Sammy, a 51-year-old retiree, is seeking advice on how much she should convert from her traditional IRA to a Roth IRA each year to avoid jumping tax brackets and minimize the taxation of her social security benefits.
James analyzes Sammy's current financial situation and offers guidance on approaching the tax planning aspect of her retirement strategy.
Learn:
How to determine how much to convert from an IRA to a Roth IRA
Why forward-looking tax planning is essential
The potential consequences of certain financial decisions
Questions Answered:
What factors should you consider in planning Roth conversions?
How can you avoid going into a higher tax bracket?
Timestamps:
0:00 - Sammy’s Roth conversion question
2:29 - The Roth/tax rules today
4:58 - Tax on different types of income
7:24 - Some assumptions
10:19 - Figuring tax and making assessments
12:28 - RMD part 1
15:33 - RMD part 2
17:25 - Caution about tax bracket assumptions
21:58 - Important side note
23:45 - Takeaways
Create Your Custom Strategy ⬇️
Sammy, a 51-year-old retiree, is seeking advice on how much she should convert from her traditional IRA to a Roth IRA each year to avoid jumping tax brackets and minimize the taxation of her social security benefits.
James analyzes Sammy's current financial situation and offers guidance on approaching the tax planning aspect of her retirement strategy.
Learn:
How to determine how much to convert from an IRA to a Roth IRA
Why forward-looking tax planning is essential
The potential consequences of certain financial decisions
Questions Answered:
What factors should you consider in planning Roth conversions?
How can you avoid going into a higher tax bracket?
Timestamps:
0:00 - Sammy’s Roth conversion question
2:29 - The Roth/tax rules today
4:58 - Tax on different types of income
7:24 - Some assumptions
10:19 - Figuring tax and making assessments
12:28 - RMD part 1
15:33 - RMD part 2
17:25 - Caution about tax bracket assumptions
21:58 - Important side note
23:45 - Takeaways
Create Your Custom Strategy ⬇️
In today's episode of Ready for Retirement, we're going to be breaking down Sammy's financial plan. Sammy's done well. She's 51 years old and she's already been retired for four years, after saving up a good amount of money in her portfolio. Her challenge, though, is determining how much she should convert from her IRA to her Roth IRA so that she doesn't run into any major tax bills in the future. I'll walk you through how to think about using Sammy's situation as an example, so you can identify areas in your own plan where you might be able to save significant amount of money on taxes. And it's all coming up next, on today's episode of Ready for Retirement.
Speaker 1: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. So let's jump into Sammy's question. And Sammy just right off the bat apologies, I'm saying her, so I'm not sure female or male, but I'm going to be saying her, and my apologies if I'm incorrect in that Sammy says Hi, james, I'm a subscriber to your YouTube channel and I find your videos extremely helpful.
Speaker 1:I am single and I will be 51 years old in early 2024 and I've been retired since I was 47. I am trying to figure out how much I should be converting each year through a Roth conversion to avoid jumping tax brackets and possibly avoid getting my social security heavily taxed. For this I would like to assume a 10% rate to return on investments, since I have an aggressive investment portfolio, and that the tax rates remain the same in the future. I do not have any earned income, only capital gains I have. And then she lists her assets $1,115,000 in a traditional IRA, $322,000 in a Roth IRA, $1,250,000 in investments outside my retirement accounts, $400,000 cash, which I will rebalance soon with my non retirement investments for an 80-20 split, and then, finally, a home that is paid outright. I plan to start taking social security when I am 67 years old, receiving just over $3,000 per month. I've been converting about $50,000 per year, but I think I need to be converting closer to $100,000 per year or more. I'm also not sure if I need to be converting until social security kicks in or until RMDs start.
Speaker 1:Thanks for all your help. I hope this makes it into one of your videos regards Sammy. Well, sammy, it's making it into one of the podcast videos. So thank you for that question, and I'm going to start with this. Sammy says I'm trying to figure out how much I should be converting each year through Roth conversion to avoid jumping tax brackets and possibly avoid getting my social security heavily taxed. So there's two components to what she is saying here. Number one is jumping tax brackets, which is definitely a concern, so potential future tax liability when required distributions kick in, maybe pushing Sammy into a higher tax bracket. And number two, the second concern, avoid getting social security heavily taxed.
