[Editor's Note: The post today is about “The RMD Problem,” which is generally overblown. However, if one actually does have an RMD problem, the solution is Roth conversions as discussed in this post. ]
By Dr. David Graham, Guest Writer
Employed physicians and other high-income folks are frequently “401(k) Millionaires.” We earn good money and during our peak income years, when we are in high-income tax brackets, it makes sense to defer income into 401(k), 403(b), or 457 plans.
We think of this money as our nest egg for retirement, but the IRS calls it IRD (income in respect to the decedent) and wants to crack that egg open to suck out taxes on the deferred income inside.
“Tax bracket arbitrage” makes a lot of sense (defer income when we are in high brackets until later when hopefully we are in lower tax brackets) but there are some important considerations. No one can predict future tax laws. If you are a 401(k) multi-millionaire, however, it makes sense to try and manage your future tax burden with the big picture in mind. What may be the sum of your tax payments now and in the future? Some may consider partial Roth conversions as a strategy to lower overall tax burden.
White Coat Investors are awesome accumulators. We know how to make money and where to put it.
Planning for de-accumulation (or distribution), however, is difficult for super-savers. We spend 20-40 years growing this egg, but what is the next step? Understanding RMD’s is important when considering spending your nest egg in retirement.
Required Minimum Distribution (RMD) Problem
Required Minimum Distributions (RMDs) start in the year you turn 70 and a half years old. You take the previous year’s December 31st IRA balance (assuming you roll over all of your deferred accounts into one IRA) and divide it by a denominator that can be found on the IRS’ Uniform Life Table.
Say you have been a good accumulator and have $2 million the IRS wants to tax. Doing the math from the table above, the IRS will force you to take out and pay taxes on about $75,000 that first year. When you turn 90, that same $2 million will bleed out $175,000 of income for the IRS to tax.
However, it would be nice to control when you take income out of your deferred accounts, and retirement can be a window in time to take control of your future distributions rather than having the IRS force them out via RMDs.
Use Your Tax Planning Window to Lower RMDs
The Tax Planning Window is a window in time as you transition from accumulation to distribution. This window opens as soon as you stop earning income (and thus can access your lower tax brackets) and closes when you are forced to take RMDs.
Figure 1
As an example, a theoretical doctor’s income is represented above. Assume she is 55 years old, married, earns $400,000 a year, and wants to retire at 60. She and her husband currently have $1 million in a taxable account and $2.5 million in a 401(k), which are both invested 70/30 in stocks and bonds, earning 8% and 3% respectively. She will continue to contribute to her 401(k) while working, and they have $100,000 in backdoor Roth IRAs. They spend a modest $150,000 a year and plan to continue spending that amount in retirement. They plan to fund their retirement from their taxable account to delay social security until their full retirement age of 67.
As this doctor retires at age 60, the light blue shows her income dropping down from above the 24% tax bracket (which becomes the 28% tax bracket in this example when the Tax Cut and Jobs Act of 2017 expires) into the 10% tax bracket. They continue to have capital gains and dividends from the taxable account. There is a little bump in income when social security kicks in at age 67. When RMDs kick in at age 70 and a half, note that they are quickly forced back above the 24% tax bracket.
Figure 2
The figure above shows what this couple’s expected cash inflows and outflows should be over time. Note these are net negative until age 70. Also, note the expected tax payments during the working years and then again when RMD’s kick in. Thus, there is an opportunity between retirement and RMDs to do some tax planning.
This window between accumulation and distribution—between income and RMDs—might be the time to consider Capital Gain Harvesting, but in this example, let’s look at the implications of partial Roth conversions.
Roth Conversions
A Roth conversion happens when you pay taxes on your tax-deferred account (IRA), and convert the money into a Roth IRA.
That’s it. It is not fancy. You now have Roth money—some of the sweetest currency around.
These partial conversions fill up your previously empty, lower tax brackets with income, so be careful not to overdo it, as you don’t want to pay more in taxes now than you would have otherwise done in a future without these conversions.
