scenarios where you’re working, your income tax liability is based on your income. Once we get to retirement, that’s where we start to see it change, so I have this couple retiring at 65, but something to note here, the software, and in this situation, even though they’re retiring at 65, you still have a tax bill here because the software is trying to optimize the overall account balances, as well as reduce the amount of taxes paid.

The entire account is not being converted, but what we’re doing is we’re taking Social Security at 70. Both husband and wife are deferring till 70, and look how much it is. It’s $104,000 in both scenarios. They both have about maximum Social Security, because obviously, someone who saved a good amount of money by their 40s, they have $200,000 of income. They’re both going to have very good Social Securities, but this is what it would look like for them as far as age 70, Social Security.

Now, they are taking from the retirement account the remaining balances from the IRA, letting the Roth continue to defer and grow. In the real world, we may want to start reducing taxes immediately in this area. It’s one of those things where we don’t have to follow what’s number one exactly. It’s a year-to-year discussion of your particular situation and say, “If we do it this way, this is what the consequence is. If we do it this way, it’s what the benefit is.” Then weighing those consequences and benefits to determine what’s the best course of action for this year, but we need to have context of how those decisions impact everything over time.

Okay, so here’s the big change, doing no conversions, doing conversions, the big conversion. Once we get out here, we see at 72 when we require minimum distribution start, this is your annual tax paid column. Okay? This is not a good situation to be in, because this assumes taxes are what they are today. If you believe taxes are going to be much higher in the future, this is going to be a much greater number.

When we look over here compared to this side, yes, we paid that big tax amount in the beginning and there’s a cost to doing so, but here’s where we get to the savings. Okay. This is what we’re paying throughout retirement. Okay. Equals about $1.2 million versus down here, about $3.9 million in total taxes paid. Pretty big difference here. Remember, we’re going through this to help you understand why it’s important to consider Roth conversions if you’re in your 40s and you’ve done a really, really good job saving.

Now, I want to show you, instead of doing that very aggressive strategy, which personally, I probably wouldn’t do myself, especially after seeing this analysis, comparing it to doing a lesser conversion strategy, but more extended. We’re targeting the 24% bracket. We’re not just focused on how do we pay the least amount of tax over time. We’re taking other things into consideration. I don’t want to spend $484,000 in taxes initially. I want to spread that out, but I still want to have the benefit of getting money out of that tax-infested retirement account.

This is comparing the 24 targeting the 24% bracket versus doing it all at once. The green is doing it all at once. The blue is spreading it out over time. It’s hard to see here because the graph is in $2 million increments. Obviously, if we spread it out, we will have more money in the IRA because we’re paying less tax immediately to grow and to earn interest on.

Here’s where it’s really cool. This is where I would be convinced personally. This is what I’m afraid of in the future for large IRA balances. I’m afraid of it growing much more than what we show here typically in these videos of six percentage. If you average 8%, 9%, 10%, your RMDs could be so astronomical when you get to be 72, you could be forced to be put or forced into a very, very high bracket forever, but here’s a pretty cool thing. Doing the 24% bracket, we see our RMDs only are $10, $20, $30,000 in that range. Okay? They’re not gone, but guess what? I’ll need to spend this money in retirement. I don’t need to pay. I don’t mind paying taxes on that little bit compared to the total tax chart over here.

This is the 37% bracket, the most aggressive. Yes, we paid it all upfront. We actually paid less over the course of our lifetime, and we actually have a little bit more money in the accounts, but again, we’re modeling way out into the future, over 40 years into the future. We just need to use this as a guiding path for us to help make decisions, but we need to have some common sense as well.

Targeting the 24% bracket versus being aggressive. We see we’re spreading this out over the first few years. Then we have the remaining working years where the taxes are fairly similar, and then we kind of get out here to retirement where we see in this one like we said before, taxes are very, very minimal. Okay?

Over here, taxes are still fairly manageable. This isn’t horrible when you save this much money in your retirement accounts. This is manageable. If taxes go up significantly in the future, I’m still not getting crushed with this strategy over here, just because this is the analysis today, guess what would happen next year, the following year, the following year, the following year, the following year? Every year, we’re doing analysis and we can always change course.

The main thing I want to point out here is for me going to the 24% bracket right now and extending or spreading that conversion strategy out over a few years, seems to me, is something I would be more willing to do than doing it all at once. Even though when we look at the total taxes paid, it’s estimated to be a couple hundred thousand dollars more than doing it all at once, ending balances roughly about the same, a little bit less.

Again, we’re modeling out over multiple years. Take all of this information with a grain of salt. It’s just an analysis that has to be done every single year and we make the best decision with the given information that we have. If we think taxes are going to be extremely higher in the future because whatever happens in three, four, five, six, or seven years, we can get more aggressive at that point. Now, going up to the 24% bracket still definitely compares positively to doing nothing whatsoever.

If we see here, this is going into the 24% bracket, estimated taxes over the course of your lifetime, $1.4 million versus $3.9 doing nothing. Ending balance is $10.2 versus $12.5. Obviously, there’s a huge advantage of still doing the conversions. Personally me, I would go with the 24% bracket over the more aggressive strategy for this year, but then I look at it next year and the following year and then determine each year what is the right thing to do.

Yes, if you’re young, and you’ve saved a lot of money, if your children have saved a lot of money, tax strategy is extremely critical when it comes to optimizing the overall balances, taxes paid, and security and retirement. Being aggressive may not be the right move if you’re young in this area, spreading it out over multiple years seems to make sense as well. Both of those strategies and many of them in between are far better from the numbers from the analysis we’ve ran today than doing nothing whatsoever.

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