Speaker 1:As the rules stand today, you'll never have more than 85% of your social security benefit taxed. On top of that, if you are single, the way that social security taxation works, the social security looks at what's called your provisional income. If your provisional income is under $25,000 and you're single, it means that none of your social security is included in your taxable income. If you are single and your provisional income is over $34,000, then 85% of your social security benefit is included in your taxable income. Here's the thing, though provisional income is not indexed to inflation. So, sammy, you're 51 years old today. You're 11 years out from even being eligible for social security. Social security is going to receive a bunch of cost of living adjustments between now and then, you're going to have dividends, interest, ira distributions. I'm not going to get into the complexities of this, but the bottom line is there's almost zero chance your provisional income will be under $25,000, meaning your social security wouldn't be taxed in that case, almost certainly you're going to have the full 85% of your social security benefit included in your taxable income.
Speaker 1:Of other episodes where I talk about provisional income and what that means, the bottom line for you, sammy, in this case, is this is one of those things sometimes financial planning is about understanding what should we focus on and what shouldn't we focus on. This is one of those things I would not spend any more effort even focusing on is trying to reduce how much of your social security is taxed, because there's almost no way that that's going to be a thing for you. So, that being said, the other part of your question of how do I avoid going into higher tax brackets, how do we avoid jumping tax brackets that is where I would put a lot of time and energy and focus, with your financial planning, into solving that. So what we're going to do today is I'm going, to the best of my ability, read off a framework of numbers to you and try to do it in a simple enough way to where it's understandable, where it's digestible. The absolute best solution is to model this out in financial planning and tax plan software. If you haven't done that yet, go find an application online. Do it with your financial advisor. It's going to be far, far more effective than the numbers I'm going to be going over today, just because, as I'm talking these numbers to you, it's much more difficult to get into the nuances and some of the intricacies of planning. But I'm going to try to simplify these things down and walk you through what you should be focusing on. But the bottom line, try to run actual projections if you can.
Speaker 1:At the end of the day, though, what this comes down to, when we're modeling out, should we do a Roth conversion or not? What we're asking ourselves is when do we want to pay taxes on our IRA distributions? Do we want to pay them today, at today's tax rates, or do we want to pay them in the future, at future tax rates? And in the future, there comes a point when we're going to be forced to start taking income out of our IRAs, and the real question is what's that going to do to our tax picture Once we're not just taking money out because we want to, but we're now required to start taking distributions from our IRAs. Here's one of the many places this is going to get complicated, sammy, as we walk through this for you.
Speaker 1:Today you're living on capital gains and some interest in cash, and those are taxed at various different rates. In the future, you'll be living on capital gains, interest, social security, ira distributions from RMDs and Roth IRAs. So what we're looking at is different income types that are all taxed differently. When we're comparing today's income versus future income, all of these are taxed differently. So, for example, capital gains assuming it's a long-term capital gain is going to be taxed at, at least in today's rates either 0%, 15% or 20%. Interest will interest on cash or interest on bonds. That's taxed ordinary income. Social security is taxed ordinary income, but anywhere between 0% to 85% of it is included in your taxable income. That's 0% to 85% of your actual social security benefit, based upon what's called your provisional income, which is what I just mentioned. On top of that, every state, or many different states, tax social security differently, so it might depend based upon where you live.
Speaker 1:Cash Cash, of course is tax-free. If you're living on cash, then what you're pulling out, you've already paid taxes on it, so that's tax-free, with the exception of any interest that you're earning, and that interest is taxed at ordinary income rates. Then you have your IRA, and your IRA is taxed at ordinary income rates, like earned income is. And then, finally, you have your Roth IRA, which is tax-free. One of the difficulties of going through this without financial playing software is well, depending on where you're taking income from. Is it cash? Is it Roth IRAs? Is it traditional IRAs? Is it social security? Is it dividends? Is it interest? Your tax picture is going to look wildly different based upon how much of your income comes from various different sources.
