When planning for retirement, many individuals seek strategies to minimize taxes and maximize savings. One popular strategy is the Roth IRA conversion.
In this article, we’ll delve into how by implementing Roth IRA conversions, you can create tax-free savings to be used as an income stream in retirement or to efficiently pass assets to heirs. We will model Roth IRA conversion scenarios within a financial plan using the Advanced Tax Calculation features in SIPS.
What Are Roth Conversions?
A Roth IRA conversion involves transferring funds from a tax-deferred IRA into a tax-free Roth IRA. This process requires paying taxes on the converted amount, but the funds in the Roth IRA grow tax-free thereafter.
More importantly, qualified withdrawals from a Roth IRA are also tax-free, providing a significant tax advantage during retirement. This strategy is especially beneficial for those who anticipate being in a higher tax bracket in the future (like from RMDs) or who want to manage their tax liabilities more effectively.
Why Are Roth Conversions Important?
Roth conversions are crucial because they offer a way to mitigate the impact of Required Minimum Distributions (RMDs). Tax-Deferred IRAs require account holders to start taking RMDs at age 72 or 73, which can lead to higher taxable income in retirement.
By converting to a Roth IRA, you can reduce the amount subject to RMDs, thereby lowering your overall taxable income. This can be particularly advantageous for individuals with substantial tax-deferred assets who want to manage their tax obligations proactively.
Exploring Roth Conversion Strategies
In this blog, we will explore an efficient way to implement Roth conversions using PlanScout’s proprietary planning tool, SIPS Advanced.
We will use the automatic tax calculations and dynamic mode in SIPS Advanced to demonstrate how to identify optimal conversion opportunities, execute the conversions, and analyze the financial benefits.
Whether you are a financial planner or an individual investor, understanding these strategies can help you make informed decisions and enhance your retirement planning.
We recommend you follow along live with our ROTH conversion tutorial video or simply keep reading to see the highlights:
Identifying Conversion Opportunities
The initial analysis reveals several factors indicating that a Roth conversion could benefit the client:
- Excess RMDs starting from year 14.
- Low tax years between years 3-10, offering an optimal window for conversions.
By creating a tax scenario for year 1, we find the client is at the top of the 22% tax bracket. For this example, we will work to keep the client within the 22% marginal tax bracket during conversions only because this was the marginal tax bracket the client was used to being in while working.
Executing a Roth IRA Conversion
- Add a Roth IRA account and set the tax calculation option to “Do not tax (Roth)” in SIPS Advanced.
- Plan and iterate on conversion amounts:
- Using Dynamic Mode in SIPS Advanced, you can quickly and efficiently find the sweet spots for the amounts and duration of conversions.
- In this example, we chose to convert $100,000 annually from years 3-5, stopping before year 6 when Social Security begins.
- This keeps the client within the 22% tax bracket, aligning taxes close to their working years but reducing the taxes paid over the client’s planning horizon.
Despite these conversions, some excess RMDs persist from year 24 onwards. We can see this because money is being added to non-qualified accounts from the RMD withdrawals. So these clients are still being forced to withdraw more money than they need from their tax-deferred accounts than they require to fund their lifestyle in retirement and are putting those excess funds into non-qualified savings. We’ll now iterate to do more tax-free conversions to improve the tax-efficiency.
Results Comparison
Finally, we compare the financial outcomes with and without the Roth conversions:
| Without Roth | With Roth | Change | |
| Savings left at the end of plan | $3,092,784 | $3,333,213 | +$240,429 |
| Total Tax | $713,741 | $509,727 | -$204,014 |
While this conversion increased savings left at the end of the plan and reduced overall taxes paid, what we haven’t yet measured is how much more valuable the tax-free savings are to heirs, which can be tremendous.
Conclusion
Using the tax planning capabilities in SIPS Advanced, we identified this client as an ideal candidate for a Roth conversion, determined the optimal years for conversion, and tracked income taxes throughout the plan. The Roth conversion resulted in significant tax savings and increased the total account value.
For more planning resources and tutorial videos, visit help.sipsplanning.com. To learn more about our outsourced financial planning services where we create plans like these in as fast as 3 days for financial professionals, visit www.planscout.com.
Thank you for reading, and have a great day!
Warm regards,
CEO & Founder of PlanScout
Ps. Want to connect? Feel free to book a meeting with me now and follow PlanScout on LinkedIn.
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