Ready For Retirement

Is Your Portfolio Big Enough to Benefit From Roth Conversions?

November 07, 2023 James Conole, CFP® Episode 188
Ready For Retirement
Is Your Portfolio Big Enough to Benefit From Roth Conversions?
Show Notes Transcript Chapter Markers

What are the benefits of Roth conversions in retirement planning? James addresses questions about when Roth conversions become worthwhile.

This episode explores key factors:
Changes in tax bracket
Spousal scenarios
Impact of portfolio size on tax savings

Potential tax savings tend to increase with a higher portfolio balance but be careful not to take unnecessary Roth conversions. James explains different strategies to optimize tax planning.

Questions answered:
Is there a specific portfolio value at which Roth conversions should be considered?
Why might one choose not to do a Roth conversion, and what are the alternatives?

0:00 Intro
3:14 Scenario
6:47 Tax bracket
11:15 Provisional income
14:27 Spousal scenario
16:45 Bottom line
20:29 Outro

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Speaker 1:

One of the most talked about retirement planning points is Roth conversions, and for good reasons, because in some case, a good Roth conversion strategy can save you hundreds of thousands of dollars or even more. But at what point do they become worthwhile? Is there a portfolio value one needs to have before implementing this type of strategy? And, alternatively, is there a portfolio value at which you don't need to worry about this? That, and more, is what we're going to discuss on today's episode of Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Kanol, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode is based upon a listener question, and this question comes from Danny. Danny asks the following. He says I really appreciate all the great information in your podcast and especially that you take feelings into account when giving options. One thing that I have noticed is that you most often give advice to portfolios of between $1 and $2 million. That makes sense because there's a greater tax impact for those people. I am retiring in March and I will receive $65,000 per year from Social Security and Appention. I have two 401ks with a combined value of $400,000, and our mortgage is paid off, so I shouldn't need to tap into them for a few years. I am wondering how some of the usual advice regarding Roth conversions versus the impact of RMDs, required minimum distributions and surviving spouse issues apply with a smaller portfolio. Thanks again for all the information you provide, danny. Well, danny, thank you for that question. I appreciate it and you are right, I think. Typically, at least, when we're talking about tax planning points, I am talking about portfolios that are maybe $1, $2, $3 million or more, not because tax planning is unique to that, but because there is more tax planning opportunity the larger your portfolio is. But, danny, you bring up a really good point. Is there a point, or is there a threshold, at which I need to start being concerned about some of these issues? Here's my portfolio today, my other income sources. So what I'm going to do on today's episode is use Danny's situation, I'm going to make some assumptions about it, and I'm going to use this to show is there any potential benefit to tax planning at the current portfolio value and how might that change at different portfolio values in the future or in other cases. Before I do so, though, I want to highlight the review of the week as saying thank you to all of you who are leaving reviews. This review comes from username jauntijoe from Jersey. I like that jauntijoe from Jersey leaves a five star review and says I have tried literally dozens of retirement podcasts and this was by far the best. The information is succinct, relevant and financially sound, and he makes it so everyone can understand. You don't need to be a CPA to follow the podcast. Thank you so much, james. Well, thank you, jauntijoe, for that review. Really appreciate that, and if you have enjoyed this podcast or received any value from it, would really appreciate you taking a few moments and leaving a review so more people can find the show and get the information they are looking for. So with that, let's jump right into the episode. So, danny, a couple things. One again. Thank you for the question. I'm going to start with what I don't know about your situation and, by the way and this goes for every episode none of this should ever be construed as advice or recommendation. This is really just for educational purposes only, but providing some context within a specific person's situation. So here's what I don't know about Danny's situation, before we start diving into what we do know. I don't know what Danny's desired living expenses are. That's going to be a big part of tax planning. I don't know what amount he's receiving from pension and what amount he's receiving from Social Security. I know that he's receiving $65,000 combined but I don't know what's pension and what Social Security. That's important because they're taxed differently, social Security versus pension. It's also important because Social Security has a cost of living adjustment. The pension may or may not. If it's a government pension, it most likely does have a cost of living adjustment. If it's a private sector pension, it most likely doesn't. Also, social Security has survivorship options. So if Danny predestines his spouse or vice versa, the surviving spouse can collect the higher of the two current benefits With the pension, though I don't know what the survivorship options are, if any. The pension could go away completely if Danny passes away, or it could be a joint life pension. So again, we know $65,000 is coming in, but I don't know what should. That is Social Security and which of that is pension. And