One of the biggest conundrums regarding Roth IRA’s that I run into is either: “should I have money in a traditional IRA or Roth?” -- or “perhaps I shouldn’t use them altogether?”
As a matter of fact, we’ve actually explored this before.
Check out this article where I made a confession.
Certainly that confession applies to a certain group of folks.
For many millionaire savers, they are currently in a super high tax bracket and they want that tax deduction NOW. They are maxing out their 401ks with pre-tax dollars, or maybe they are even socking away $19k or $25k a year and getting a tax deduction for it today.
On top of those deductions, they are saving more and more money each month and every year, and in turn they want to find other places to stash it away.
That’s a wonderful place for the Roth IRA. However, the government puts limitations on it.
However, there are fortunately some super sneaky ways to get around typical income limitations around Roth IRAs.
This leads us to…
The Problem Retirees Run Into
By the time one hits retirement, there is now this huge imbalance in the types of accounts that they have. This is pretty typical in what I see with many clients.
Let’s say that we have John and Jane Doe. They have just retired at the age of 60 with $2.7 million in assets and have living expenses of $80,000 per year.
John Doe-- $ 1,000,000 in pretax 401k
Jane Doe-- $1,000,000 in pretax 401k
John Doe- $100,000 in Roth IRA
Jane Doe- $100,000 in Roth IRA
John and Jane Doe- $500,000 in non-qualified joint account
Total Assets= $2,700,000
Which means that they have $2 million out of $2.7 million in pre-tax accounts. That’s nearly 75%!
In this example, possibly 3 out of every 4 dollars could get taxed in the future if they withdraw money on a pro-rata basis from each account.
One could make the argument that you can have TOO much money in traditional IRAs/401ks.
You see- eventually the government is going to try to get their hands on all that lovely tax-deferred money you’ve been socking away.
This becomes a bigger and bigger problem with compounding growth where now the government requires you to take out a higher and higher percentage every year after you turn 72.
The Possible Solution for Retirees
This is where Roth conversions come into play.
You might be wondering - what is a Roth conversion?
This is where you purposely take money out of traditional pre-tax IRA and then IMMEDIATELY convert it to the Roth IRA.
For someone who is 60 years and isn’t currently taking Medicare, we don’t have to worry about IRMA and income brackets and cliffs and hidden taxes.
For example, if we look at the 2021 tax brackets for a couple who is married filing jointly:
Married filing jointly and surviving spouses | ||||
0 to 19,900 | 0 | + | 10.0 | 0 |
19,901 to 81,050 | 1,990.00 | + | 12.0 | 19,900.00 |
81,051 to 172,750 | 9,328.00 | + | 22.0 | 81,050.00 |
172,751 to 329,850 | 29,502.00 | + | 24.0 | 172,750.00 |
329,851 to 418,850 | 67,206.00 | + | 32.0 | 329,850.00 |
418,851 to 628,300 | 95,686.00 | + | 35.0 | 418,850.00 |
Over 628,300 | 168,993.50 | + | 37.0 | 628,300.00 |
Remember, with a standard deduction, the first $25,100 of your federal income ISN’T taxed. (This could potentially be even higher if you itemize your deductions)
So, if you have $60,000 of potentially taxable income (maybe from pensions or even drawing a nominal amount from your pre-tax IRAs), you are only going to get taxed on $34,900 because of the standard deduction.
Of that $34,900 that you are getting taxes on, you are getting taxed at 10% of the first $19,900 and then 12% on the next $14,999.
You could utilize ALL of that 12% bracket by converting $46,150 (81,050-19,900-14,999) to a Roth IRA.
Now, instead of having only $200,000 in Roth IRA, John and Jane Doe have $246,150 (assuming no growth).
Also, instead of having $2 million in pre-tax 401k, now they have $1.953 million.
What if they do that again and again and again, ever year in their early 60s?
If they do that again when they are 61, 62, 63, and 64, now they have an additional $230,750 in their Roth IRAs for a total of $430,750--- MORE than doubling what they started out with. ALL assuming no growth.
On top of that, their pre-tax IRA and/or 401ks are now $1,769,260. They’ve decreased the amount there from just about 75% to only 65% of their assets.
This will help them lower their future RMDs and ensure that they could take out more tax-FREE money from their Roth IRAs if they wished to do so.
You can imagine with keeping an eye on the IRMA cliffs, they could do this again and again during ages 65 to 71 to further lower and lower that burden before they ever are forced to take money out by the government.
Final Thoughts
Converting pre-tax 401k/IRA dollars to Roth IRAs can be VERY powerful.
I will say to you- if you’ve made it this far, you’ve already won! If you have a few million in assets, you’ve done a wonderful job of saving.
If you haven’t gotten there yet, I hope this inspires you to save more and more and utilize Roth when it makes sense.
The tweak of using tactics of the Roth conversion could help you pro-long your assets and possibly avoid or at least reduce onerous future taxes.
The next question becomes--- when is an optimal timing to do a Roth conversion?
We’ll talk more about this in our next article in this 3 part series.
Have questions?
Call me at (612) 284-2409 or e-mail me at dave@daviddenniston.com