Speaker 1:Because of that, what I'm going to do is I'm going to make some pretty significant assumptions. I'm going to take some liberties here of assuming where might you be today and where might you be in the future, so we can start to illustrate what are the most important things to focus on, sammy, for you as well as for everyone else who's listening to this, asking yourself the same question. Here's the assumptions I'm going to make. I'm going to assume, sammy, that you're earning $10,000 in interest on your cash. You have $400,000 in cash today. I know you mentioned you might invest some of that maybe some of its earning interest today in a high-yield savings account. For simplicity, I'm just going to assume that that generates $10,000 per year of interest.
Speaker 1:Sammy also mentioned that she has non-qualified investments, a non-retirement account investments. There's $1,250,000 there. Depending on how that's broken down into cash, bonds and stocks, you get a totally different makeup of interest and dividends. I'm going to assume $12,000 per year in interest there and I'm going to assume $20,000 per year of qualified dividends. If you have qualified dividends, those are taxes same at long-term capital gains.
Speaker 1:I'm going to assume, sammy, that you're not realizing any of your capital gains. Just to keep it simple, you're not paying taxes on long-term capital gains until you actually sell the investment that has them. So just to keep it simple, I'm going to assume you're not realizing any of those. In addition, even if you did realize some long-term capital gains, they would be taxed at long-term capital gain rates which are taxed on an entirely different schedule than ordinary income is. So it wouldn't really impact how much you convert to Roth.
Speaker 1:Most likely, I'm also going to assume that you continue to convert $50,000 per year from your IRA to your Roth IRA and then your Roth. Of course, you're not paying any taxes on that one because you're not pulling anything out, and number two because even if you did pull anything out, it wouldn't be taxable. It's fully tax-free. So I'm assuming that, and I'm also assuming, say, that you are taking your standard deduction, which for 2024, if you are single is $14,600. So here's what this looks like if we add up all those different income sources $22,000 total in interest from cash and bonds, $50,000 of ordinary income from Roth conversions, so moving money from Sammy's IRA to her Roth IRA $20,000 of qualified dividends, which is going to be taxed at long-term capital gain rates, which means that's $92,000 total adjusted gross income. $72,000 of that is subject to ordinary income taxes. That's cash and bond interest, plus the Roth conversion that's taxed at ordinary income rates. $20,000 from the qualified dividends. That's taxed at long-term capital gain rates. So it's a $72,000 I'm going to focus on right now that is taxed at ordinary income rates.
Speaker 1:Big disclaimer here I know these are just assumptions. None of you are going to have these exact numbers, and this is why I recommend you consult with your financial advisor, your tax planner, do something that's a lot more in depth than what I'm actually talking about here. If your financial advisor doesn't do any tax planning, they're probably not worth what you're paying them. So find a financial advisor that does, or tax repair that does, because this should be a pretty critical component of most people's long term financial planning. But anyways, I'm using these overly simplified numbers to illustrate this. Talk to your financial advisor to make sure that you're doing the numbers in the right way, based on your specific situation.
Speaker 1:So if we go back to those numbers, $72,000 of Sammy's income that I'm making up here is subject to ordinary income rates. We then subtract the standard deduction, which is $14,600. Taxable income is what's left over. So in this example, sammy's taxable income would be $57,400. And that's what's now taxed at the different ordinary income rates. Well, if you're single in 2024, the first $11,600 of taxable income is taxed at the 10% federal tax bracket. The next amounts between $11,647,150 are taxed at the 12% federal tax bracket and the next amounts between $47,150 and $100,525 are taxed at the 22% federal tax bracket. So as we look at Sammy's taxable income of $57,400, that's subject to ordinary income taxes. Sammy has filled up the 10% bracket, she's filled up the 12% bracket and she's now partway between the 12% and the 22% bracket. So the next dollars that she's earning she's paying 22% federal taxes on, not taking into account state income taxes, because I don't know where she lives. But again, going back to your personal planning, when you're doing this on your own, make sure that you're also considering state income taxes. So that's where she is today.
