A Roth Conversion Case Study

I worked with a recently retired couple with a very strong financial position.

They wanted to spend approximately $140,000 per year in retirement.  They hoped they could afford to spend $160,000 per year for a very comfortable lifestyle, including more travel.

After completing their retirement plan, they learned they could safely afford to spend approximately $230,000 per year.

That difference matters.

They had $70,000 per year of additional spending capacity beyond the amount needed for a very satisfying retirement lifestyle.  That gave them the ability to pay Roth conversion taxes without reducing their desired retirement spending or creating a meaningful risk of running out of money.

This is a key feature of a strong Roth conversion opportunity.

The following diagram shows their taxable income by year in the blue-shaded area.

Filling Up the 22% Federal Tax Bracket

For this couple, the strategy was to complete annual Roth conversions up to the top of the 22% federal income-tax bracket.

This increased their taxable income during the first 14 or so years of retirement. However, it substantially reduced taxable income later in life.

Rather than allowing their future RMDs to force them into higher tax brackets, they deliberately used lower-tax years to move money from traditional retirement accounts into Roth IRAs.

Under the assumptions used in their retirement plan, the couple would remain mostly within the 22% federal tax bracket for the rest of their lives. They might move slightly above that bracket in their 90s, but not nearly as much as they would without Roth conversions.

Tax laws and tax rates can change, of course. Any Roth conversion analysis must use current law while also recognizing that future tax policy is uncertain.

After conversions, their taxable income by year is shown in the green-shaded area.

The Potential Benefits of Roth Conversions

For this particular couple, the Roth conversion strategy created significant long-term benefits.

More After-Tax Wealth for Their Children

The projected result was more than $1.9 million in additional after-tax ending portfolio value.

This matters because children and other heirs who inherit traditional IRAs or 401(k)s must empty the accounts and pay income taxes within 10 years. Inherited Roth IRA are much more tax-efficient.

For this couple, Roth conversions were not simply about reducing their own future taxes. They were also about improving the after-tax inheritance available to their children.

Lower Lifetime Taxes

The projection also showed approximately $954,000 less in lifetime taxes.

That does not mean every dollar converted avoided taxes. The couple still paid tax on the Roth conversions. But they paid those taxes during years when their marginal tax rate was lower than it was expected to be later.

The goal of Roth conversions is often to pay tax at a lower rate today, rather than being forced to pay tax at a higher rate later.

Lower Required Minimum Distributions

Their projected RMDs would be more than $2.6 million lower over their lifetime.

Reducing RMDs can create several advantages:

• Lower taxable income in later retirement
• More control over annual income
• Less chance of being pushed into higher tax brackets
• Lower exposure to Medicare IRMAA surcharges
• More flexibility for charitable giving and estate planning

Why This Couple Was an Ideal Roth Conversion Candidate

This couple had three qualities that made Roth conversions especially attractive.

1. They Could Afford the Taxes

This was the most important factor.

They hoped to spend about $160,000 per year to enjoy retirement. Their financial plan showed that they could safely spend about $230,000 per year.

That gave them approximately $70,000 per year that could potentially be used for Roth conversion taxes without reducing their lifestyle or undermining their financial security.

Many retirees do not have this flexibility. They may need most of their available income to fund normal living expenses. In that situation, large Roth conversions may create unnecessary pressure on cash flow.

2. Their Future RMDs Were Expected to Be Large

Large traditional IRA and 401(k) balances can create a future tax problem.

Retirees who delay withdrawals from large tax-deferred accounts may eventually face substantial RMDs. Those withdrawals can occur at the same time Social Security benefits, pensions, investment income, and rental income are already increasing taxable income.

If future RMDs do not push one into a much higher bracket, then paying taxes up-front in retirement for Roth conversions may not make sense.

3. They Had a Taxable Brokerage Account

The couple had a brokerage account that could be used to pay the income taxes generated by Roth conversions.

This is important.

Using taxable brokerage assets, cash reserves, or other non-retirement funds to pay conversion taxes generally allows more money to remain inside the Roth IRA, where it can potentially grow tax-free.