Back to the previous example, what if our retired doctor and her husband “fill up” their 10, 12, or sometimes even the 22 or 24% tax brackets with Roth conversions? What affect would that have on current, future, and total tax rates? Financial Planning Software can pinpoint the sweet spot of Roth conversions the next figure demonstrates.
Figure 3
In this example, we see the darker blue “filling up” to the 12% tax bracket. This represents “income” (or taxes paid) because of partial Roth conversions every year.
Notice what this does to the RMD’s, shown as the darker blue within the iceberg of the RMDs expected without partial Roth conversions. Instead of quickly going above the 24% tax bracket, they stay in the 22% tax bracket over time, lowering total taxes paid over their remaining life. As an interesting twist, also note that between 67 and 70 our couple runs out of brokerage funds and is forced to start using tax-deferred money to fund their retirement. We can see these numbers below.
Figure 4
Note the partial Roth conversions between the ages of 60 and 66. This results in a large addition to their tax-free (Roth) account balance and rapid depletion of their taxable account, which are both funding retirement and Roth conversions.
Consider the conversion amounts above estimates and likely to be inaccurate, as year to year income is variable and will affect the amount you can convert and stay within a specified tax bracket. In addition, the Tax Cut and Jobs Act of 2017 is set to expire in 2026 making planning around that time a binary exercise (where you either plan for it to expire or not). Each year conversions will need to be carefully planned as recharacterizations of Roth conversions are no longer allowed. You used to be able to convert extra money and later “undo” or recharacterize the conversion if you put too much in, but this has been disallowed making partial Roth conversions a more arduous yearly math puzzle. The fundamental math is straightforward, however: you just take the maximum dollar amount for the tax bracket you wish to fill and back out your adjusted taxable income and you get your conversion amount.
Figure 5
Not only does this lower total tax paid, but partial Roth conversions (seen on the left above) also result in a higher ending portfolio balance that is 46% Roth money. Compare this to no conversions (the right) with a lower ending balance, and of course less Roth money. These account balances over time are demonstrated below.
Figure 6
For those of you interested in the “4% safe withdrawal rate” rule of thumb, the withdrawal rate from this fictional portfolio is demonstrated below.
Figure 7
Purpose of Partial Roth Conversions
In addition to a lower cumulative tax rate during your retirement, lowering your RMDs may also:
1) decrease the amount of taxes you pay on your social security earnings;
2) decrease the risk of higher Medicare premiums;
3) decrease the risk you’ll get stuck paying IRMAA for Medicare part B and D;
4) decrease your capital gains rate; and
5) leave you less susceptible to the widow/widower tax penalty (lower tax brackets once your spouse dies). If you have enough income deferred, however, it is unlikely you will benefit from any but the last of these potential savings.
The main reason to do partial Roth conversions: you get to keep more of the money you made.
Perhaps equally as important is that you leave a tax-free legacy to your children. Instead of your kids having to take “income” from your tax-deferred accounts—likely at their peak earning years—give them tax-free Roth money to enjoy.
What do you think? Have you done Roth conversions other than an annual Backdoor Roth IRA? Do you plan to at some point in your career or early in your retirement? Why or why not? Comment below!
[Editor's Note: David Graham, MD, is an Infectious Disease physician who blogs at FiPhysician.com. After discovering his passion for personal finance, he started a Registered Investment Advisory to promote “Financial Literacy for Physicians.” This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]
Thanks for this. What if the taxable account which was used to pay off conversions and to live on from 60-67, has embedded gains?. If I have a million in my taxable but it has tripled in appreciation, will the example fairly represent the tax burden as the taxable holdings are liquidated?
Thanks for the comment.
You have to watch your long term capital gains in your brokerage account when you sell assets. Although cap gains “stack on top” of ordinary income (and are taxed at 0%, 15%, 18.8% or 23.8%), they can bump your income up into the next tax bracket which would make Roth conversions cost more. Now that you can’t undo Roth conversions, generally you want to wait until the end of the year when you have a pretty good idea what your income and write offs will be before calculating the conversion amount.
Why deplete Taxable account ? Wouldn’t it be fully Tax free to surviving spouse, upon one of the spouses passing away!? (Due to step up in cost basis). In choosing this option, you pay zero capital gains taxes on the Taxable account gains anyway. Use this tax free money after such life event., instead of depleting earlier – this Brokerage amount then automatically adds these amounts to your Tax-Free bucket with zero taxes paid on these.
Doing the math (not using the taxable account vs. the method described in the article) is best way to tell in your particular case. Just use the skeleton spreadsheet shown in the article adjusted for your scenario (make sure you appropriately account for taxes/growth/inflation). In my case, using the taxable account to live on during the “tax window” serves a double purpose 1) allowing more money from the 401K to be transferred to the Roth (taxes paid by taxable account rather than from the 401K withdrawals – this can be viewed as an accounting method of moving some money from the taxable account into the Roth), and 2) it allows me the option of delaying social security up to age 70 (if desired). While social security optimization was not mentioned by the author, you can see from the chart that it allows a bit more money to be transferred to the Roth if Social Security is taken later.
As an aside, QCDs also allow you to reduce the RMD problem if you plan on doing charitable contributions.
your taxable account is only going to be tax-free to your spouse if the taxable account is in your name only. If it’s jointly owned, there’s no step up in basis I believe
Read recently elsewhere that jointly held account inherited by surviving spouse receives step up cost basis on half of each holding. The other half of each holding retains original cost basis.
you’re right. only half gets a step up cost basis
In Community Property (CP) states, the whole thing gets a basis step up. In non-CP states, only half gets the step up.
I don’t believe that is correct.
Yes you are right that one would not spend down the brokerage account to zero. The financial planning software used isn’t smart enough to figure that out yet, but of course you plan Roth conversions every year depending on that year’s circumstances and not 10 years in advance.
So this is really interesting. I never really thought much about this, but you DO get the step-up in basis for at least the deceased spouse’s portion and in some states (community property states), the entire thing! Now that’s a cool trick.
Yes,
Community property states do get a good break on assets such as investments and real estate, with a complete step-up of basis. One reason in this case I prefer somewhat to not deplete the taxable account and use it as an inheritance.
Not depleting the taxable account may mean paying some of the Conversion tax out of the IRA. The same amount of IRA is “spent down” each year you just get less in the Roth account, but increasing the Roth account is not really the goal here as a “no capital gain” taxable account is worth just about as much as the same value Roth account for an inheritance. The only difference is any tax drag over the years from the taxable account.
Excellent point.
Very well done David. I would add that this is not an overblown problem. Many WCI and POF followers who like you mention are exceptional savers and spend their money prudently will find themselves in the position of being in high tax brackets shortly after a retirement due to RMD. I find the $2M in assets at retirement to be too conservative. The current generation will experience a gradual increase in their contribution limits set by the IRS for all retirement accounts and WCI/POF followers will in general be better investors long term than physicians from the previous era. Furthermore, if they end up working until 55-60, that will 5-10 years of predominantly capital-driven growth after 50 (as opposed to contribution-driven growth that dominates their early years).
Thanks! I agree its not overblown!
Saving is easy; spending is hard!
Not for most people.
I’ve had two emails this week from docs who truly do have an RMD problem- $2-5M in tax-deferred accounts in their 40s who plan to work another couple of decades. But that’s not the case for most docs. Heck, 25% of docs in their 60s aren’t millionaires and another 25% has less than $2M. Those folks aren’t even close to having an RMD problem.
This is a very timely post. I just put a question regarding this calculation on the forum. My question to anyone here is…
what about starting to put money in Roth 401k instead? would that remedy some of this issue down the line?
Also, exactly what does NOT get taxed when passed on to the kids? Other than Roth accounts?
Taxable accounts don’t get taxed when passed on. They go to heirs with a step-up in basis. But any gains after your death are fully taxable, unlike a stretch Roth IRA.
If you expect to have an RMD problem, then yes, start doing Roth contributions now. But realize that is a very small percentage of docs.
Roth 401Ks have RMDs so (if there is the same protection from lawsuits etc) moving money in Roth IRA (earnings tax free) is better than keeping it in Roth 401K where you lose the “no more taxes ever” benefit for the RMD amount from that account annually.
You can just wait until your career is over and your risk goes down, then rollover to a Roth IRA before age 72.
