Roth conversions in retirement seem to be a hot topic and are becoming more common. The recent tax law change, which lowers income tax rates, makes Roth conversions in the next few years even more attractive. Every retirement plan I run with my clients, we discuss the reasons a Roth conversion strategy may make financial sense So, why did I advise recent clients to not pursue a Roth conversion strategy although they are the perfect candidates for Roth conversions? This article discusses how Roth conversions don’t necessarily make sense, even when they look appealing on paper.
First, Roth conversions are simply taking pre-tax IRAs and 401(k)s and converting to a Roth IRA. Many people implement this strategy after they retire and before Required Minimum Distributions (RMDs) start at age 70 ½. This allows you to get more money in Roth accounts, which reduces RMDs and allows the money to grow tax-free. The amount that you convert is taxed in the year of the conversion, but if conversions are done correctly, this strategy should reduce your long-term tax liability. Roth conversions are perfect for retirees who have after-tax money to pay the taxes on the conversions, and will have a spike in taxes at age 70 ½ when RMDs start. Although Roth conversions are a great tool, it’s not perfect for everyone.
I was going through a retirement plan with a couple recently, and I encouraged them to do the retirement plan because I really wanted to discuss Roth conversions with them. I knew, and they knew, that they were going to be fine in retirement. He has a high pension, and they both have significant social security benefits, which should cover all of their expenses. They also have significant after-tax and pre-tax savings which they will probably barely touch in retirement. For them, the issue is not spending too much and running out of money. The issue for them is not spending enough money and not dipping into their savings. Yes, not spending money in retirement is an issue. For many retirees, actually taking withdrawals, and sometimes seeing retirement savings go down is difficult. This couple was going to have this problem. So, after completing the retirement plan, although the Roth conversion looked perfect on paper, I strongly suggested they don’t start Roth conversions.
When we implement a Roth conversion strategy, we do this by “filling up” tax brackets. For example, if you are married and file a joint tax return, your 12% tax bracket starts with taxable income over $19,050. The 22% tax bracket starts when taxable income exceeds $77,400. If a couple has $40,000 of taxable income before the conversion, we may decide to convert $37,400, in order to “fill up” that 12% tax bracket without going into the 22% tax bracket. The lower your taxable income, the more that you can convert. Here lies the problem of the Roth conversion.
I’ve written before that one of the issue with taking the lump sum, is not spending enough of it. This is the same issue with Roth conversions. In the back of your head, you know that the less you withdraw each year from your retirement savings, the more you can convert and stay in the lower tax bracket. Ultimately the more you convert, the better this is for minimizing long-term tax tax liability. So, the less you spend the better. Well, better for someone, unfortunately that person is not always you.
When we ran the retirement plan the conclusion was that, on average, the couple was going to pass on over $5 million to their kids if they don’t start Roth conversions, and closer to $5.5 million if they start a Roth conversion strategy. The “problem” is that they don’t have a goal to leave a large inheritance. The kids are fine on their own, and they have already helped with both undergraduate and graduate schooling, and don’t feel like maximizing an inheritance is a goal now. Why spend the next eight years focusing on Roth conversions when at the end of the day, they’ll never even touch this Roth money, and you don’t care how much your kids receive when you pass?
In this scenario I suggested that instead of the couple implementing a Roth conversions strategy, they implement a travel optimization strategy. That’s right, a strategy which optimizes not how much they pass onto their children, instead how much they enjoy their savings now. This couple could take roughly $20,000 per year and convert to a Roth IRA in which they would never really use, or they could take this money and go on a river cruise in Europe. We decided that the couple would prefer to travel around the world, and not pay for another vacation for the kids after they have passed.
A lot of financial planning topics look great on paper, but aren’t so practical. Delaying social security may maximize your long-term benefit, but you are also foregoing benefits when your income need may be at its highest. The lump sum pension may result in more flexibility, but will it also lower your spending and potentially happiness in retirement? Roth conversions may result in the maximum tax-free money going to your kids, but is that even a goal of yours? The goal of a retirement plan is to maximize your lifestyle and enjoyment. You have spent enough time scrimping and saving just to get to retirement. Now is the time to enjoy your years of work and savings, and Roth conversions may make you feel like you’ll never reach the goal of financial independence. At the end of the day, you’ll need to decide if you prefer a Roth conversion optimization strategy, or a … golf, boat, travel, new kitchen, or spoil the grandkids…optimization strategy. I know what I would choose.