Just when you think you know enough to manage your finances, comes along a new wrinkle: the Roth IRA conversion.
Until recently, I had a yeoman’s understanding of the Roth IRA. A few years back I toyed (dangerously) with converting some Traditional IRA investments to Roth, though with a relatively small amount of money (less than $50K).
This post is for you if you have a sizable 401K stash to sustain you in your later years.
The 401K Tax Surprise
Why would a Roth conversion matter to an early retiree in his or her 40s or 50s? It all comes down to taxes. The current rules for Gen X (and younger) retirees call for required minimum distributions (“RMD”) starting at age 75.
That means if you retired today at age 50 with about $1.5M in your 401K, assuming a 7% growth rate, you’d have to take a distribution of $270K at age 75, increasing to $350K by the year you turn 80.
You can almost see the tears in the tax man’s eyes… Notice how the Estimated Account Balance continues to grow despite the large distributions. The IRS thanks you in advance!
This is all fine and good if you plan to spend that much dough during your late 70s and 80s but keep in mind you’ll also be receiving social security by this time. Suddenly, you’ll find yourself in a much higher tax bracket and begging your accountant for a tax avoidance miracle…
Early Retiree Assumptions
What’s an early retiree to do? Our community saved and frugalized every nook and cranny to get HERE. We’ve followed all of the Mustachian steps.
We may have a little real estate on the side, a brokerage account, and some Health Savings Account (HSA) funds built up. Can’t we just let our pre-tax 401K “ride” and happily pay the taxes when RMDs come due?
You certainly can take that approach, but you’d be betting on relatively low tax brackets. If and when brackets get adjusted higher, your projected federal tax bill of over $100K per year might be enough to persuade you to take action TODAY.
Roth Conversion to the Rescue
I’ve been retired for a couple of years now, and only in the last few months have I taken the time to explore the “dark side of the early retirement moon”: Post-retirement taxes and distributions. I’ve watched several YouTube videos of CFPs flashing the big numbers on screen – WARNING! Your retirement savings are at serious risk!
The Roth conversion is typically the method these CFPs propose to solve the impending tax doom. How does it work? There are some basic steps, but do your homework and go into this process with your eyes wide open.
Key Things to Know Before You Go Roth Crazy
- Roth conversions are irreversible. Once you convert those traditional IRA dollars to Roth, they stay characterized as Roth.
- Roth conversions are taxable. You are electing to pay taxes now on converted amounts when your bracket is low in early retirement, so you don’t have to pay through the nose when RMDs are due (at which point your bracket is bound to be higher, thanks to the RMD alone!)
- It’s rarely a good idea to convert your entire pre-tax 401K / Traditional IRA in a single year. Why? If, for example, you convert a $1M 401K in 2025, you would owe north of $300,000 to Uncle Sam, and then whatever your state income tax rate is on top of that. Ouch.
- You still must wait 5 years to access Roth funds without penalty before turning 59.5.
- You should avoid using a portion of converted funds to pay the taxes owed on the conversion. Why? For one, you’ll eat into the future growth of your retirement nest egg. Second, you’ll get a penalty of 10% from the IRS for early withdrawal of funds used to pay taxes on the conversion…
- …This is why building up a sizable post-tax brokerage account is very smart to do before retirement so that you can pay the taxes from dollars outside the IRA.
- Unless your accountant says otherwise, it’s always a smart idea to make quarterly payments to the IRS on conversion taxes due. Don’t wait until filing your annual tax returns, or you could be penalized.
- Make sure you consult your accountant and/or financial advisor to avoid missing key steps that could be quite costly. You’ll need to set up a rollover IRA and Roth IRA accounts if you don’t have these already established. Once you do, you can transfer 401K funds to the rollover IRA account. For many, this is DIY territory, but be extra diligent and seek professional financial advice if you’re unsure about any step in the process.
How Much and How Long Do I Need to Make Conversions?
This is the 1.5 million dollar question. Fortunately, there are lots of simulator tools that can make this process a lot easier. After watching those countless YouTube CFPs flashing fancy simulations and graphs, I figured the software must be available to regular Joes and Janes.
The tool I landed on is Planner Plus, hosted on Boldin.com. Unlimited access costs $120 per year, and even if I didn’t have a year of free access, I’d happily pay this nominal amount for access to this toolkit. It’s impressive.