I am thinking of a scenario that my practice partner is in. He is 71. He is still contributing to 401k and defined benefit plans at the same time has to take RMD. What can he do or could have done in past to help. And in the same what if I am not planning to retire in my sixties. Any ideas or suggestions?
Thanks for a very thought provoking article.
Can he roll-in his other 401ks/IRAs into current 401k plan – while/since he still continue to work? The RMDs should not be forced on ‘active/current’ 401k – while he continue to work (and contribute as well). RMD to QCD is an great idear – if Charity is in your partner’s plans.
The plan has to allow that.
https://www.irahelp.com/slottreport/still-working-and-past-age-70-12-answers-7-frequently-asked-questions
Question: If I am still working past age 70 ½, can I delay required minimum distributions (RMDs) for my IRAs?
Answer: No. All IRA owners (other than Roth IRA owners) must begin taking RMDs when they turn age 70 ½. This applies to traditional IRAs, as well as to employer-sponsored IRAs, like SEP and SIMPLE IRAs. Whether you are still working makes no difference.
Question: If I am still working past age 70 ½, can I delay RMDs for my 401(k)?
Answer: Maybe. If you’re age 70 ½ or older and still working, you may be able to delay taking RMDs from the plan sponsored by the company for which you’re still working. This is commonly known as the still working exception. For this exception to apply you must:
•Be considered employed throughout the entire year
•Own no more than 5% of the company
•Participate in a plan that allows you to delay RMDs
More Roth conversions.
You are right about in most of the states that only 50% of the capital-gains are considered for stepped-up cost-basis upon spouse’s death., except in not-so-many community property states (https://www.kiplinger.com/article/investing/T065-C001-S003-selling-jointly-owned-stock-death-of-a-spouse.html). Sorry I wasn’t clear earlier about this distinction.
If you want to contribute to charity – what better way/time to do that: doing an QCD to reduce the impact of RMDs – thus reducing taxes on the QCD amounts, while ‘hopefully’ enjoying lower tax bracketed (or close to zero in some cases) CapitalGains tax-rates on brokerage amounts !
It sure gets complicated as various scenarios comes to play .. again – good post and many good points!
Thanks for the comments. QCDs are great but you can’t start them until RMDs kick in at 70 1/2 years of age. Qualified money is always the best money to give or leave to charity!
Partial Roth conversions are tricky with a lot of moving parts and fun math problems. Perfect for those who wear the white coat!
I agree QCDs are great for givers.
https://www.whitecoatinvestor.com/qualified-charitable-distributions/
Schwab has a roth ira conversion calaculator
I used it to convert and the difference was minimal with 100k conversions and a large IRA of 4.15m
Great reminder! I had forgotten about RMDs when I was anticipating my withdrawals and tax rates in retirement. If you start both RMDs AND Social Security at age 70, lower earning eg part time or lower paid specialty docs may well jump brackets as we were projected to do from one of my sabbatical years with no doctor pay. Has made me max out any tax bracket I’m in below our max expected [under current laws] future brackets, at least for now while our ROTH accounts are well under 50% of our retirement funds.
In the first example, starting retirement with $2 million in a tax deferred account does not at all mean that you’ll still have $2 million in that account by age 90. RMDs are actually a very conservative means of slowly depleting a portfolio, and unless your investments have very good returns, the inflation-adjusted dollars you’ll be withdrawing as RMDs unlikely to increase dramatically over time. For instance, using the Schwab RMD calculator, at a 3% real return, the nominal RMDs for a starting $2 million tax-deferred account balance would peak at under $106k. Based on the last 19 years of inflation, that would actually be a smaller withdrawal than their first at age 70.5. Now if your real returns were much higher, then the inflation-adjusted RMDs may indeed increase significantly over time. For this reason, it seems to me that you may want to keep your fixed income investments in tax-deferred accounts and put your equity investments in Roth and taxable accounts.
But yes, I agree that doing Roth conversions when feasible is a very good strategy.
Vanguards financial planners recommend putting your bond allocation into your tax deferred space. One thing this does is to limit some growth thereby limiting RMDs.
