Strategic Roth Conversions Reduce Future Taxes by $68,000

Strategic Roth Conversions Reduce Future Taxes by $68,000

Executive Summary

Santos Financial Research Group encountered a client concerned about higher tax liabilities in retirement. To mitigate this, Dr. Santos implemented a strategic series of Roth conversions, converting pre-tax retirement funds to Roth accounts during years with lower tax brackets. This proactive approach, leveraging tax planning software and future tax bracket projections, is estimated to save the client approximately $68,000 in taxes during retirement.

The Challenge

Mr. and Mrs. Thompson, both 58 years old, approached Santos Financial Research Group with a growing concern about their future tax burden. They had diligently saved for retirement, accumulating a substantial $1.2 million in traditional IRA accounts and $300,000 in a 401(k) plan. Their current combined income placed them in the 24% federal tax bracket, but they anticipated moving into the 32% bracket upon retirement due to Mrs. Thompson's pension and potential rental income from a vacation property they planned to purchase.

Specifically, they were worried about Required Minimum Distributions (RMDs) from their pre-tax retirement accounts, which would be taxed at the potentially higher rate. Modeling their projected RMDs, which were estimated to be around $60,000 annually starting at age 73, showed a significant tax liability looming. Adding to their concerns was the potential for future tax rate increases, further eroding their retirement savings. They wanted to explore strategies to minimize their future tax burden and preserve more of their wealth for their long-term goals, including leaving a legacy for their grandchildren. The Thompsons were particularly averse to the idea of losing a significant portion of their retirement income to taxes, especially given their diligent saving habits. They felt they should explore options to avoid paying an additional 8% in taxes, equivalent to losing a substantial portion of their hard-earned savings.

The Approach

Dr. Santos, a Certified Financial Planner and founder of Santos Financial Research Group, began by conducting a thorough review of the Thompsons' financial situation, including their current income, retirement savings, projected retirement income sources, and long-term financial goals. This involved a detailed analysis of their current tax bracket and projections for future tax brackets, taking into account potential income sources like Mrs. Thompson's pension and the rental income.

Recognizing their concerns about future tax liabilities, Dr. Santos recommended a strategic Roth conversion strategy. This involved systematically converting a portion of their pre-tax retirement funds (Traditional IRA and 401(k)) to Roth accounts. The key to this strategy was to convert funds during years when the Thompsons were in a lower tax bracket (24%) compared to their projected future tax bracket (32%). The Roth conversion would be taxed at the current 24% rate, but future withdrawals from the Roth accounts would be tax-free, eliminating the tax liability on RMDs in retirement.

The decision framework centered around balancing the immediate tax cost of the conversion with the long-term tax savings and flexibility offered by Roth accounts. Dr. Santos carefully considered the amount to convert each year to avoid pushing the Thompsons into a higher tax bracket in the present. The strategy also factored in the five-year holding period rule for Roth conversions, ensuring that the Thompsons would be able to access the converted funds tax-free in retirement. To manage the conversions effectively, Dr. Santos scheduled them annually, optimizing for tax efficiency without disrupting their current lifestyle or financial stability.

Technical Implementation

To accurately model the impact of the Roth conversion strategy, Dr. Santos utilized sophisticated tax planning software, specifically Holistiplan and RightCapital. These tools allowed for detailed projections of the Thompsons' future tax liabilities under various scenarios, including no Roth conversions, aggressive Roth conversions, and the recommended strategic Roth conversion approach.

The software incorporated the following key variables:

• Current IRA and 401(k) balances: $1.2 million and $300,000, respectively.
• Current Federal Tax Bracket: 24%.
• Projected Future Federal Tax Bracket: 32%.
• Mrs. Thompson's Pension Income: Projected $30,000 annually, beginning at age 62.
• Rental Income: Projected $20,000 annually, beginning at age 60.
• RMD Start Age: 73.
• Estimated RMD Amount (Without Conversions): $60,000 annually.
• Conversion Amount: Dr. Santos recommended converting $40,000 per year for the next 5 years.

The software calculated the immediate tax cost of each $40,000 Roth conversion at the 24% tax rate, which amounted to $9,600 per year. It then projected the tax savings on future RMDs at the 32% tax rate, assuming the RMDs were drawn from the Roth accounts. The projections also considered potential future tax rate increases and the impact of these increases on the Thompsons' overall tax liability.

The integrations of Holistiplan and RightCapital allowed Dr. Santos to provide the Thompsons with visual representations of their projected tax liabilities under different scenarios, making it easier for them to understand the benefits of the Roth conversion strategy. The software also allowed for dynamic adjustments to the conversion amount based on market fluctuations and changes in the Thompsons' financial circumstances.

Results & ROI

The strategic Roth conversions implemented by Santos Financial Research Group yielded significant tax savings for the Thompsons. Here's a breakdown of the projected results:

• Total Roth Conversions: $40,000 per year for 5 years = $200,000
• Total Taxes Paid on Conversions: $9,600 per year for 5 years = $48,000
• Projected Tax Savings on RMDs (at 32%): $200,000 * 32% = $64,000
• Additional Tax Savings from Future Growth (estimated): $4,000

Overall Estimated Tax Savings: $68,000

This figure represents the difference between the taxes they would have paid on the RMDs from their traditional IRA and 401(k) accounts at the projected 32% tax rate and the tax-free withdrawals they will receive from their Roth accounts.

Furthermore, the Roth conversion strategy provided the Thompsons with greater flexibility in retirement. With tax-free access to their Roth accounts, they have more control over their income and can better manage their overall tax burden. The converted funds also provide a valuable source of tax-free income for potential future healthcare expenses or other unforeseen needs.

Key Takeaways

1. Proactive Tax Planning is Crucial: Don't wait until retirement to address tax concerns. Implement tax-efficient strategies like Roth conversions early to minimize future liabilities.
2. Understand Future Tax Bracket Projections: Accurately projecting future income and tax brackets is essential for determining the optimal Roth conversion strategy. Use financial planning software to model different scenarios.
3. Balance Immediate Costs with Long-Term Benefits: Roth conversions involve paying taxes upfront. Carefully weigh the immediate tax cost against the long-term tax savings and flexibility offered by Roth accounts.
4. Strategic Conversion Amounts are Key: Convert funds in a way that avoids pushing clients into higher current tax brackets while maximizing long-term tax benefits.
5. Consider Legislative Risk: Tax laws can change. Consult with tax professionals to understand the potential impact of legislative changes on Roth conversion strategies.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors optimize tax planning, personalize investment strategies, and deliver superior client outcomes. Visit our tools to see how we can help your practice.