these may seem like unimportant differences when we're looking at tax strategy. It might be tempting to look at then say, yeah, that's all important information for maybe a comprehensive plan or an income plan, but we just want to know about the tax stuff. Well, all of these things feed into one another. So these details, yes, have income implications, investment implications, long term retirement implications, but they also have tax implications. So those would be important things to know. I'm assuming that Danny is married. He didn't come out and say it, but he referred to our mortgage and he referenced what are the issues for survival, driving spouse with this. So I'm going to make the assumption that Danny is married. I don't know his age. So I know he's eligible for Social Security, but I don't know his exact age. I don't know if charitable giving is something that he does. Again, may seem irrelevant, but when we're looking at things like Roth conversions, it very much is relevant, and I'll show you why in just a bit. And I don't know what state he's in. So, again, when we're looking at Roth conversions, it's a tax plan, but there's the federal tax issues and then there's a state tax issues and every state is different. So these are just some pieces of information. I don't know, and I just highlight this because, as we go through this, I do not want to give the impression that this is advice or that this is going to be universal information, because any number of those things I just listed could potentially change this. So with that context, here's the assumptions I'm going to make, just so we can kind of have clean, tidy numbers to work with. Of the $65,000 per year that's coming in, I'm going to assume that $48,000 per year of that is combined social security. So I'm going to say $2,000 for Danny and $2,000 for a spouse I don't know if maybe a spouse's social security was on top of the $65,000, but I'm just going to make the assumption that it's included. So I'm assuming $2,000 per month for each of them for social security, which is $48,000 per year, and I'm going to assume that Danny's pension is $17,000 per year. So combined that comes out to $65,000, and then he has $400,000 combined in 401K plans. The question should he do Roth conversions? He said, james, I know you talk about this, you talk about this quite a bit, but typically the portfolios are maybe a million dollars or $2 million. I see the case for Roth conversions. There there's more tax implications. But with my situation here's my pension, here's social security, here's 401K would that be worthwhile for me? So let's explore that. The first thing that we want to know if we're going to do a Roth conversion, we want to ideally know that the tax bracket we're going to pay today for any potential conversion is lower than the tax bracket we'd be in in the future. So pretty self-explanatory If you're going to be in a higher tax bracket today, let's not do a Roth conversion and add to our tax bill. Let's only do it if we can do so and pay less in taxes today than we otherwise would in the future. Now I'm going to make another assumption that there's no other income, no interest income, no dividend income. No, any other income outside of Danny's pension and social security. Yes, he has a 401K and if you were to pull money out of the 401K, that would be taxable income. But he referenced in his question that he's not going to need to tap into that for some time. So here's why that matters. If there is zero other income and if we assume a $17,000 per year pension, it's fully taxable $48,000 of combined social security and I'm assuming a standard deduction of $30,700. If Danny and his spouse were both 65 or older, they would actually get an extra standard deduction above and beyond that. But even with just these numbers and this is important Danny is in the 0% tax bracket once he retires. Again, this is just looking at federal taxes, because I don't know what state he's in, but you might be asking how on earth could he be in the 0% tax bracket? He's got $65,000 of income. Even once you back out the standard deduction, there's still some taxable income left. Well, here's why that's the case. I'm assuming the $17,000 of pension income is fully taxable, which it almost certainly is, unless it's some type of a military or VA pension and there's a VA disability of some sort probably fully taxable pension. But here's the thing with social security. With social security, there's something called provisional income. When you want to know how much of your social security is included in your taxable income, you need to understand your provisional income. I've talked about this on other podcasts. I'm not going to go too into it today, other than to say that his provisional income is such that only 4,500 per year of their combined social security benefit would actually be included in their total income. Yes, they have $48,000 of social security benefits, but the taxable part is only 4,500. You add that 4,500, the $17,000 of pension income, their adjusted gross income is 21,500. Now, as a married couple, their standard deduction is $30,700. It's even higher if they're 65 or older. What do you get there? Well, if you have an adjusted gross income of 21,500 but deductions of 30,700, your taxable income is zero. In Danny's case and again I want to be very clear I'm assuming zero interest income, zero outside income. I'm making the assumption that the $65,000 that Danny gave me is including a spouse's social security and that that's not additional. I'm taking some liberties here because they're not explicitly provided in the question, but what we can see here is look, danny, you're in the 0% tax bracket. You could convert for free a certain part of your 401k into a Roth IRA, at least at the federal level, before we even look at state