For over a decade we have been recommending Roth conversions as a method of maximizing the after-tax net worth of our clients. During this time we estimated the Roth conversion amounts which we thought ideal as best we could. Our estimates were usually much better than doing nothing, but not as precise as we could be.
In 2015, we developed a complex Roth funding and conversion analysis algorithm which models doing a client’s tax return every year until age 100. The analysis includes tax brackets, alternative minimum tax, inflation, the growth of brokerage and retirement accounts, capital gains, Social Security, Medicare surcharges, required minimum distributions, and other factors. While all projections are still estimates, this analysis catches the often complex interaction between components of the U.S. tax code.
While our simplistic estimate were advantageous to clients, they were not always optimal. With every client where we found a better conversion strategy, we analyzed what tax code interactions produced the optimal recommendation. We even gave names to some of the common conversion strategies.
For our “Comprehensive” clients, we offer this customized Roth conversion target recommendations from our tax review service. Over a client’s lifetime, we believe this service can be worth hundreds of thousands of dollars and in many cases for high net worth clients millions of dollars. But this service can require 4 to 6 hours for a single review depending on the complexity of the client’s situation.
Time consuming services like this were one of the obstacles to launching our “Do-It-Yourself” service level, which has no account minimums. For this reason, we decided to reserve Tax Reviews as premium services only available to our “Comprehensive” service level.
But in the process of developing our comprehensive analysis, we also improved our rule of thumb for those without access to our full analysis. Doing some conversion is usually much better than doing no conversion at all. And we offer these two simple but effective strategies to calculate a very good conversion target for this year.
Younger than 70 1/2
If you are younger than age 70 1/2, the IRS deemed “required beginning date” for required minimum distributions (RMDs), then there is a measurable amount of time before you are required to begin RMDs. This measurable amount of time is how long you have to protect your IRA assets from proverbially leaking into your brokerage account via RMDs. Once in the brokerages account, they will be subject to interest, dividends, and capital gains and be taxed in this way for the rest of your life.
Thus, if you take your current traditional IRA balance and divide by the number of years you have left before RMDs begin, this makes a fairly good one-year target.
So take 70, subtract your current age, and add one if your birthday is between July and December. For example, if you are 65 with your birthday in August, then you have 5+1 or 6 years until your required beginning date.
If you have a $250,000 traditional IRA balance, then you might benefit from converting $250,000 / 6 or $41,667 this year.
If most of your tax return is due to wages and you know with certainty that you are going to retire with enough time before both age 70 and when you file for Social Security, then you could wait for what we call your “gap years,” the years between retirement and social security when your income is low, to begin converting. However, if your retirement date is uncertain or your income is a small percentage of your tax return, it is normally safer to just convert now.
Older than 70 1/2
If you are older than age 70 1/2, then you have already been introduced to required minimum distributions (RMDs) and are likely either retired or doing a job you love and don’t want to retire from yet.
In these cases, a very good conversion strategy is to convert to the top of your current marginal bracket. This formula is:
Top of Your Top Marginal Income Bracket (You look this up via the tax brackets.)
Your Total Ordinary Income (found on Qualified Dividends and Capital Gains Tax Worksheet Line 7)
Roth Conversion Target
Imagine that in 2018 your top marginal married filing jointly bracket is the 22% bracket. The 22% bracket starts at $77,400 and the top of that bracket is $165,000. If your total ordinary income line 7 is $100,000, then your conversion target would be $165,000 – $100,000 or $65,000.
This strategy tends to smooth your taxable income as it pulls forward the days when you might need to draw down your traditional IRA to support your lifestyle into the Roth conversion while simultaneously protecting the growth in a tax-free account.
As said before, these two strategies are simple but effective. Although there is a “best conversion” and we can do our best to predict which plan it is, even the “worst conversion” plan can save hundreds of thousands or even millions of after-tax value over doing nothing. Don’t delay Roth conversions.
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