Good financial planning can save you money.  A lot of money.

This example shows a simple Roth conversion strategy for a person entering retirement that can shift a large percentage of money from taxable to non-taxable.  Most people don’t understand this subtle yet important tool.

Let’s start here:  The IRS is not your buddy (if you were still wondering).  Over the years they’ve tweaked and changed IRA rules, added complexity, then issued thousands of pages of ‘clarifications’ to help with your insomnia.  You’re forgiven if you don’t understand the interplay between your company retirement accounts, Traditional IRAs, Roth IRAs – hardly anyone does!  Let’s start with a quick refresher on what’s what:

Rule 1 – all IRAs are retirement accounts, but not all retirement accounts are IRAs:

  • I find this is where the confusion begins. You likely have a retirement account through work, which can be any number of account structures (again, the IRS said why create one or two types of company retirement plans when you can have 30?!).

Rule 2 – every person can have both a Traditional IRA and a Roth IRA in their name:

  • You cannot combine them together, combine them with your spouse, etc. They’re yours and they are individually owned and operated, and stand alone outside of your company’s retirement plan.

Rule 3 – a Traditional IRA was designed for pre-tax money, a Roth IRA was designed for post-tax money:

  • The Traditional IRA was designed to encourage retirement savings.  You make a contribution of your income and the IRS gives you a tax deduction as a ‘reward’ for being a responsible human.  In return for this deduction, you pay tax on the money when you use it in retirement.
  • The Roth came along later, and was essentially the opposite of the Traditional IRA. You get a paycheck from your company with taxes removed, then you make a contribution to a Roth IRA.  The reward for saving this way is the money grows tax-free and is used tax-free in retirement.
  • The simple rule? The IRS will get their pound of flesh at some point.

Rules 4 – infinity

  • Now, you know the IRS wasn’t going to stop with three rules – in fact they just kept making them until their own rules contradicted and consumers stopped trying to figure it out. I could write another 5000 words here without covering all the permutations.  For the purposes of this example, understanding the basic rules 1-3 will suit you just fine.

The Setup

Chester Copperpot (gratuitous 80s movie reference, gold star if you got it) and his wife Jane are about to retire at age 65.  Chester and Jane have worked their entire adult lives and have been diligently saving the gold coins from their pirate business since the beginning.  Here’s the inventory of their accounts:

  • Chester’s 401k: $1,200,000
  • Jane’s 401k: $600,000
  • Chester’s IRA: $175,000
  • Jane’s IRA: $168,000
  • Chester’s Roth: $65,000
  • Jane’s Roth: $60,000
  • Regular Savings Account: $200,000

IRS rules require a person age 70.5 to begin taking a ‘required minimum distribution’ (RMD) amount each year from Traditional retirement accounts (so the IRS ensures they can tax it while you’re alive).

Also, the Copperpots can elect to start their social security income at any point until age 70.

They have to use this money to live in retirement…so how can we pay as little tax as possible?


The Plan

Somewhere between Rules 4 – infinity, the IRS granted the ability for us to ‘convert’ assets from Traditional retirement money into Roth retirement money as long as we pay the owed tax at the time of conversion.  In other words, you are not technically withdrawing the money from your retirement account, you are converting it into a different type of retirement account.

(please enjoy this LONG IRS write-up about Roth conversions)

The Copperpots retire at the end of this year, so starting next year, their combined income will drop from $150,000 (current Pirating salary) to $0.  Obviously, this changes their tax rate, in this case from the max rate of 22% to 0%.

The income planning shows you where this is going:

Year 1 of retirement:  $0 income

Year 2 of retirement:  $0 income

Future years of retirement:  RMDs + social security

The Copperpots aren’t required to use their Traditional retirement accounts or social security income until age 70…thus giving them 5 years of zero income (and zero tax).

If we convert assets from Traditional to Roth money during this time frame, they’re able to utilize the lower tax rates of early retirement, vs the higher tax rates of later retirement (when social security and RMDs are added).


The Payoff

The easiest way to show the result is through pictures, which we’ve added here from RightCapital.

Here’s the baseline income graph without a Roth conversion.  The line across the middle of the graph represents the 22% income tax threshold.  The arrows point out the areas of very low income (left arrow) and when the income exceeds the 22% threshold (right arrow):

If we utilize a Roth conversion in the early years of retirement, now look at the small but powerful difference in the graph.  The lower tax bucket is ‘filled up’ (left arrow) in early years.  This lowers the amount of taxable money in future years (right arrow), when we know the Copperpots income will be higher, and thus lowers their future and overall tax obligation:

The result?  In our example, assuming they live a healthy retirement to age 90, the final portfolio finishes over $250,000 higher by executing the Roth conversion early.


Summary

Obviously we’ve made assumptions here, every person’s situation requires careful planning and your mileage may vary, but the value of understanding the nuances and having a sound financial plan is clear.

This is just one example of how IRAs can be maximized.  Even if you’re just starting out, it’s worth learning these rules to get the most out of your accounts, or hiring someone that can help.

If you ever wondered what advisors do, here’s a simple, $250,000 answer to your question!

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