Roth conversions are one of the most discussed financial strategies for retirees, yet many individuals fail to realize their full potential due to an overly simplified approach. While most people focus on a single factor—filling up tax brackets to minimize future required minimum distributions (RMDs)—this is just the tip of the iceberg. By understanding and implementing five critical factors, retirees can unlock significant tax savings, potentially adding hundreds of thousands of dollars to their portfolio over time. In this blog, we’ll break down these five factors and explore how they can shape a personalized, optimized Roth conversion strategy.
The Case of Eric and Michelle
To illustrate these strategies, let’s consider Eric and Michelle, a recently retired couple, both aged 65, with a net worth of just over $4 million. Their assets include $2.5 million in investments, $1.5 million in home equity, and some cash reserves. Their retirement goal is to live on $6,500 per month, adjusted for inflation, while optimizing their financial plan to reduce taxes.
Eric plans to delay claiming Social Security until age 70, at which point he’ll receive $3,900 per month. Michelle will begin collecting her $2,600 Social Security benefit at age 67. These income sources, combined with their expenses, form the foundation of their cash flow projections. However, without a strategic approach to Roth conversions, Eric and Michelle could miss opportunities to save significantly on taxes.
Factor 1: Ordinary Income Tax Brackets
The first and most commonly understood factor in Roth conversions is managing ordinary income tax brackets. The idea is to convert enough funds from a traditional IRA to a Roth IRA to fill lower tax brackets without spilling into higher ones. For Eric and Michelle, this means converting funds up to the 22% tax bracket in their early retirement years, before RMDs begin at age 73.
By converting systematically, they can reduce the balance in their traditional IRA, thereby lowering future RMDs and avoiding the higher tax rates these distributions might trigger. For example, converting up to the 22% bracket could add $455,000 to their tax-adjusted ending portfolio balance compared to doing no conversions at all.
Factor 2: Avoiding IRMA Surcharges
Many retirees overlook the impact of Medicare Income-Related Monthly Adjustment Amounts (IRMAA), which increase Medicare premiums for high-income individuals. If Eric and Michelle convert too much in a single year, they risk crossing the income threshold that triggers these surcharges.
For example, converting up to the 22% tax bracket might seem advantageous, but if it pushes their income above an IRMAA threshold, their Medicare premiums will rise significantly. By strategically capping conversions just below these thresholds, they can avoid these additional costs. In their case, adjusting the conversion amount could increase their tax-adjusted portfolio balance from $455,000 to $563,000—a difference of over $100,000.
Factor 3: Long-Term Capital Gains Tax Brackets
Another factor to consider is the interaction between Roth conversions and long-term capital gains tax brackets. For retirees with taxable investment accounts, realizing capital gains at the right time can be an effective strategy. If their income, including Roth conversions, stays below a certain threshold, they may pay 0% federal taxes on long-term capital gains.
For Eric and Michelle, this means balancing Roth conversions with capital gains harvesting. If their taxable income remains below the 15% capital gains tax threshold, they can sell appreciated assets tax-free. This strategy might not be as impactful for them due to the composition of their portfolio, but for others with significant taxable accounts, it can be a game-changer.
Factor 4: Terminal Tax Rates
Planning for terminal tax rates—the taxes paid on inherited assets—is essential, particularly for retirees with high net worths. Eric and Michelle’s children, for instance, could inherit their traditional IRA balances and face substantial taxes if they are in higher tax brackets.
By converting funds to a Roth IRA now, Eric and Michelle can reduce the tax burden on their heirs. For example, if their children are in a 30% tax bracket when they inherit these assets, the value of Roth conversions during Eric and Michelle’s lifetime becomes even more significant. This forward-thinking approach ensures that more of their wealth is preserved for the next generation.
Factor 5: Timing and Flexibility
The final factor involves knowing when to stop Roth conversions. Many retirees assume they should continue converting every year, but there’s often a point where additional conversions are counterproductive. For Eric and Michelle, converting up to the 22% bracket for 10 years, rather than throughout their entire retirement, could add over $150,000 to their ending portfolio balance.
This highlights the importance of annual reviews and adjustments to the conversion strategy. Financial planning is not static; it requires flexibility to adapt to changing circumstances, including tax laws, market conditions, and personal goals.
Conclusion: A Comprehensive Approach to Your Roth Conversion Strategy
By integrating these five factors into their Roth conversion strategy, Eric and Michelle can maximize their financial outcomes and achieve greater peace of mind in retirement. Their case underscores the importance of moving beyond simplistic tax bracket calculations to a holistic, dynamic approach.
For retirees with significant assets, a tailored Roth conversion strategy can be the difference between a good retirement plan and an exceptional one. Whether it’s avoiding IRMAA surcharges, leveraging capital gains tax brackets, or planning for terminal tax rates, each factor plays a critical role in optimizing your financial future. By working with a qualified financial planner and revisiting your strategy annually, you can ensure your wealth works as efficiently as possible for you and your heirs.