Speaker 1:We have a general sense of okay, sammy, if you're converting $50,000 per year from your IRA to your Roth IRA, you're probably filling up the 10 and 12% tax brackets, and you're partway through the 22% bracket. Now what we need to do, though, is recognize it's not enough to know where we are today. It's all relative. We want to know is that higher or lower than where we expect to be in the future? If that's higher than where we expect to be in the future, then my guidance is probably Sammy back off on some of his Roth conversions. Don't pay taxes on conversions at a higher rate today if you're going to be a lowered tax bracket in the future. On the flip side, if Sammy's in a lower tax bracket today than she's likely to be in the future, then the opposite would be true. Can we convert more from IRAs to Roth IRAs to avoid being forced to distribute those assets at a higher tax bracket in the future.
Speaker 1:What we're really concerned about in the future isn't so much Sammy's spending, because Sammy has a good amount of money and non-retirement accounts in a Roth IRA and cash and she'll have future social security probably enough if I'm just taking a wild guess here to support her actual income needs. It's not that we're concerned about Sammy's spending going up like crazy and that triggering a jump in her tax bracket. What we're really concerned about is the tax impact required minimum distributions. That's when Sammy's going to be forced to start taking distributions out of her IRAs. There will be a lot of things that happen between now and age 75, which is when Sammy's RMDs will start.
Speaker 1:I'm going to take some pretty gross liberties here with these calculations that any good financial planner out there would be quite upset by. But I'm not doing this to provide specific guidance to Sammy. This should never be construed as a recommendation. As much as I'm trying to illustrate the concept, I'm going to keep repeating that, just to make sure that you know. Be on a shadow of a doubt, this is not the best way to approach this. Use software model this out in a more precise way, but I'm going to simplify this in a way to illustrate where are those variables? Where do those variables exist that we need to spend time focusing on?
Speaker 1:But the biggest unknown right now is what will those required distributions be when Sammy turns 75? Are they going to push her into a much higher tax bracket? Will they keep her in the same current tax bracket that she's already in? Will she somehow be in a lower bracket at that time? That's what we need to start making some estimates for, so we can start to see what we're in today, which we just looked at, but how does that compare to the tax brackets we expect to be in the future? So what we need to do to start is calculate at least an estimate.
Speaker 1:Calculate what Sammy's IRA balance will be at age 75, because your required distribution is a factor or percentage of how much you have in your IRA. Using this example, I would make up some rate of return 6%, 8%, 10%, whatever it might be. Sammy gave me the rate of return, though she said that's assumed 10%. She said I'm invested pretty aggressively the market, long terms return, 10%. This is, of course, no guarantee it will do the same, but I'm just going to use Sammy's recommendation or what Sammy's projecting here to illustrate this out of.
Speaker 1:If we take Sammy's IRA today, which is $1,115,000. If we assume that we're taking $50,000 per year out of that via Roth conversion so not a distribution, we're just moving $50,000 from the IRA to the Roth IRA and if we assume that the remaining balance grows at 10% per year on average, and if we do that for 24 years, so between Sammy's age 51 and Sammy's age 75, the question is, what might we expect to have in our IRA at that time? Well, I ran the numbers and the numbers are about $6.5 million, so $1,115,000, even as you're taking money out for Roth conversions. If you're getting $100,000, or, I'm sorry, if you're getting 10% per year growth, that will grow to about $6.5 million by the time that Sammy reaches age 75. Now that's part one in determining how much will Sammy's RMDB.
Speaker 1:The second part is understanding how much will the IRS now force Sammy to take out of her IRA based on her age. Well, it depends, and every year it goes up. But your first year of required distributions is just under 4% that you're forced to take out. So I'm just going to use 4% as a nice round number here. If Sammy has $6.5 million in her IRA at age 75, and if she has to take out 4% to use simple math with RMD, her first year required distribution might be around $260,000.