Doc W- thanks for the comment and the great points.
Asset location discussions are a lot of fun! (I have another blog that PoF will publish on asset location comparing WCI and PoF’s asset location tips.)
I have only thought about asset location in an accumulation portfolio. It is interesting to thing about the implications to RMDs in de-accumulation! I wonder if it is again WCI’s “not a free lunch” idea ( https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/ ) but I will be thinking more about it. Thanks again for the thoughts.
Outstanding analysis and something I knew superficially was what I wanted to do but now have a much deeper dive analysis courtesy of you to confirm that this is the right way to go.
True it is first world problems but it is a problem nonetheless and I would much rather keep my hard earned cash in my pockets rather than lining uncle Sam’s.
This is also a major benefit for those who want to retire early (which I do) as the window for these partial conversions is longer and thus you can have more money in the lower income tax brackets taken out.
I have heard people mention that current 24% tax bracket is where they would max out as and try to have conversions and income fall under that amount. Is that your feeling too?
Thanks again for the visuals it really drove home the point. Very impressive post
Thanks! And yes the goal is to pay the least in taxes over your whole lifetime. Knowing what tax bracket to convert up to is tricky. It most certainly involves projecting what your future tax liability is likely to be, but there is a lot more to it than that (and even more for FIRE than fatFIRE). Considerations include ACA credits, college needs based scholarships, and other instances when you want to keep your “income” low and not do conversions. Conversely, you may convert more early because you want to use the money in 5 years (5 year rule on conversions, the so called ‘Roth ladder’) and want your “income” low in the future.
It seems like 12% and 24% tax brackets would be natural breaks. Also, however, consider NIIT (3.8% surcharge on unearned income) at 250/200k and the 23.8% cap gain break point as “bump zones” you want to avoid. https://www.kitces.com/blog/long-term-capital-gains-bump-zone-higher-marginal-tax-rate-phase-in-0-rate/
It actually gets less complicated as you get richer, doesn’t it?
Precisely. Once you’re really rich the confiscation levels off at 48% and becomes linear after that. Progressiveness is only for us pretty rich dweebs.
Good post. I worry about this also. I recognize that when 70.5 rolls around for me my tax bracket will jump up due to 70 yo ss plus RMDs plus taxable account dividends and interest. I plan to Roth convert and QCD. Then I will just pay the taxes, pay the increased medicare premiums, and increased part D. It is really hard to avoid this problem.
You should probably be doing Roth conversions now enough that your tax bracket DOESN’T go up at 70.
I have done several already.
Thanks for the article. Agree with your strategy as laid out. Would add that there are additional benefits that you did not mention.
1. Partial Roth conversions decrease the size of your taxable estate at death, potentially decreasing the tax burden at that time.
2. Assets in non-retirement accounts are subject to creditors. Using that money to fund Roth conversions decreases the amount subject to creditor risk.
3. Roth dollars are worth more than non-Roth dollars. Funding the conversion with non Roth dollars effectively results in a “contribution” to the Roth account.
4. Roth retirement accounts currently can be passed to your heirs and provide tax free income for the their life expectancy (although there is talk in Congress about changing or limiting this option)
1. Only an issue for a rare doc in most states. 75% of docs have less than $5M. They’d need more than twice that (four times married) to have a federal estate tax problem.
2. Agree
3. Agree
4. Agree. James Lange was really convinced it was going to happen a couple of years ago. Even wrote a book about it as I recall. Hasn’t happened obviously.
Lange’s blog from yesterday predicts the death of the stretch IRA again! Says bipartisan support this year will cause the death of the stretch for IRAs >400k. https://paytaxeslater.com/the-potentially-dire-consequences-to-your-legacy-with-the-death-of-the-stretch-ira/
Bumping up the RMD age to 72 has also passed thru half of the Congress, which is also a good thing to help with this problem.
As far as James Lange goes, he has been wrong for about 10 years that tax rates were going up – as far back as the Bush tax cuts.
Agree with your comment on #1 with current law; but, remember the Estate Tax exemption goes down to 5 million after 2026, which may affect more physicians. In any circumstance, there is no downside to decreasing the size of your taxable estate by creating more Roth dollars. It is hard to predict where any of us will be 30 years from now from an Estate tax standpoint..
