Our Customized Roth Conversion Recommendations

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Simple Roth Conversion Calculation

(for people who are not our clients)

Back at the founding of our firm, David John Marotta did some careful mathematics to figure out that on average for his clients doing a Roth conversion to fill up the top of their current bracket was a good idea. This principle is still true today. If you’re wondering how much Roth conversion you should do, using this simple formula will, on average, be a good idea. Not necessarily the best but normally a good one.

Top of Your Top Marginal Income Bracket (can look up online)

minus

Your Total Ordinary Income (found on Qualified Dividends and Capital Gains Tax Worksheet Line 7)

=

Roth Conversion Target

Our Customized Roth Conversion Recommendations

(for our clients)

Then in 2015, I developed a more complex Roth funding and conversion analysis algorithm and since then we have learned so much about the ideal Roth conversion targets.

Now, our process is to have the tax specialist (currently me) use your most recent tax return, net worth, standard of living, and age to prepare your taxes, grow your portfolio and its accompanying dividends and interest, model your standard of living and the effects of inflation, start taking Social Security, model your Required Minimum Distributions (RMDs) as they gradually increase, and in general model your financial life each year until you are age 100. It is just an estimate, but it is a good estimate.

Then, I start changing things — What if you did a Roth conversion to the top of your marginal bracket each year? Only for five years? What about the bracket higher? — and compare the scenarios both to the baseline and to one another in order to find the best plan. It is a manual process with powerful tool. This program we’ve made runs the decades of analysis at lightning speeds.

We’ve learned from this that there is not one best Roth conversion plan that you can apply to everyone. As a result, any given tax review takes 2 to 6 hours to complete depending on the complexity of the situation I’m trying to model.

Here are some of the techniques which our modeling has found that project even more savings than just to the “top of the bracket” conversions:

Top of Your Future Bracket

Required Minimum Distributions (RMDs) often push people one, two, or sometimes even three brackets higher than their baseline retirement bracket because of the size of their Traditional IRA and/or 401(k) funds. This means that even if they are in a low bracket now (say 15%), later they might be as high as the 28%.

Sometimes in these circumstances, it is worthwhile to convert into the 28% bracket now, since you’ll be taxed at this rate for RMDs anyway. You save yourself some tax by putting the withdrawal in a Roth IRA where the future growth is not subject to tax. If you delay, the money and some growth has to be withdrawn later, and at that point you are forced to put the money into your a regular brokerage account where you will be taxed on future dividends, interest, and capital growth.

A Relief Cut

Sometimes there isn’t a lot of room left in your current bracket, and the small conversions that fit there just don’t make enough impact on the size of your RMDs. However, one year with a really large conversion in a higher bracket decreases your future RMDs enough that you can fit decent size conversions in your current bracket, reducing your future tax burden.

Rip the Band-aid

Alternative Minimum Tax is weird and sometimes a little bit of Roth conversion or RMD each year is taxed at a higher rate than if you’d just done a total conversion (or close to it) in one year. I call this the “rip the band-aid plan” because a total conversion normally costs a lot of tax all in one year (which hurts), but then it saves you the arm and the leg that AMT would have cost you gradually each year.

Wait for It

Sometimes there is a known window of time when taxable income will be low and if you wait for it you can do a large conversion in the lower tax brackets. We call the most common window “the gap years,” the years after retirement and before age 70 when you start withdrawing RMDs and taking Social Security.

That being said, it is risky to wait if you aren’t sure about your retirement date. If you end up not retiring until after age 70, you will start losing IRA money to both the IRS and to RMDs. In many of these cases, it would have been better not to have waited.

Feed Yourself First

If you’re in the 0% capital gains bracket and are living off your brokerage account. you may need to realize capital gains so you can spend the proceeds. If that is the case, it is sometimes better to either wait to convert or only convert what keeps your capital gains in the 0% bracket.

Make Room for Gains

On the flip side, if you are realizing capital gains only because it is good tax planning, convert first to save yourself the tax on all of the future growth and RMDs. Then, after you are done converting, you’ll likely be in even a lower bracket and able to realize even more gains.

Seize the Day

You might have a random dip on your taxable income while you switch jobs, go on unpaid leave, or cut back your hours. In this case you can convert your entire IRA to a Roth and then figure out your conversion plan when the dust settles. You have until Oct 15 of the next year to recharacterize (undo) any conversions that weren’t a good idea.

Let It Slide

When RMDs are a large part of your taxable income, sometimes it is wise to convert a precise dollar amount every year. The first year, it will be above your marginal bracket, but as the conversions lower your RMDs, your taxable income will slide down through the brackets. Eventually, you’ll find yourself in the 10% or 15% bracket if you are lucky.

10% is More Savings Than 3% Costs

Moving from the 25% bracket to the 28% bracket is only a 3% marginal increase. If that move can get you into the 15% bracket later, that’s a 10% marginal decrease. You’re ahead 7% — or more because of the time value of money!

Remember the 401(k)

Don’t forget that you have an employer plan. Your employer 401(k) plan is a hidden source of taxable income in retirement. Profit Sharing, Employer Match, and any Traditional balance will all likely be subject to RMDs after you retire or age 70.5 (which ever is later). And, alas, for most people, they cannot convert while the money is in the plan, but a lucky few of us can. And some money can often be rolled out of the plan while you are in-service (working for the company). Once it is rolled out, you can convert.

Just Convert Something

Roth conversions are almost always a good idea and converting something is almost always better than doing nothing. There is a “best conversion” and we can do our best to predict which plan it is, but even the “worst conversion” plan can save hundreds of thousands or even millions of after-tax value over doing nothing.

Although we’ve learned many interesting techniques to optimize saving a few hundred thousand dollars more of after-tax value for our clients, the simplest conversion strategy is still a great idea to capture a lot of savings for the average investor.

Photo used here under Unsplash Creative Commons Zero.

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Megan Russell has worked with Marotta Wealth Management since 2005. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine