An Example of When a Roth Conversion Makes Sense – Case Study – Cravitz Financial & Insurance Solutions

An Example of When a Roth Conversion Makes Sense – Case Study

Video Transcript:

How's it going, everybody? It's Ryan here. Okay, so when I'm constructing a retirement income plan, there's several different pieces to the puzzle, and all of them need to be addressed in order to make sure the plan is set up to work as efficiently as it can possibly work. Now, one piece of the puzzle is taking a look to see whether it makes sense to do any Roth conversions, Roth IRA conversions. Now, I've been talking about Roth IRAs recently and Roth conversions, and I've been asked, I'm trying to get a sense, or I've been told, I'm trying to get a sense of, "What is really the impact?"

"How can this really help me potentially in my retirement? What might this look like?" We're going to do exactly that. I'm going to take you under the hood, and I'm going to share with you an actual example. This is a sample retirement income plan based upon John and Jane sample. Completely hypothetical.

With that, with no further ado, let me go and share my screen here with you. Okay. Here's what we're looking at. This is a couple, again, John and Jane's sample. They are both 60 years old. Their dates of birth are exactly October 1st, 1960, both of them.

They're both making $60,000 a year in their jobs, so $5,000 a month in their job, and they're planning to retire when they're 67 years old. That's the scenario. Now, from social security, if they were to delay and take their benefit at age 70, John's total social security amount would be 3,224, and Jane's would be 1,860. The projected COLA that we're using, cost of living adjustment is 2%. Now, I'm not going to talk about social security here today.

Remember, you can take it anytime between 62 and 70. Now, they're still working, so they probably don't want to do it before full retirement age because of the earnings test, but they could do it at retirement age, or they could stagger, one take it at maybe at 67, one at 70. That would be a whole another video and discussion, but let's just say they both take it at 70. From, based on their assets, John has an IRA. He's got $500,000 in there, and then I also assume another taxable, just a savings account, 1,099 interest, and they've got $150,000 combined as joint account in that account, okay?

I know that says at risk. That doesn't matter for the sake of what we're looking at right here today. Okay. That's it. There's no pension, there's no other assets or anything like that, just a very simple type of an example, and their goal, as far as their monthly income that they would like to have when they retire is $7,500 per month after taxes. What I did there, actually when they retire is I did include a 2% cost of living adjustment as well, 2% inflation rate at age 67, when they plan to retire.

Now, based upon just this very simple example ... By the way, I'm assuming a 6% rate of return on their money here on both of their accounts, just for the sake of simplicity, just 6% all the way around. Now, understand that the chances of anyone earning exactly 6% per year are going to be slim and probably none. More than likely, you're going to get a fluctuating rates of return, of course. Also, beyond the scope of this video, we've got sequence risk and other factors to take a look at there when we're taking withdrawals from our accounts, but just for the sake of simplicity right now, because the only thing I really want to highlight is the benefit of potentially doing a Roth conversion is their earnings exactly 6% every year, okay?

If that were the case and they retire in 2027, so you can see over here on the left side, this is the retirement summary, the very first year, excuse me, the very first year they're retired ... Take some water. Their very first year they're retired would be 2027, and remember, they wanted $7,500 a month after taxes, and you'll see that it's actually slightly higher at 7,525. That's because it's starting to factor in the cost of living adjustments on a monthly basis, so that's really what's going on there. Okay.

All the way on the right, you'll see the retirement funds. This is how much they have total in all their assets. What I want to bring your attention to next is all the way at the bottom, this shows that by the year 2060, if they both lived to be 100 years old based upon the projections that we have here, they would have about $270,000 in their accounts. Okay, $270,000. Now, the other thing I want to bring your attention to is over the course of their lifetime, when we look at their taxes...

By the way, I'm not assuming any state taxes. I'm actually in California. There's certainly a state tax in California, but I just assumed 0% because I want to keep this as simple as possible and just focus on the federal tax. Over the course of their lifetime, they would be, well, assuming they lived to be 100, they would pay a lifetime amount of taxes of $490,878. Actually, even by, let's say the year '50 or 2050, they would be 90 years old, they would still pay 453,270.

Remember those numbers, 490,000 here at 100, and at 90, they're still paying 453,000. Okay. Let's take a look. Now, if we're taking a look to see if maybe we want to do some Roth conversions, one of the things we look at is, let's call this bracket tracker, and what we can take a look at ... This is an estimate.

Understand that everything that we're doing here, none of this is tax advice. This is all tax for planning. You always want to run any of this by your CPA before doing anything, or your tax advisor, whoever that might be, but what we always want to look at here when we're looking at this type of planning is saying, "Okay. In the year 2020, they could potentially have another, or realize another $73,589 of income and still remain in the 22% federal tax bracket." It's not until they take a dollar more that that next dollar is taxed at 24%.

Now, not really a huge deal. I mean, it's not a huge bump between 22 and 24. It's not like the bump between 12 and 22 or the bump between 24 and 32. What's interesting is a lot of times, in a lot of the conversations that I've had is, I don't know if I want to consider doing a Roth conversion if I have to pay 22% in tax on the conversion, especially while I'm still working. I'm not even sure that that would even make sense to go ahead and do that.

Well, of course the answer is maybe, maybe not. Here's what we did. In 2020, in 2021, they have 73,000 and change here and 66,000 and change here between these two years, so what we did here is just ... Actually, this is on the next chart. I'll show you that there, but what we did was we're just going to show converting just a portion in 2020, and then also in 2021.