John / WCI,
On your 4 additional benefits I mostly agree, except that I see item #3 as a wash to actually defeating the stated (or unstated) goal of this article, which is to solve the RMD problem by lowering the IRA balance.
Paying the tax from elsewhere does not get more money out of the IRA. In fact I contend that selling down the taxable account actually does just the opposite, as you need to allow then for extra taxes and actually cut down the amount taken from the IRA.
In fact if your real goal is to get the IRA down under $2m – $2.5m then I think you need to consider not spending any of the taxable at all and recalibrate your thinking to just spend down and live off the IRA between 60 -70, which is essentially what I have been doing.
Remember, while it is true that Roth dollars are more valuable than non-Roth dollars, as an inheritance they are essentially equal to your heirs on the day they receive them and the following tax can be either zero to a small amount depending on their tax bracket and how they manage them.
So, you have to ask yourself, which makes more sense in your 60’s-70’s:
1. Spending down IRA money that avoided high taxes while working and now can be spent across 0% (SD), 10%, & 12% (maybe even 22%) bracket.
2. Spend after-tax money, that is in fact very similar to spending down a Roth, that does not need to be spent down at all. From a pure tax differential (working tax paid (taxable) vs spending tax (IRA) the seemingly large differential after the working years and before RMDs seems to favor spending down the IRA. Sure we all want to get rid of an inefficient taxable account, but it doesn’t need to be that inefficient.
3. If you need a third item to consider, with the present tax code, which one is likely to cost you more in the future, thus reducing your after-tax spendable income. I contend if you hang on to too-much IRA ($3,$4,$5m) that’s going to be much worse than a taxable account that you have no requirement to spend at all and even if you do spend it, most of the tax has already been paid or at least will be paid in a lower tax bracket.
Finally, you may be saying I really think I need more Roth. I would say to that – just label 80% of your taxable account as a Roth and see if you would still say the same, because that is probably about what your taxable account is – 80% tax-free — or more correctly “tax paid’.
“Remember, while it is true that Roth dollars are more valuable than non-Roth dollars, as an inheritance they are essentially equal to your heirs on the day they receive them and the following tax can be either zero to a small amount depending on their tax bracket and how they manage them.”
Zero to small tax amount??? That’s a BIG assumption, as most beneficiaries inheriting from their parents who are 75+, are themselves in their 50-60’s and at their peak earning incomes. OF COURSE, a beneficiary would rather inherit a Roth IRA than a traditional IRA, that will be taxed at likely their highest tax bracket during their lifetime.
Geez! Readers, proceed carefully!
Very impressive breakdown, and one which I’m going to have to bookmark for later.
It also drove home the point that when it comes to taxes, timing and expertise do matter. For many of us, the window to do various shenanigans like this is finite. Missing it could mean lots of lost income or wealth.
Personally, I’m going to plan to enlist professional help to run various scenarios when my focus turns from accumulation to maintenance/drawdown.
Thanks for this great post David!
— TDD
Still not clear that this works for that many people. Saving 4% on tax rates but paying the taxes early may not be that advantageous. Given the rate at which income tax rates and rules change, I would be reluctant to pay much now on the speculation of gaining in the future. The farther out the benefit and the larger the discount rate, the less appealing this would be.
The estate tax and asset protection arguments are a lot stronger.
For those who work past 70.5, there will be no low income years in which to do conversions. Once they retire their RMD, SS and taxable investment income may still have them in lower brackets than while working. Then they can consider conversions for estate planning and asset protection.
As for the stretch, we will see. Slott has been predicting its demise for years. Will deal with it if and when it comes.
I recently retired at age 52. My physician wife, 49, continues to work with high income and has no plans to retire anytime soon . Should we consider filing our taxes as “married filing separately” to allow me to start converting my 401(k) to Roth at a low tax rate?
You can run the numbers both ways, but probably not.
Very good article. I had heard and read some about this before but never with as much analysis or data.
For the younger docs (> 15 years out from retirement still), is there anything different to do that would make this process, assuming the laws don’t change enough to make this moot, easier or better? In other words, any changes we should be making?