taxes. Now, I don't care what tax bracket you're going to be in the future. If you can convert funds at a 0% rate today. It makes sense to convert funds at a 0% rate today. One thing you have to be mindful of, though, when we go back to this tax analysis that we did, where we said look, of the $48,000 in social security benefits, a very small amount $4,500 of it, to be precise is actually included as taxable income. Well, as you're looking at conversions, you have to look at a couple things. Number one. Every dollar that you convert increases your adjusted gross income by $1, but it also brings in another portion of your social security benefit into your taxable income. This is what's called the tax torpedo. The social security tax torpedo is not only does the extra conversion amount increase your adjusted gross income by itself, but it's also pulling with it more and more of your social security benefit that now becomes taxable. So still absolutely makes sense to do in a lot of cases, but something that most people miss and something that's important to be mindful of. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment tax, legal or other financial advice. It is for informational purposes only. Another thing that you want to make sure that you're noting at least for people who are in situations here like Danny, where a big part of their social security benefit maybe isn't taxed today is that when we're looking at that that provisional income, as I mentioned and provisional income is what determines how much of your social security benefit is included in your taxable income the income bans or the income thresholds for provisional income are not indexed for inflation. Practically speaking, what that means is every year, all else being equal, more and more of your social security is now included in your taxable income. Why does that matter? Well, if you're in a situation like Danny at least under the assumptions that I'm making here your tax bill is probably going to be going up over time because more and more of your social security benefit is going to be added to your taxable income, which is going to push you out of the 0% tax bracket at some point. Now you could still be in a very low tax bracket, at least relatively speaking, but that's something to be mindful of. Of that benefit, of not having your full social security benefit taxed, isn't going to last forever. And this goes back to what I was saying before. Should you do a Roth conversion? Well, it does have to do with how much you have in your IRA balance or 401k balance, which I'll get to in a second. But the biggest thing is what's your tax bracket today, or at least in the year that you're considering a conversion, versus what's your tax bracket in the future? Well, what's Danny's tax bracket going to be in the future? Well, things could change in the tax world. But let's just look at what we do know. I'm going to assume that he's 65 years old today and I'm going to assume, with that being the case, that his required distribution starts at age 73. Well, we know that right now Danny has $400,000 in retirement accounts and we know that right now he doesn't really need to touch them to meet his living expenses. Social security and pension will do that. Well, if we assume that that $400,000 grows at, say, an average return of 6% over the next handful of years until required distribution start, then his $400,000 will turn to $640,000 by the time that he's 73. His required minimum distribution on a portfolio of $640,000 would start right around $25,000 per year. What does that mean? What means in the future, at age 73,? Now his taxable income isn't just pension plus social security, it's now pension plus social security plus required distribution of, call it, $25,000 per year. Now, that's not going to bump him into a huge tax bracket, but what it will do is most likely put him in a higher tax bracket than he's in today. So, danny, to go back to even the premise of your question of hey, I know Roth conversions work for the million dollar portfolios plus. What about for mine, well, it's less a portfolio size, although portfolio size absolutely plays a role in this. But what I would look at is are you in a higher tax bracket in the future when you do have those required distributions, or today? It's likely, with the assumptions I'm making I'm not going to say these assumptions are all accurate, because I'm just making assumptions. As I mentioned, I'm making some of these up it would make some sense to at least consider doing Roth conversions. To what extent depends upon a whole bunch of different things. I'd want to have a lot more information, but I would very much still consider this in someone's situation like Danny is describing. Let's now take this one step further Danny alluded to in his question. He said well, what about the impact of, say, one spouse predestined the other? How do Roth conversions play into that type of a decision making process? Well, let's examine that. Let's assume that of the 48,000 that I'm assuming they have coming in from Social Security, so 2000 per month each or 24,000 per year each. Let's just assume that one of them passes away and after that the Social Security benefit drops to $24,000 per year. So it goes from 48 to 24. And let's assume that the pension has a survivorship option so that pension stays at exactly $17,000 per year. Well before, when they were married, because of a combined standard deduction, they were in the 0% federal tax bracket and there's really not technically, a 0% federal tax bracket. Being in the 0% bracket, the way I'm saying it, is just the understanding that whatever income they have is completely offset by their deduction. So technically they're in a 0% bracket even though that bracket doesn't exist. So when we're looking at this, daniel will go from a 0% tax bracket today