Getting Your Financial Ducks In A Row

This is the second in a series of posts about Ideal Roth Conversion Candidates.  See the first post, Low or Zero Tax, at this link.

One of the planning options that most all folks have available to them is the Roth IRA Conversion.  For the uninitiated, a Roth IRA Conversion is a transaction where you move money from a Traditional IRA or a Qualified Retirement Plan (QRP) such as a 401(k) into a Roth IRA.  With this transaction, if any of the funds in the original account was pre-tax, that amount would be included in income as potentially taxable in the year of the Conversion.

As you might expect, making a decision like this can result in a considerable tax impact, depending on the individual circumstances.  A Roth IRA Conversion may make a great deal of sense for one individual, while another may decide that the Conversion cost is too great for the result.  Detailed below is one specific circumstance that indicates a Roth IRA Conversion is a good move – although each individual needs to consider his or her situation carefully, because every situation is unique.

Protecting Non-Taxation of Social Security

In this situation, the individual has a very low taxable income, low enough that she would not likely need to include Social Security benefits as taxable income, once she begins receiving the benefits.  However, once she reaches age 70½ and Required Minimum Distributions (RMDs) are necessary, the amount of these distributions will increase her overall provisional income to a point where Social Security benefits will be taxable at the fullest rate, 85%.  Converting a portion of the IRA to Roth IRA will help to keep the RMDs low enough that SS benefits can be taxed at a lower (or zero) amount.

For example, Jane is 60, single, and has retired.  She intends to begin receiving Social Security benefits of $24,000 at her full retirement age of 66.  She needs a total of $40,000 each year to live on.  She presently withdraws that amount from her IRA on an annual basis.  Her IRA balance at this point is $600,000.

If she did nothing about converting to Roth, when she reaches 70½ the amount of her RMD will be large enough to bump up her provisional income to a point where her Social Security benefits will be taxable at the maximum 85% rate. This comes about because her balance in the IRA (after withdrawals and annual increases averaging 5%) is roughly $557,000 at her age 70½.

If, however, Jane began a process of converting a small portion of her IRA to Roth IRA each year between now and when she reaches age 70½, she could reduce the size of her traditional IRA and therefore reduce the size of her future RMDs to a point where the tax impact on her SS benefits is eliminated.  In our example, if Jane withdrew an additional $15,000 from her IRA and converted the after-tax portion to a Roth IRA, this would reduce her IRA balance to a point where the RMD (when required at age 70½) would be low enough that her SS benefits would no longer be subject to taxation at all.

This series of conversions brings her Traditional IRA balance down to approximately $359,000.  At the same time, she has amassed a Roth IRA with a balance of approximately $148,000 – so her total of the two accounts is approximately $507,000.  The tax cost of the conversions and the lost income/appreciation on the money used for taxes makes up the difference.

This conversion would cost her an additional $3,750 per year for ten years, but the effect of non-taxation of her future SS benefits would be a reduction in future tax of $5,100 – for the rest of her life.  With this in mind, approximately 10 years later, at her age 80, this strategy would have paid off.  If she died prior to that age, the Roth Conversion would have cost more than the benefit.

Note: the figures used in the examples do not include inflation, and are purposely rounded for simplification.  Real-world results will differ, perhaps significantly, from this example.

Conclusion

There are many other situations when a Roth Conversion makes a lot of sense, the above is one example of a very good scenario for the conversion.  As I mentioned previously, each individual’s situation will be different and may or may not result in the same decision to convert or not.  Watch for more examples in future posts!