I max out a 403(b) and 457 as a W-2 employee with low limits, and then max out Roth IRA for me and spouse, HSA, and then everything else goes into taxable. My current plan is to retire in 18 years at 58, and then take distributions from my 457 plan for 7-10 years or so before thinking about taking SS at age 70. I’m guessing I should hold some money in cash to use for expenses and to keep my income low so that I can do Roth conversions. Anything else?
If you’re a supersaver, consider Roth contributions. But otherwise, not really. No need to hold cash for decades until you need it.
Thanks. I guess I phrased that incorrectly. Not so much as hold cash for decades, but maybe as I get close to retirement (last 2-4 years) divert more of my investments towards cash or MMF type funds. I’m guessing there are some recommendations for late career docs to have some of their allocation in cash anyway, so would just do that to get to my desired cash allocation. I know the “buckets” retirement strategy discusses this some, and although I wouldn’t plan to that indefinitely, maybe doing it for a few years with some of a cash position while I do Roth conversions would be acceptable. Certainly something for me to ponder. I’m in the 35% tax bracket currently (probably won’t ever be higher while I’m working, until tax laws change) so not sure that Roth 403 is the right choice, but one could certainly make an argument that tax rates are likely to go higher, so even though I may be in one of the higher tax brackets now there’s no guarantee it won’t be higher in retirement even with lower income.
In reality, a Roth conversion is just moving money from taxable + tax-deferred into Roth. So it wouldn’t be selling low to sell taxable stocks in order to do a Roth conversion if the Roth money is then invested in stocks. So no need to keep cash just for that purpose.
I guess I was thinking more of having cash on hand for living expenses to keep my “income” as low as possible to keep the rate at which I do Roth conversions as low as possible. If I’m able to keep my 457 distributions low enough and then have cash on hand to live on as well, my tax rate could be quite low and I could fill up more of the lower brackets with Roth conversion money. Probably too complicated though since I’m having a hard time even explaining it.
Great post! Nice strategy and demonstration of how to keep some money from Uncle Sam. I’m positive that I will utilize this strategy when I retire. Income, capital gain, and death (estate) taxes are definitely hitting high income slaves like us harder than anyone else.
My wife and I fatFIREd three years ago when I was 45. I am looking to take advantage of the tax planning window to do Roth conversions. However, like most people’s lives, our income and taxes are messier than what is conveyed in blog posts. We currently have income from interest, dividends, inherited IRAs, and rental properties. In ten more years there will be a pension and then social security and RMDs after that.
I have built a spreadsheet that models cashflows, including federal taxes, for the next 50+ years based on the current 2017 tax reforms but would like to speak with tax specialist/strategist to run different scenarios. Is anyone working with a tax strategist that they recommend that we talk with?
https://www.whitecoatinvestor.com/tax-strategists/
David,
Can you explain the math behind your first spreadsheet? I don’t see any way to get to $130k of tax unless you are considering the income is self-employment or there is a large State tax.
Did you use any inflation for the tax brackets and standard deduction in your spreadsheet or assume they are going to be the same every year of the 19 years shown?
Also seems like you inflated the working year expenses but not the income??
Being an engineer, it’s frustrating to see a spreadsheet and not be able to see the math that created it.
Thanks for the article.
I did a very similar article recently that did inflate the tax brackets, SD, & SS, the one difference being it was from the viewpoint of “I am 70 now, so what is the consequence of having this size Roth / IRA / taxable account and the most efficient way to spend it.