If someone must withdraw part of the converted IRA money to pay the taxes, the strategy becomes less attractive.

The Bottom Line

Roth conversions can be an excellent retirement tax-planning strategy. But they are not universally beneficial.

They often work best for retirees who have:

• Ability to afford paying taxes voluntarily
• Significant IRA and 401(k) balances
• Lower-income years immediately after retirement
• Large projected future RMDs
• Taxable brokerage assets or cash available to pay conversion taxes
• A desire to leave more after-tax wealth to children or other heirs

For the right household, Roth conversions can lower lifetime taxes, reduce required minimum distributions, and create substantially more after-tax wealth.

For everyone else, the benefit is not worth the cost.

Links to 2023 Mutual Fund and ETF Year End Distributions

The following links take you to the details of funds that are paying out capital gains or dividends in 2023.

American Funds by Capital Group

Blackrock and iShares Mutual Funds

iShares ETFs (there are only 4 with distributions)

Janus Henderson 2023 Per Share Distribution Amounts

Vanguard 2023 Year End Distributions

Capital Gains 0% Rate

The first strategy for saving on your taxes in 2023 is harvesting capital gains in your brokerage accounts. Income taxes for the year are calculated by totaling all incomes (regardless of type), subtracting deductions, and then splitting your income into capital gains and other income types.

Capital gains tax rates use a different set of brackets from the ordinary income tax brackets. The following diagram shows the brackets for capital gains rates in 2023. The rates are 0%, 15%, and 20%.

If you are married filing jointly and your taxable income will be less than $89,250 in 2023, you will pay 0% on capital gains!  The cutoff for singles is $44,625.   

People at this income level are usually retired with no pension income and currently living off savings or investment income while waiting to claim Social Security.   

If you fit this category and you plan to sell your investments for spending at some point during your lifetime, then harvesting the gains in years when you will pay no tax is a smart move.  You can take some future tax liability off the table.   

Since you are selling at a gain, you can buy the investment back once the sale clears and you have cash available in your account to trade.  Your new cost basis will be higher. 

If you never plan to sell these shares and instead pass them on to an heir or a charity, then there is no need to harvest the gains because those two recipients will not pay taxes on the gains.  Heirs will get a step-up in basis and charities don’t pay taxes.  

To implement this strategy correctly, and not end up paying tax, you need to predict what your taxable income will be for the year, so you can be sure the amount you sell will keep you under the 0% limit.  This month, mutual fund companies release the expected per share dividend and capital gains they will pay out.  You can find their estimates on their websites. 

As an example, the following diagram shows a client’s portfolio holding in the Growth Fund of America.  They have $98,225 of gains.  They won’t be able to harvest all those gains in 2023, but they can harvest some and increase their cost basis for future sales above the current $46,752. 

Harvest Tax Losses to Offset Capital Gains 

If your income is too high to harvest any tax-free capital gains, you can still look through your brokerage accounts and possibly find opportunities for tax savings.  

With last year’s market drops and this year’s mixed returns, you may have some losses in your accounts in either stock or bond funds.  Recently, I have seen a surprising number of client positions that are at a loss. 

By selling offsetting gains and losses, you will be able to eliminate some future gains while having no current taxes due. 

Selling at a loss does make you susceptible to an IRS rule called the wash sale rule.  This rule was put in place to stop people from taking losses and immediately buying back the same investment.  

When you sell an investment at a loss, you or your spouse cannot buy it or a “substantially identical” stock or fund within the next 30 days.   The easiest way to abide by the rule is to wait until the 31st day to buy the same investment back, but this leaves you open to missing a big move that could occur in the next month. 

Another way to avoid breaking the rule is to buy something different.  (The IRS has never defined the term “substantially identical”, but a fund from a different company or different asset class will suffice.)   

A straightforward example of this would be someone whose portfolio is overweight in US stocks.  This could be an opportunity to sell offsetting gains and losses and rebalance into some international or emerging market stocks. 

After adding up the losses and gains of the trades you place, you are allowed to write off $3,000 of losses, but beyond a $3,000 loss, you must carry over the difference to your 2024 return.