One of the biggest mistakes I see people make is not knowing how much they should convert to a Roth IRA, and even whether you should even do any Roth IRA conversions at all. Both not converting enough and converting too much could cause you to pay more in taxes over the course of your lifetime and may put you in a position where you have less money to spend.
A well thought out withdrawal strategy in retirement can make a tremendous difference in the lifestyle you are able to have all throughout your retirement years. Tax planning is an important component of a sound retirement plan. In this video I will go over this is some more detail. Specifically in this video, we'll look at a sample case study where for this couple converting too little and converting too much are the less than optimal choice.
Full Transcript:
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One of the biggest mistakes that I see people make when it comes to Roth IRA conversions is not knowing how much to convert or really even if you should be converting at all. I see mistakes on both sides. I see sometimes where people aren't converting at all and probably should. And then I see on the other side where people are converting too much. So let's break this down in this video and let me share my screen here with you and we'll walk through this. This is just a sample couple that I made up. They're both 58 years old. They're both making $120,000 a year, and they're planning to work until they're 65 years old. Okay? So you can see right here they're 58 and they're working. So their income is good right now and they're paying a good amount in taxes, of course, as a result of that.
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Now their plan by default is that they want to retire at 65 and then when they do well based upon the withdrawal strategy that they are thinking about. This sample couple here, which I'll call Jack and Jill sample, their taxes are going to drop considerably a lot. And in fact, I'll show you right here in the details. You can see that once they retire, their total federal taxes paid, for instance are $1,400 here their first year it goes up a little bit, but it doesn't even reach 2000 in total federal taxes. Now, this couple that I have here is in California, which of course has California state tax, but we're just looking at federal taxes here for this purpose. So their taxes would be extremely low. But the issue here is that over time, their taxes would start to rise considerably right here. And let's go back over here for a second.
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So you can see that right here. By the time they hit age 75, which is the age when you have to start taking Required Minimum Distributions, their taxes go from about $1,900 for the year to about $32,000 for the year, and they continue to rise tremendously there on out. Now what's also interesting for you to see right here is that even when I'm assuming that Jack passes away at age 90 and that Jill lives to age 95, those taxes are still very high. In fact, they continue to grow. Even though Jane is now living on one Social Security check, he's now passed away, but the taxes are still real high because she's now having to file as a single person. So this situation can get even worse if you have one spouse pass away even earlier. But we're not going to get into all that here today. What I do want to show you now is where there's some opportunities perhaps for conversions versus maybe where there's opportunities to do too much conversions.
(03:10):
So I think that's proper English, right? Too much conversions. There we go. So, all right, let's take a peek. So here's our situation. By default, what they are assuming that they're going to do is they are going to withdraw money from their taxable accounts first in retirement. Then after they deplete their taxable accounts, then they're going to tap into their tax deferred monies like their IRAs, 401(k)'s in that order. Instead of doing any sort of blending strategy, maybe where you're taking some money from one other money from others and try to take advantage of maxing out maybe the 10% or 12% tax bracket. That's sort of thing. This couple's paying very, very little in taxes. They're not even taking advantage of the 10% tax bracket. In other words, remember the money that's in your IRAs, your pre-tax retirement accounts, this is going to be subject to tax eventually once you have to start taking your Required Minimum Distributions, but you want to start getting in control over when you're going to pay those taxes.
(04:17):
So let's take a look. For instance, if they were to just fill up the 10% tax bracket, so if they were to do that, just convert just enough in years where they could still stay within that 10% bracket, they could do that and it'll end up improving their position by 57,000. So in other words, at their life expectancy, it is assumed or projected, I should say, that they would have a $57,000 more of tax adjusted ending portfolio value. And if they just converted that 10%, we can take a peak right here to see what that means as far as when they would be doing those conversions. And there's a little bit of opportunity here between ages 65 and 74. Again, 65 is when they're planning to retire, and then 75 is when they have to start taking out the Required Minimum Distributions. Now, I would suggest that we take a look here, of course, at the 12% bracket because that's not too much more, and take a look at this.
(05:34):
If we convert up and use up that 12% bracket, that puts them in a much better position. Now we're looking at a $459,000 more of tax adjusted ending portfolio value at their life expectancy. And by doing that, let's take a look over here. We could see the conversions are going up, the amount that we have to convert here, but still the conversions are only going to be done in that window of opportunity. I like to call it oftentimes, which is between when they're going to retire and when they have to start taking out their required minimum distributions. Now, let's take a look next at the 22% bracket. And by the way, you might be wondering what this 15% is after 2025, the tax cuts and jobs act is going to sunset. So the 12% bracket is going to be become the 15.
(06:34):
So if they were to fill up the 22% bracket, it does improve their situation, but not by a lot more than if they were to just convert up to the 12%, right? So notice this at 22%. This is called this 498,000 at 12%, that was 459,000. So they may not want to convert. It may be preferable just to only convert up to that 12% instead. Now, let's go over here to the 24 and see what happens. Now notice this, if they converted up to the 24%, now it's putting 'em in a worse position. I mean, it's better than no conversions at all, but it's actually a worse situation than if they were to convert up to the 12% bracket. Now, let's go to the 24 or not to the 24, the 32. I mean, now look at this. Now we're going in a situation where they're going to have even less money or less tax adjusted ending portfolio value at retirement and the issue or not at retirement, at life expectancy.
(07:55):
And the issue is the reason why we're seeing this is in order to fill up this bracket, they're having to pay taxes at a much higher rate much earlier on. I mean, yeah, it's nice later on, they're paying very little in taxes. But if they were to do this, take a look right here. If they were to do this, they're having to pay a lot in taxes over the course of the next six years. Now, again, over time, they're paying nothing in income taxes here, and they're only in this 10% bracket. And the reality is that they could be withdrawing some more money from their IRA in these later years here and still not have to pay taxes. They've shifted all their money, I believe. Let's take a look in this scenario, yes, all their money at this time by the year 2028, let's go right here, is out of the tax deferred account.
(09:02):
All of it is now either in the tax free, the Roth IRA, and some of it's still in the taxable account that they had had as well. So they're going to pay nothing in income taxes. They're not even taking advantage of the standard deduction. And so this is a prime example of converting too much. So it's really important to kind of think about this as we want to smooth this out. So let's go back to the 12. I like the 12 here. See how this is being smoothed out considerably. Now, the 22, which does improve it a little bit, would look something like this.
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So it's really important to understand really how this works as far as where you are within the brackets. What's your overall withdrawal strategy? This Roth conversions is just one component. As I had mentioned earlier. Sometimes it doesn't even make sense to do Roth conversions. Sometimes it just makes sense to say, Hey, we're going to take a certain amount from our IRA and we're going to take a certain amount from our Roth IRA. And by doing that, perhaps that's going to keep us in the 12% tax bracket or wherever you are within your tax brackets. Sometimes that's the wise thing to do, so it's always a case by case basis. Hope this helps, and if it did, make sure that you like the video. Make sure that you subscribe and I'll see you in the next one. Take care.