Roth Conversions - Saving Taxes with a New Kind of Math

For financial advisors who know both investments AND taxes, one of the many tools in our client serving toolbelt is the Roth conversion. But what is it, how do they work, and how do you know when it's right for you?

aRothmetic is the super nerdy pun I created for describing the calculations needed to identify both how much of a Roth conversion you should complete each year, and the total projected value saved over your lifetime by doing so.

There are plenty of variables involved with Roth conversions to help you minimize your lifetime tax liability. Using aRothmetic with Formula Wealth can help you solve for your best retirement.

What Is a Roth Conversion?

When you funded your Traditional IRA or 401(k), you received a tax break each year that you contributed to the account – your taxable income in those years was reduced (deducted) by the amount you put in the retirement account (hence why they're called deductible contributions).

Not only did you receive a tax deduction in the year of contribution, but the account was able to grow without the burdens of capital gains taxes or taxable dividends and interest. These Traditional retirement accounts are "tax-deferred," meaning nothing is taxed while the money remains in the account, regardless of what you buy and sell.

Typically, these funds are saved for retirement, and once the owner is age 59.5 or older, they can pull the funds out to use them as part of their regular lifestyle needs. The owner is taxed at ordinary income rates on the amount of money that comes out.

So you get tax-deferred growth on your investments for a long time. Yay. BUT… sometimes there are opportunities for families to be a little more proactive with their retirement investments by converting their Traditional IRA or 401(k) into a Roth IRA.

A Roth conversion allows you to convert some or all of that tax-deferred money into a Roth IRA, where it can grow tax-free. In exchange, you’ll pay income tax on the converted amount in the year of the conversion.

Stay with me, this gets good.

Why Consider a Roth Conversion?

1. Tax-Free Withdrawals in Retirement: Roth IRAs offer tax-free withdrawals if you follow the rules, so any money you convert now can be taken out tax-free later. This can make a big difference if you expect your tax rate to go up in retirement (anyone think it's remotely possible that someday the US government decides they need more money and chooses to increase tax rates?).

2. Required Minimum Distributions (RMDs): With a Roth IRA, you’re not required to take out a certain amount each year after you reach a certain age, unlike with a Traditional IRA. This can help keep your taxable income lower in retirement, giving you more flexibility. By completing optimized Roth conversions before RMDs begin, you can substantially reduce future forced taxable income at higher brackets.

3. Legacy Planning: Roth IRAs can also be beneficial if you’re looking to leave assets to heirs, as your beneficiaries can inherit Roth accounts tax-free if they follow the guidelines. If you pass down a Traditional IRA, not only will your heir have required minimum distributions, but they will have to pay tax on the assets in order to withdraw from the account.

4. Tax Rate Arbitrage: If you anticipate your retirement years will be full of high taxes from Social Security's ordinary income, Traditional IRA withdrawals, and higher tax brackets, you may ultimately pay less in taxes by paying now at a lower average rate. You don't have to convert all of your IRA in one year, you can spread out these conversions over as many years as you like. A particularly great time to consider these conversions is in your first full calendar year after retirement before claiming Social Security. Your income is likely very low this year - use that to your advantage! Never let a low bracket year pass you by.

5. Multiple Buckets: Distribution planning is one of the greatest ways to add value to your bottom line in retirement. Pulling from certain accounts in a strategic manner allows you to take control of what is taxed and when. By having this third bucket of assets in a tax-free account (first bucket is taxable brokerage account which is taxed on dividends, interest, and capital gains, second bucket is ordinary income from Traditional IRA, pensions, or Social Security), you have more flexibility for your plan. Although normally we want to save the Roth IRA for next generation, there are times when it's a game changer to access during your own retirement. If it's November and your income thus far has you approaching the next highest tax bracket for the year or IRMAA surcharge limits, it might be a great time to pull from the tax-free bucket for the final two months of the year.

Roth Conversion Example

Imagine you’re 65, sitting with a $1 million IRA, and you're concerned about the tax bite that might come in the future once Required Minimum Distributions (RMDs) kick in during your 70s. You're in the 24% marginal tax bracket now, but with the expected RMDs, you could be pushed into the 37% bracket down the road—a big leap! Roth conversions can be a great tool here, allowing you to gradually move some of this money into a Roth IRA, where it can grow tax-free, and, importantly, won't come with RMDs.

Let’s break down how this might work for you:

1. Why Convert Now? Since you're in the 24% tax bracket, you have the opportunity to pay taxes on some of your IRA funds at that relatively lower rate. If tax rates or your income were to rise (or both!), you might be paying much more in the future. By converting part of your IRA to a Roth now, you're getting ahead of that.

2. How Much to Convert: Let’s say you convert $100,000 this year. That $100,000 will add to your taxable income this year, taxed at 24%. You’d pay $24,000 in taxes on this conversion amount, which might feel steep now but can be worth it compared to a possible 37% hit in the future (or whatever the higher brackets are at the time). Using aRothmetic can help you calculate the optimized amount each year for you and your family.

3. Long-Term Benefits: Every dollar you convert today means that future RMDs will be based on a smaller IRA balance, potentially keeping you in a lower tax bracket as you age. Plus, Roth accounts don’t have RMDs, so if you don’t need the funds, they can continue to grow tax-free. This strategy also offers you flexibility and potentially lowers the tax burden on any funds you leave to heirs, as Roth IRA distributions are tax-free.

4. Over Time: You could consider converting $100,000 or a similar amount each year over several years, as long as it keeps you within your ideal tax bracket. This way, you’re spreading out the tax bill while reducing your future RMDs and avoiding the higher brackets altogether.

Converting strategically like this, a little each year, lets you take control of the tax impact over time rather than facing it all at once at higher rates when RMDs begin.

 Effects of $1 Million IRA Filling Up the 24% Bracket Annually Compared to Other Strategies

In these scenarios, the married couple is 65 years old, retired, has a $2 million brokerage account and $1 million IRA. They are delaying Social Security until age 70.

A.  Filling up 24% bracket compared to all taxable first, then tax-deferred

Benefits

Tax Brackets 

B.  Filling up 24% bracket compared to Pro-Rata Withdrawals

Benefits

Tax Brackets

When It Can Make Sense

The Roth conversion strategy can be especially useful if:

·        You’re in a lower tax bracket now and expect to be in a higher bracket later.

·        You’re in a year with less taxable income, so the taxes on the conversion are lower.

·        You're concerned about the impact of forced required minimum distributions from a large IRA balance.

When Might a Roth Conversion Not Make Sense?

A Roth conversion isn’t for everyone. Here are some reasons why:

High Tax Bracket Now: If you’re currently in a high tax bracket, it might be best to wait for a lower-income year to make the conversion.

Need Cash to Cover Taxes: Ideally, you want to be able to pay the tax bill with money outside of your retirement account. If you have to pull from your IRA to pay the taxes, it can reduce the benefits of the strategy (although still possibly worth it).

Timing Roth Conversions with Tax Strategy

A key variable in the aRothmetic calculations is timing. Many people consider Roth conversions in years when their taxable income is lower – for example, right after retiring but before taking Social Security or RMDs. This way, you can spread the conversions over several years to keep yourself from bumping into a higher tax bracket.

Discover your formula for a tax-efficient retirement today!

Completing strategic Roth conversions in retirement can minimize taxes over your lifetime and empower you to pass tax-free assets to the next generation. At Formula Wealth, we use aRothmetic to calculate ideal retirement strategies. What's your formula?