A reader writes asking:
“Can you describe exactly the steps you would take to determine if a Roth conversion makes sense? Conceptually I understand that they are advantageous when your tax rate is low, but you can detail exactly how you would find out and determine how much conversion you have. to do? “
What follows is my process for planning for retirement account distribution, including Roth conversions.
The process has two major stages:
- Create a “fictitious” plan (or maybe you could call it a “default” plan) and
- Improving this plan.
Make a fictitious plan
By a “fictitious” plan, I mean a plan in which each year:
- Do not convert Roth.
- Invest first in wages / earnings, minimum required distributions, Social Security, pension income, dividends / interest from shares in taxable accounts and only then from subsequent distributions of deferred tax accounts.
- Get enough out of retirement accounts to: a) meet your RMD and b) provide enough dollars to meet the desired level of spending, after considering taxes.
What we want to know is what your marginal tax rate (for ordinary income) would be in each of the next few years, under this “fictitious” plan. Keep in mind that we care about yours real marginal tax rate, not just the tax bracket you’re in.
The software I use for this process is Holistiplan, which I think is excellent, but is priced based on the assumption that it is used as an advisor for many clients rather than for a single home. For most people who do DIY planning, a reasonable option is to use tax preparation software to prepare hypothetical returns. Honestly no think a spreadsheet is a good tool for calculating the marginal tax rate, as it is quite a challenge to create a realistic tax model that includes all relevant factors.
For each year, you will create a scenario / return for your tax modeling software, and then begin recording the results in a spreadsheet.
For each year, see if you have enough after-tax income to meet your desired spending level. (So this calculation is basically: wages / income, more RMD, more Social Security income / pensions, more income from taxable account investments, less taxes, and compare them to your desired level of spending.) If this income level is not enough, increase deferred tax distributions until you have enough. Remember, we don’t include any yet further away distributions of retirement accounts.
Then repeat the process for each of the next / several years. (As I mentioned earlier, I don’t think there’s much value a lot for each year, be sure to include appropriate adjustments for changing circumstances, such as:
- The largest standard deduction for people over 65,
- Salary / self-employed income that ends / decreases due to retirement or partial retirement,
- Social Security income from
- Selling your house.
If you’re married, it’s also important to direct “just a living spouse” scenarios according to the fake plan, to see what the marginal tax rate would be after one of them dies.
Note that all of this analysis requires making some assumptions and estimates. For example, you will need to decide whether to assume that the tax bracket structure is allowed to return to levels prior to the Tax Cuts and Jobs Act in late 2025 or whether to extend the current structure. And you’ll need to make assumptions about portfolio performance, in order to determine RMDs.
With this “fictitious” plan in place, see how your projected marginal tax rate changes over time. A pattern that is very common for people in near-retirement or recently retired settings is something in this regard:
- The marginal tax rate decreases once labor income stops,
- The marginal tax rate increases once Social Security begins,
- The marginal tax rate increases even more when RMDs begin and
- (For married couples), the marginal tax rate increases even more when one of the two spouses dies.
From here, the goal is basically to “soften” the marginal tax rate. That is, we want to move revenue out years in which you have a higher marginal tax rate and inside years in which you have a lower marginal tax rate. The tools with which we can change income from one year to another are:
- Changing revenue before making Roth conversions, either
- Change income later by meeting previous years ’expense through Roth accounts or settling taxable holdings on a significant basis.
During the years when it makes sense to do Roth conversions, you have to decide how much convert. To do this, first identify the next thresholds (for the year in question) at which you would increase your marginal tax rate. These could be the top of a tax bracket, an IRMAA threshold, the thresholds for the taxation of Social Security benefits, the bottom of the elimination range for a particular deduction / credit, or the threshold at which 3.8% of the Investment Income Tax begins.
Then determine exactly what your marginal tax rate would be after you reach that threshold. If this higher marginal tax rate is higher than the marginal tax rate you expect to face later, you want to make Roth conversions up to this threshold (but not beyond). If the marginal tax rate beyond this threshold is still below the marginal tax rate you’d expect to face later, you’ll probably want to convert Roth to Next threshold. It should be noted that it is an iterative process, as as you make more conversions in the early years, you can reduce your marginal tax rate in later years (because RMDs will be smaller).
What is the best age to claim social security?
Read the answers to this question and several other questions about social security in my latest book:
|Social Security is Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
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