Speaker 1:Now, before I go further, this is where I want to emphasize again that it's a little absurd to try to do this with rough numbers outside of financial planning software because there are so many variables. So I'm not even considering here and in fact halfway through outlining this episode I almost just disregarded it and trashed it and moved on, because it's difficult to convey the amount of variables that go into this in a real simple outline. So I'm just showing this here. But again, this is overly simplified and I'd advise you to do this with a financial advisor or a tax planner or some retirement planning calculator that's going to take into account all the different variables that are needed. So, going back to that, sammy has required distribution of $260,000, that first year of required distributions at age 75.
Speaker 1:If you look at today's tax brackets and you say, okay, sammy's got to take $260,000. But at that time she would also have $36,000 per year in social security based upon the information she provided. She would also have interest, she would also have dividends, she would also have other income sources. You start to add all that up and what you see or what you think you see is Sammy really quickly gets pushed into the top tax bracket or the second top tax bracket, at today's income levels. Or if we use today's tax brackets, she would quickly get pushed up into the 35% tax bracket, which is the second highest tax bracket that we have today at the federal level. But in this is an area that people get tripped up on sometimes. That's assuming tax brackets stay fixed at today's level.
Speaker 1:And when I say fix at today's level, I don't mean the 10% to 12% to 22% to 25%, I mean even the dollar amounts that it takes to get into the 10% bracket or to get into the 12% bracket or to get into the 22% bracket. Those dollar amounts go up with inflation each year. So hypothetically we could have the same exact tax structure of still 10, 12, 22, 25 and beyond, but the brackets or the dollar amounts required to push yourself into each of those elevates each year with inflation. So to disregard the impact of inflation on this is to significantly overestimate the tax bracket that Sammy will be in, because we're showing a higher portfolio value but still using today's tax brackets, which is just not realistic as we're doing these projections.
Speaker 1:Here's one simple way of looking at it Today. And so in 2024, if you're single the 24% tax bracket goes up to $191,950 of tax full income. So once you exceed that, you cross out of the 24% tax bracket. So that's a top of the 24% bracket today. What, what if we apply a 3% inflation rate to that number over the next 24 years, so from Sammy's age 51 to Sammy's age 75. Well, at that rate, we keep the same tax structure as today, but $390,000 would be the equivalent of $191,950 in today's dollars.
Speaker 1:So why do I say that? Well, I say that because an initial analysis says oh my gosh, sammy, you might be in a 35% tax bracket If we project out what your required distribution will be if we add on social security and dividends and interest, etc. Well, that's true if we take future numbers, 24 years out and slap them onto today's tax brackets. What we should be doing instead, even in a simplistic manner, is saying well, we need to inflate today's tax brackets by 3% per year to see what would that actually land her in? Well, based upon the numbers that we just ran, sammy's actually projected to be in about the 24% tax bracket at age 75, not the 35% tax bracket like we initially projected.
Speaker 1:So here's the implications of this. If you do this wrong, if you just look at this and say, oh my gosh, 35% tax bracket in the future because of projected income at that time, that would lead you to believe you should convert your IRA all the way up to the 32% tax bracket today, so one step below the 35% bracket. And you do that because you would say, okay, I'd rather pay 32% taxes today than pay 35% taxes in the future. So you want to again try to shift income, you want to realize income in the years that you're in lower tax brackets. Well, if you ended up doing that, if you ended up converting all the way to the 32% tax bracket, she would be hurting herself because she'd be converting all this money and then she would come to find that she's actually a lower tax bracket in the future than she actually thought she would be in. So for Sammy's case today, just to look at it again and compare where she is and where she might be today, she's partly through the 22% tax bracket If tax brackets stay the same, if she gets 10% growth on her investments, if we use all the assumptions that Sammy provided she'd probably be in about the 24% tax bracket, at least that first year of required distributions kicking in.
Speaker 1:One thing I would add on to this is Sammy said well, let's just use current tax brackets like we have today, which isn't a bad idea, because who knows where tax brackets are actually going to be in the future? You don't know what's going to happen in the next 10 years, 20 years, 30 years so you can use today at least as a benchmark for comparison purposes in the future. What we do know, though, is that actual current tax brackets are only current through the end of 2025, at which point they sunset and go back to tax brackets like they were in 2017. What we know is the current 24% tax bracket that we're projecting Sammy will be in in the future, using a very simplified analysis that 24% is scheduled to revert to a 28% tax bracket in 2026, once current brackets expire. What does that mean? Well, what that means is we're comparing. Does Sammy pay 22% today taxes to avoid 28% taxes in the future?