What I do want to bring your attention to is notice this number also right now. Their total tax is, the federal is 22,201 this year. Now, obviously, if they do the conversion, that's going to raise their taxes, but their bottom line, this is what you want to remember, at age 100, and we can see that up here, at age 100, they would have 270,325. Their total taxes, again, cumulative, and you wrote this down perhaps, but age 100 is 490,000, by 2050 when they're 90, 453,000. Okay. Let's take a look at the next one.

Everything else is exactly the same on this. The only thing that we're doing that's a little bit different is we're going to inject Roth conversions into this, and we're going to do $65,000. We're going to convert from his traditional IRA, from John's traditional IRA in 2020, and another 65,000 in 2021, and then they're going to use the money from the joint account that they have in order to go ahead and pay the taxes on that, and so let's say, okay, so that's all they're doing, and that money, of course, is going to go over into a Roth IRA. Let's take a look at the difference here. By the time they're 100, if they both lived to 100, they would have $660,000.

Okay. A lot more than they ended up with, on the retirement side without doing the conversion. That's a huge number, $660,000. By the way, here's the other really nice benefit of that, is that, let's say they both pass away at age 100, or it could have been 90 or whatever it is. All of this money by that time period is all in the Roth IRA, and if they have kids, people that they care about, that they want to inherit that money, their kids are going to receive that money completely income tax-free when they go to take the withdrawals from it, so also really nice, especially if you have kids that are making a good living, maybe at a higher tax bracket.

Instead of having to take that money from a traditional IRA, they're getting that money from a Roth IRA, so nevertheless. Let's go back over to taxes. I don't want to get sidetracked. Go over to taxes here, and what you'll see here, total cumulative tax is now ... Look at that.

Even if they lived to be 100 is only $277,000, so that dropped significantly from where they were before, and I'll show you the summary just in case you didn't write it down just a second. What you will notice this year is that they did pay more in tax, I think before it was at about 21,000, if I recall, but now, they're up to 36,000, of course, because they had to add on and pay taxes on the IRA withdrawal in doing the conversion this year. You'll see, like this year in 2020, that projected federal tax is about 36,500. If we look at 2021, because they're also doing a conversion that year, it's still about 37,000 a year and change. Watch what happens in 2022, because they're not doing the conversion that year.

Now, it drops, right? Now, it's down to 23,000, so their tax both went down. A lot of times, there's that hesitation, "I don't know if I want to pay that much more in taxes right now." Well, with these folks, they have the money sitting in the savings in order that they could potentially pay the tax. A couple of things you want to consider are, "Does it make sense to bite the bullet, pay the taxes now, and be in a position where, again, this is our first scenario, where if you don't do it, you'll end up having about $270,000 based on the projections, of course, by the time you're 100, and end up paying $490,000 and change, a total tax over the course of that period of time, or does it make sense to bite the bullet, pay the taxes, the additional taxes on the conversion the next couple of years, and then end up with still, if you both lived to be 100, $660,000?"

That's a huge difference. Not only that, but you're saving a ton of money in tax. What is that? That's a difference between 490,000 and 227,000, so more than $250,000, and on my calculator right here. You can see, that's a huge savings over time. Now, here's another, one other thing that I want to bring to your attention on this as it relates to this, is that this is assuming that they both lived to 100, but what if one of them passes away?

Well, let's just see. Let's take a look. Let's pick on John. Let's say, I don't want to say John dies right away. Let's say he dies in 10 years when he's 70, just as an example. Let's say he passes away when he's 70.

What happens? Now, this whole tab is talking about life insurance. We're really not focused on life insurance they may potentially need, or that John may potentially need it on his life in order to pay to Jane. What I want to point out here is the following down below, is that if he passes away in 2030, keep in mind that when you're married, filing jointly, you have two standard deductions, and then also, you have a more favorable tax chart, so to speak. In other words, you can have more income and pay less taxes because of the way the tax charts work, but if you're single, now you only have one standard deduction and you have a less favorable tax chart. Here's what I'm talking about.

Let's say 2,000 ... What do I have here? This is 2,029. Total projected taxes to be owed are $11,000 basically. Let's go to 2030. Same thing, 2030, and the year that he passes, still 11,538.

Now, let's take a look and see what happens the next year. Wow, so not only did the taxes go up. Now, they're at 18,794. What did I just say the other one was? 9,802, so call that almost 10,000. Call that almost 19,000.

That's almost $9,000 more just in federal tax. Again, we're not even talking about state tax. Now that John has passed away, not only does Jane have to pay about $9,000 more a year in taxes, but also, she has less income because she just lost a social security check. You take a look right here, remember, their combined social security income before, right here in 2030 was 5,084, 2031, 5,186, but now, he's passed away in 2030. By the time that year rolls around, she's only getting a check for 3,224, so that's around $2,000 less per month.

Not only is she paying about $9,000 more in taxes, but she's also losing $24,000 approximately in income, and social security income is what I call tax advantage income. I won't get into that right now, but so it's definitely, it's a double whammy. More taxes, less income at that point. Now, if she had the Roth, if she had done the Roth conversion or he had done the Roth conversion on his IRA, might she end up paying less in tax over time? Yeah.

Yeah, probably, and might this be even more favorable? Yeah, probably. Almost definitely. I just haven't run that scenario here yet, but certainly, because that money is all coming out tax-free. I hope all this made sense.

I know that was kind of a lot and really taking you under the hood so you can really ... I really want you to see kind of how this works so you can understand it a little bit better. If you have questions on this, let me know. I'm here to help. Take care.


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