if married to, if one of them passes away and social security drops to $24,000 per year and pension stays at $17,000 per year. Now the surviving spouse is at the top of the 10% bracket and very soon to cross over into the 12% federal tax bracket. All that because now there's fewer deductions. They can't take the same standard deduction. That gets cut in half. Also, provisional income, slightly different brackets around that. So when you're looking at this, that is something that you very much need to keep in mind Not just what tax bracket am I in today versus what tax bracket am I in in the future, but what would be the tax hit and the impact to the surviving spouse if one of us pre-deceased the other. What you can see is, right away, it would push the surviving spouse and Danny situation into a higher bracket. So relatively low tax bracket, all things considered, still in the 10% to 12% rate. But if you're doing Roth conversions with the goal of protecting a surviving spouse and you're in a 0% tax bracket today, absolutely take advantage of the 0% rates. But also consider how high do we want to go under the 12% bracket or 10% bracket or whatever the case might be for your specific situation. So here's the bottom line for Danny Danny, in your situation, you probably won't ever being a significantly higher tax bracket. It's not as if you're going to go from the 0% bracket into the 35% bracket because of RMDs or anything like that. This is barring anything exceptional huge inheritance, huge windfall, huge something or other. So in your situation, there's not going to be a huge impact to tax brackets. But, that being said, the right tax strategy could still save thousands or even tens of thousands of dollars in taxes over the course of your lifetime. Now, that is pretty significant, regardless of your portfolio balance. So the general principle that I add on top of this is yes, the higher your IRA balance, the more impactful the right tax strategy becomes and we can see that real. Simply, we talked about Danny's RMD maybe being around $25,000 by the time he turned 73, under the assumptions that I made. Well, if, instead of having $400,000 in his portfolio, he had $4 million in his retirement portfolio Now, specifically, I'm seeing retirement portfolio, so IRA, 401k, things that are subject to required distributions Well now, instead of his RMD starting at $25,000 per year, it would start at $250,000 per year and increasing. So you can see the dramatic impact that would have on both his income and his tax bracket in the future if we use a significantly larger portfolio. So in those cases, the larger your portfolio balance is, the likelihood is that you're going to have a more of potential tax savings through having a good tax strategy in place. But I wouldn't say there's a point at which you should never consider Roth conversions. You should always consider it. It doesn't hurt to run the numbers. It doesn't hurt to have an analysis to see can it save you money, but keep this in mind. This is what I'm always looking at when I'm looking at tax returns and tax plan for clients. Is there a good reason not to do it? It's always the lens I'm looking through, because Roth conversions cost you money. You're having to pay taxes today that you otherwise wouldn't have paid for several years. In many cases that's not necessarily pleasant, but it can save you a lot of money in the right circumstances. You know, for example, a reason that you might not do it. I mentioned before some things I don't know about Danny in his situation is was charitable giving part of something that he does? If it is well, then maybe you just use a qualified charitable distribution to minimize the impact of Roth conversions. Talked about that in recent episodes of ways to lower your required minimum distribution or certain tax planning opportunities. So the qualified charitable distribution you just give funds directly to the charity from your IRA so you never have to have that money touch your bank account and become taxable to you. So this is just one little example of that, that lens that you want to look through. Is there any good reason not to do a Roth conversion? They're gonna cost you money. So let's not do a Roth conversion unnecessarily. If there are other things that we can look to do that will help to minimize the impact of Any potential required distribution or the tax impact on the surviving spouse if one predecessors the other. But, going back to this, everyone should consider it in my opinion. But the magnitude of potential savings from a good Roth conversion and really just a good overall tax planning strategy Really starts to increase the more your portfolio balance increases over time. So, no, there's not an actual number of, is it 250,000 verse 500,000 versus a million dollars in your portfolio. It's not a specific number, but that does tend to correlate. That portfolio balance number does tend to correlate the higher it goes, the higher your potential tax savings goes. So, danny, thank you for that question. I think this is a good thing to explore for a lot of people, regardless of the portfolio balance. I appreciate all of you tuning in. Please, again is reminded, leave a review for the show if you have not done so already. Also be sure to check us out on YouTube. The channel name is James Kanol. You can find this episode and other videos all around retirement planning there. Thanks for listening and I'll see you next time. Thank you for listening to another episode of the ready for retirement podcast. If you want to see how root financial can help you implement the techniques I discussed this podcast, then go to root financial partners calm clicks. Start here, where you can schedule a call the one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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