Speaker 1:There's a fairly significant margin of taxes that Sammy might save in doing that, but I'm going to say this again start with running a more detailed analysis with Sammy's actual numbers, with maybe some more nuanced assumptions in this to get to what actually makes more sense. So, as we're using simplified numbers, sammy, your question is correct is I've done well. I've retired, I have these assets. My concern is am I going to get killed in taxes in the future? We have no idea what tax rates are going to do in the future. A lot of this depends on how much does your IRA actually grow in the future, because the larger it grows, the more your required distribution is going to be. But even a simplistic analysis, as we're looking at it, says yeah, there's a good chance you'll be in a higher tax bracket in the future than you are today. That being said, run a more specific analysis to make sure you're getting accurate numbers, because the more accurate that picture, the better decisions you can make with that data in terms of how much you should actually convert from your IRA to your Roth.
Speaker 1:Now just a side note and this side note is relevant for all of you who are below age 59 and a half this could be because you retired early and you're looking into Roth conversions. This could be because you took a hit to your income this year and said, okay, well, might as well do some Roth conversions while I took an income hit, maybe you're on a sabbatical. Whatever the reason is, if you're doing Roth conversions and you're under age 59 and a half, try to use cash from a separate account to actually pay the taxes on the conversion. If you say I'm just using a round number, convert $100,000, and you withhold 20% in taxes on that conversion to pay your tax liability, that's treated as an early distribution. The amount that you withhold for taxes because you're under 59 and a half, that's treated as an early distribution and it will be hit with a 10% penalty. So this isn't the case if you're over 59 and a half. But if you're under 59 and a half, recognize that when you're doing conversions, if you're withholding taxes from the converted amount, you probably are going to be hit with a 10% early distribution penalty. So try to use cash or funds from a separate account to pay that tax liability instead of withholding from the conversion.
Speaker 1:So what are the actions or where the takeaways from today's episode? Well, number one have an actual financial plan done. If your financial advisor isn't doing forward-looking tax planning, then find one that does. But this is a really crucial aspect of retirement planning as a whole. Number two really good tax planning. It's not uncommon for it to save you tens of thousands or hundreds of thousands of dollars. I've even seen cases where there's a couple million or more dollars in tax savings over the course of your retirement, when done correctly. So do not neglect this aspect of your retirement planning.
Speaker 1:Number three Roth conversions allow you to control the timing of when you pay taxes and how much you pay. So, as you start to get a general sense of the landscape of where are you today, where will you be in five years, 10 years, 15 years, 20 years? Yes, it's impossible to actually perfectly predict that, but even a general understanding of that helps you to identify opportunities, of what are the years that we should be doing these Roth conversions, so we can shift tax payments from years when we're in a higher tax bracket to years when we're in a lower tax bracket. So even though it's impossible to do that with perfect certainty, even a rough estimate is a good place to start. So that is it for today's episode. Sammy, thank you very much for that question.
Speaker 1:I hope this was helpful to all of you who are listening. If you're watching this on YouTube, make sure that you hit the like button, make sure that you subscribe, if you're not already subscribed, so that any time new episodes come out, you are notified. If you're listening to this on Apple Podcasts or Spotify, please be sure to leave it a good review if you're enjoying this content and finding any value in it. And also if you know someone who is looking to retire, prepare to retire, and they're struggling to find out where do I go to get good information about that, I'd appreciate it if you'd introduce them to this podcast or this YouTube channel so they can get the information needed to create a more secure retirement. That is it for today's episode. Thank you, as always, for listening and I'll see you next time. Hey everyone, it's me again.
Speaker 1: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. 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 in this podcast, then go to RootFinancialPartnerscom and click Start here, where you can schedule a call to 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.