For over a decade we have been recommending Roth conversions as a method of maximizing the after-tax net worth of our clients. During part of this time we simply estimated the Roth conversion amounts which we thought ideal as best we could. Our estimates were usually much better than doing nothing, but were not as precise as they 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 estimates 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 these customized Roth conversion target recommendations through 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.
However, 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 four simple but effective strategies to calculate a very good conversion target for this year.
Strategy 1: While You Are Young
If you are in your 20s or 30s, then there is a good chance that you are at the lower end of your earning potential. While you are just starting out in your career is a great time to get your Roth balances going.
By default, we would recommend that you start off contributing everything that you can to the Roth side. This means contributing to your Roth IRA and deferring to the Roth side of your 401(k) or 403(b). That being said, even the most Roth-loving among us likely will accumulate some traditional retirement balances. For example, employer retirement plan matches and employer profit sharing always go in as traditional assets. Also, not all retirement plans have a Roth option.
When you do find that you have a traditional IRA balance, you should consider doing a total Roth conversion. While not all employer plans allow for an in-service rollover or in-plan Roth conversion, if yours does you should consider taking advantage of it.
For example, if your employer contributes $20,000 of profit-sharing and match to your 401(k), then your Roth conversion target for the year would be 100% of the value of those two accounts (approximately $20,000).
Strategy 2: Time Until RMDs
If you are younger than age 72, 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 brokerage account, they will be subject to interest, dividends, and capital gains and will be taxed in this way for the rest of your life.
Instead, 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.
This is done by simply subtracting your current age from 72. For example, if you are 62, then you have 10 years until your required beginning date. If you have a $250,000 traditional IRA balance, then you might benefit from converting $250,000 / 10 or $25,000 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.
Strategy 3: Under Medicare Lines
While each year has a standard Medicare Part B premium cost per month, if your modified adjusted gross income (MAGI) from 2 years ago is above a certain amount, you are faced with an Income Related Monthly Adjustment Amount (IRMAA). This IRMAA is a surcharge you must pay in addition to the standard premium.
If you are currently enrolled in Medicare or you are within two years of age 65 when most people enroll in Medicare, then one conversion strategy is to target just under the next Medicare Surcharge AGI line.
This conversion target can be calculated as follows:
Next MAGI IRMAA Medicare Surcharge Line (You can look this up at Medicare.gov under “Part B Costs.”)
AGI (1040 Line 11)
A safe amount of padding
(If you go $1 over, you get the surcharge costs. For this reason, leave some room before the AGI line to allow your variable income — like dividends, capital gains, or interest — to be higher than you expected.)
Roth Conversion Target
For example, if last year your joint filing AGI was $120,000, you can use the table to look up that the next AGI line begins at $176,000. So the formula is $176,000 – $120,000 – $5,000 of conservative padding = $51,000 which you may benefit from converting this year.
If you are both facing a Medicare surcharge line and are in or close to your retirement, then you may benefit from reading “How to Avoid an IRMAA Medicare Premium Surcharge 2021.”
Strategy 4: Top of Bracket
If you are older than age 72, 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 2021 your top marginal married filing jointly bracket is the 22% bracket. The 22% bracket starts at $81,051 and the top of that bracket is $172,750. If your total ordinary income line 7 is $100,000, then your conversion target would be $172,750 – $100,000 or $72,750.
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 four 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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