You can connect all of your financial accounts in Planner Plus if you prefer real-time updates of your IRA, bank account balances, etc. I opted to make manual entries for our information. This is probably the safest way to avoid any chance of key personal information and data being compromised.
Unpacking the Boldin Planner Plus
I’ve only begun to scratch the surface of what the Boldin Planner Plus offers. Right out of the gates, you get an assessment of whether you’re on track to retire with enough assets:
99% is reassuring! But this metric does not indicate the tax burden on the horizon…
Before diving into the Planner Plus’s Roth Conversion Optimizer, there are a few additional features that stand out:
I’ve got four metrics to clean up! These are warnings to look into cash flow plans for 2025 and awareness of the growing interest that will be paid on our rental mortgages over the coming years.
If you can peel yourself away from What Ifs, Insights, Coaching, and other features for just a minute, we can look at the Roth Conversion Optimizer. It’s a winner:
Here are the parameters I selected for our situation:
- Convert as much of my 401K as possible over the next several years to Roth without tipping our taxable income over the 22% tax bracket (Select the “Tax bracket limit” and “22% tax bracket” options)
- I also was careful to select the option to NOT use conversion funds to pay for the conversion taxes. That’s a non-starter for the reasons I cited earlier in this post.
And within a few seconds, here is what the simulation reveals:
This is the Money Shot. To optimize taxes (i.e., avoid paying too much by staying within a low bracket during distribution years), this model recommends several conversions deep into retirement. The bright green represents my wife’s IRA conversion.
But Wait, There’s More!
There is STILL a lot to unpack here, and the Planner Plus offers so much data to consider. Fortunately, Boldin offers additional services, including fee-for-service coaching, to help with understanding and acting on the data.
I haven’t used the personal coaching services yet, but I will at some point. I’ve only been using the Planner Plus suite for about a month, and I still feel like a kid in a candy store. For financial geeks like me, Boldin is a time sink but one that will pay itself off in seconds.
The great thing about the Planner Plus tool is its sheer flexibility. You can modify variables to run different scenarios based on inflation projections, cost of living, interest rates, and investment growth rates:
Finally, there are tons of resources for subscribers, including live and recorded classes:
Notice that Boldin offers a “Roth Conversion Planning” class. That’ll be my first sign-up!
Below is a screenshot of one of the best tools offered in the expansive toolkit. It’s the scenario comparison tool.
Once you’ve run 2 or 3 scenarios, you can compare several key metrics, including lifetime tax obligations, net worth, and so on, all based on how you set the variables (including Roth Conversion schedules) in each scenario. It sounds complicated, but it’s quite easy to perform.
Unsurprisingly, the “Maximize 22% Bracket” had the best outcomes for net worth, tax optimization, and cash flow. (The Baseline plan did not include a Roth Conversion).
My Next Steps In the Roth Conversion Journey
I already had the annual sit-down with our tax accountant (before I even signed onto Boldin), and I was advised to simply convert all of the annual growth in my pre-tax 401K (IRA) up to the 22% tax bracket income level. Duration? Just about every year going forward until I’m pert-near 80!
Our accountant does a nice job with our returns and gives solid advice, but it’s always off the cuff, based on his own experiences. You know what? I’m okay with that. I’m a DIY guy, after all. The Planner Plus outputs align nicely with my accountant’s advice, albeit with specific numbers I can plan with.
You have to be persistent about learning this (tax, retirement, financial) stuff, or it will come back to bite you. The IRS has some strong-ass saber-tooth canines.
I can’t exactly pinpoint why I started to dive into Roth conversions, but here I am. And I’m glad I have Boldin’s Planner Plus to lean on.
Some parting advice: If you’re in your 20s or 30s, at the outset of your career and retirement planning, take advantage of the Roth 401K (if your employer offers such a plan). They are becoming more prevalent for at least one obvious reason: Your wallet will thank you when you reach RMD age.
When Should You Contribute to a Traditional Pre-tax 401K?
If you start to make the big bucks, earning well over six figures, chat with your accountant about a target tax bracket. The best of all worlds is when you can optimize your tax brackets during your working years and in retirement.
Bonus advice: If you want a good read to motivate you to act on this looming IRA tax burden, check out The Retirement Savings Time Bomb Ticks Louder… by Ed Slott. It’s packed with many eye-openers, particularly for the woefully unprepared.
Featured Photo by The New York Public Library on Unsplash
