If you’ve followed our newsletter for a while, you know I write often about Roth Conversions. Advisors always want to know: Should my client convert? Do we know all the variables in play during a Roth Conversion? How should we address issues like Tax Drift, Conversion Delta, and IRMAA in the decision-making process? And what’s the math behind the variables – does it impact how quickly we should convert?
It’s a lot to evaluate. And sometimes it’s easy to lose the forest for the trees.
So I want to show you how to put all these concepts to work in a single Roth conversion discussion. And there’s no better way to do that than by looking at a real case I helped an advisor structure last week.
Here are the details of the case:
- A couple age 65 with $1M of IRA money in a brokerage account.
- They collectively make a $250,000 salary and plan to work until age 70.
- At retirement, they are well established with $90,000 of anticipated annual social security income.
- With additional IRA dollars, they have an annuity in place that guarantees, before taxes, $60,000 per year starting at age 70.
- In addition to their annual calculated Federal tax rate, this couple lives in a state with a 3.5% state income tax.
In a discussion with the clients, the advisor learned that the income levels in place from Social Security and the annuity will satisfy their retirement income needs. Which means the remaining $1M will be there for emergency money, and the rest will go to the kids.
They identified $300,000 as an amount that would make them comfortable for emergency money, leaving up to $700,000 that they could identify as legacy money.
Working with some of that $700,000, likely going to the kids, is where I will focus for this example. Let’s start with $500,000 as an even number for our analysis.
I first want to calculate the impact of that IRA money on the taxes and IRMAA fees the couple could pay. Since this is legacy money, the money would stay in the IRA, deferring taxes as long as possible. But eventually that money would go through the RMD process. Assuming the clients live to age 90, the total taxes would be about $414,000 for every $500,000 of IRA value.
That’s right. They potentially pay almost as much in lifetime taxes as the present value of the money itself.
There is some good news for the clients. Based on projected retirement income levels, IRMAA should not be an issue. Well, let me clarify. As a couple filing jointly, there would be no IRMAA issue. When the first spouse passes away, the surviving spouse would then be filing as single. At that point, it would be much more likely to face IRMAA surcharges as a single filer. But for this analysis, let’s keep them both alive until age 90.
With such a significant retirement tax bill on the horizon, a Roth Conversion of this money allocated to legacy could prove to be very attractive. And potentially save the client (and their heirs!) a considerable amount of taxes.
It also helps protect them against legislative risks from Washington. Remember, tax policy is written in pencil, and it changes – often. And as the deficit spending continues in Washington, adding trillions of dollars to our national debt, many experts have concluded that taxes at some point will have to be higher than they are today. And more “income-related” taxes (like IRMAA, Social Security taxation, and Capital Gains tax calculations) could also likely be on the horizon.
With IRA money now earmarked for legacy, inevitably facing a rising tax environment, let’s look at getting those assets out of the line of fire. Let’s look at the tax & IRMAA impact of a Roth Conversion.
For a starting point, this advisor considered a 5-year conversion. That means converting $100,000 per year for five years.
Looking at the client’s current effective tax rate and what that rate would look like during the Roth Conversion, the total tax bill of the conversion would be about $137,500.
(Remember, when calculating the impact of Roth Conversions, the rate to use is Effective Tax Rate, not their Marginal Rate. It’s a very important distinction.)
The downside: the conversion would, unfortunately, bring IRMAA surcharges into the equation, as their income would now meet the threshold for paying this Medicare surcharge.
The projected IRMAA surcharges, assuming a 6% annual increase, would be about $24,000 over the five years of conversion.
This information, while startling, should not necessarily stop the conversion conversation. In fact, you tell me. Would you rather pay $137,500 in conversion taxes and $24,000 in IRMAA surcharges, or pay over $414,000 in lifetime taxes?
(If you’re looking for a streamlined way to evaluate taxes and IRMAA for your clients’ Roth conversions, check out Stonewood’s new Roth Done Right software. It makes this analysis and client conversation simple and meaningful.)
After discussing these options with the advisor, they knew they wanted to maximize their legacy and tax savings. So they were willing to pay the conversion taxes and IRMAA surcharges from outside the IRA.
Paying those taxes outside of the IRA puts those tax payments front and center. Therefore, understandably, the client asked,” Is it really worth it to convert?”
To answer that question, when the client is paying those conversion taxes up front and then also paying those IRMAA surcharges, it makes sense for the advisor to run a break-even analysis.
For the analysis, the advisor included both the $500,000 Roth Conversion amount and the budget we created to cover the conversion taxes and additional IRMAA surcharges. That total was around $661,000.
And looking at the chart below, the “break-even point” occurs in year 15. This means that after the 14th year, the total wealth generated from the Roth is more than if the client had stayed in the IRA.
We calculated the total wealth generated every year by looking at the value of the account, less taxes, less IRMAA, and then assumed the client passed away in that given year, making the remaining value also taxable. This creates a like-for-like comparison for every year throughout the analysis.
To bring this back to the example, the client was looking at a break-even point of 15 years, which represents age 79 for them.
Of course, this analysis led them to ask: “If we do a Roth Conversion, and we both pass away before age 79, our estate loses money?”
The answer to that question is yes, potentially a little. But keep in mind, life expectancy for this couple is well into their 80s. The math behind the break-even analysis still suggests very strongly that the conversion is worth considering.
But also understanding the objection, I suggested to the advisor an extra step in the Conversion process. We asked the question, “If this money is going to the heirs, why not consider life insurance as an alternative to the Roth Conversion?” This would still meet the goal of tax-free funds being passed to their heirs, while eliminating the concern about early-year break-even (since the death benefit is available from day one in an insurance policy).
In fact, for a couple age 65, the advisor could illustrate over $1.4 million in guaranteed to age 100 death benefit from multiple carriers. I’ll leave the details to the illustrations from each carrier, but just know that the $1.4 million number is all that really matters in a true legacy case. And that number is net of fees, net of taxes, and net of IRMAA surcharges.
Now, let’s revisit that break-even analysis. And let’s add a column to that break-even analysis to reflect the death benefit you could get from a life insurance contract.
You’ll see, in terms of legacy value, which is the most important value when looking at legacy money, the break-even is day one. In fact, you’re looking at significantly more wealth generated.
In fact, the life insurance “wins” the comparison all the way to age 87, where the value of the Roth finally catches up to the life insurance death benefit.
In this case, the clients were ecstatic to deliver, from day one, a huge multiple of wealth to their heirs if they were to pass away. And they were also ecstatic to save hundreds of thousands of dollars in taxes along the way. All while protecting the legacy assets from Market Risk, Tax Risk and Legislative Risk.
I like to call this strategy “Legacy Done Right.”
And for clients who have identified IRA money that will be going to the kids and/or grandkids, the Legacy Done Right strategy can be a real winner.
The key to execution is understanding the complex while communicating with our clients in the simple. The ultimate goal of these clients was to pass on to their kids the maximum amount of wealth while minimizing taxes and risk.
Mission accomplished.
About the Author
Strategy expertise and training that actually moves the needle. Neil sees the big opportunities coming - and develops tools to let you take advantage of them.