If you are interested, here is part II, where I examine using the taxable account as a Roth substitute:
https://seekingalpha.com/article/4265876-taxable-account-roth-substitute
Thanks again,
Dave
I did some analysis on this in my 50’s and decided to quit contributing to my Pretax accounts and to contribute heavily to brokerage and aggressively tax loss harvest. This allowed a smaller pretax, more easily converted but still decades of growth. The brokerage allowed me to free up cash to live on while Roth converting. All of my ordinary income is Roth conversion (except for a little dividend income) so taxes on Roth conversion are very manageable and minimized. My brokerage grew much larger than the tax burden associated with investment and having a W2 it was easily covered. Upon retirement and beginning conversion unlike the example my brokerage never ran out of money despite a net conversion of 700K into cash for living, in fact at the end of conversion it will be about 2.5M. So part 1 (the early part) of my accumulation was into pretax and destined for tax free growth, part 2 (the tail end) of my accumulation was to develop a cash flow model to optimize my tax picture prior to RMD. Since I tax loss harvested I was able to convert the 700K tax free not unlike creating a Roth, in fact I call it my rich man’s Roth. I didn’t have a Roth until my last year when I quit early, just long enough to satisfy 1 more year of SS eligibility and established finally my Roth’s.
This plan limited my end tax burden by not having a huge TIRA or 401K and allowed me to convert at the 250K level avoiding the extra surcharges and tax bumps associated with converting to the top of the 24%, again a tax optimization. I also left about 500K in the TIRA to hold bonds and that will be in a tangent portfolio. The tangent portfolio is pretty bullet proof to recession but still has a little growth above bonds alone. It will throw off a couple grand a month but when mixed with SS will allow me to stay in the 12% bracket for 15 or 20 years post RMD giving me pretty good control of my taxes and solving to some extent the surviving spouse issue. My wife will likely be in the 22% after I kick if she keeps the same income level, but not 24% or 32%. My Roth serves as self insurance, At the end of conversion it will be about 1.5M and I’ll just let it grow and crack it if we get sick or need other extraordinary expense. We’re all going to die from something and sometimes that something takes years to play out and there are 2 of you to cover. Between the TIRA RMD (which is a bit like a inflation adjusted annuity) SS and a dab of brokerage, my future is barely leveraged.
I see the SECURE act as definitely passing. The reason we got Roth conversion was not for us but so the government could gain access to out taxes sooner. SECURE is the same gig. They will allow you to keep your money while you are alive, but after your demise they are going to accelerate the depletion to something like 5 years for both TIRA and Roth leaving your heirs with a big tax bill if you die with a big wad. Appropriators love nothing more than a big fat golden egg and baby you are the goose.
Thanks for the great article. We all want to keep uncle IRS our of our bank accounts. There is one item that you did not discuss. When following this approach, pay attention to how it will impact taxes on your qualified dividends and capital gains. You need to manage the conversion so that you do not inadvertently push you your taxable income above the break points for dividends & cap gains.
With tax rates expiring at the end of 2025 or sooner, would I be prudent with my large IRA(4+) to convert up to a 20% federal tax rate and no state income tax
Think a nice size ROTH can be a substitute for a LTC ins plan, where premiums are quite high
Maybe. You would have to run the numbers. Personally, I’d wait for legislation to make serious progress before doing any planning based on potential tax hikes.
I agree that a big nest egg like yours is a great substitute for a LTC insurance plan.
Just stumbled across this excellent article. It raises a question in my mind about pros and cons between Roth conversions and simply seeking to exhaust traditional 401k accounts during the low tax years between retirement and starting to collect social security at age 70. This strikes me as potentially “good enough” if one is in the position my wife and I find ourselves in with a sizable set of traditional retirement accounts (more than $2 million), a similarly sized set of Roth retirement accounts, and then we taxable accounts that are larger (say around 3 times the size of the traditional retirement accounts). So we have options on withdrawals. If we are both retired sometime between 57 and 60 (a couple of years from now), I would be inclined to just draw down the traditional accounts first, keeping to the 24 or 22 percent tax brackets at most. Exhaust traditional by 70. No social security until 70. Use taxable whenever needed to fund additional spending before and after 70. And let the Roth ride for as long as possible. That seems kind of simple and like it would delay capital gains taxes on taxable as long as possible. Good enough? Or is there a really big value in making the Roth as big as it can be for as long as it can be, avoiding the tax drag on taxable dividends by depleting taxable sooner, or similar, such that depleting taxable and doing conversions early really is better?
Are you going to spend all of those millions? Will any of it be left to charity? If so, you don’t want to convert it. I would venture to say that even without a charitable inclination, you probably shouldn’t convert ALL of your tax-deferred accounts.