Parts 3, 4, and 5 of this six-part series discussed the three primary benefits to be derived from a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits.
This week’s post compares a scenario with no Roth IRA conversion to a second scenario with a Roth IRA conversion to determine which one is projected to result in more total investment assets throughout the life of the scenario. Benefit #3, i.e., potential reduction in taxation of Social Security benefits, isn’t included in the Roth IRA conversion scenario since, as stated in Part 5, this benefit is less certain than the other two and there are enough moving parts in both scenarios without including this possibility.
The decision whether or not to do a Roth IRA conversion is extremely complicated with many variables that need to be considered, a change in any one of which could significantly affect the results. Given this fact, it’s critical to understand that the results of the two scenarios presented in this blog post cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate for a particular situation. A detailed analysis needs to be prepared by a qualified retirement income planner for every potential Roth IRA conversion situation.
The following is a list of seven assumptions common to both scenarios:
- There are initially two investment accounts – a nonretirement investment account and a contributory IRA account.
- The scenario begins at age 50, at which time the value of each of the investment accounts is $200,000, and ends at age 85.
- The annual rate of return of the nonretirement and IRA accounts (contributory and Roth) is 2% and 6%, respectively.
- Retirement age is 65 at which time annual withdrawals of $30,000 increasing by 3% to pay for living expenses begins.
- There will be additional withdrawals required to pay for income tax liability attributable to the IRA withdrawals and Roth IRA conversions at an assumed combined federal and state rate of 30%.
- There will be annual required minimum distributions (“RMD’s”) from the contributory IRA account beginning at age 70-1/2 based on the value of the account on December 31st of the previous year using divisors obtained from the Uniform Lifetime Table.
- There are no capital gains in connection with withdrawals from the nonretirement investment account.
In addition to the foregoing seven assumptions, the Roth IRA conversion scenario assumes annual Roth IRA conversions of $50,000 beginning at age 50 through age 53 with a final conversion of the balance of the contributory IRA account at age 54.
Exhibit 1 assumes no Roth IRA conversion. It’s fairly straightforward from age 50 through age 64, with both investment accounts simply growing by their assumed rates of return of 2% and 6%, respectively. The annual withdrawals of $30,000 increasing by 3% begin at age 65 with the initial source of 100% of the withdrawals coming from the nonretirement investment account. The nonretirement investment account withdrawals are reduced by the contributory IRA account RMD’s beginning at age 70-1/2, the initial amount of which is projected to be approximately $24,000, however, they are increased by the income tax attributable to the IRA account withdrawals at an assumed rate of 30%. As a result, the total withdrawals from both accounts is projected to increase from approximately $34,000 at age 69 to approximately $42,000 ($18,000 + $24,000) at age 70.
When the value of the nonretirement investment account is no longer sufficient to fund the difference between the annual inflated living expenses of $30,000 and the IRA account RMD’s plus the income tax attributable to the RMD’s, which occurs beginning at age 77, additional withdrawals from the IRA account above and beyond the RMD’s are required. Per Exhibit 1, the IRA account withdrawals are projected to increase from approximately $33,000 at age 76 to $43,000 at age 77. When the nonretirement investment account is depleted at age 78, the IRA account withdrawals are projected to jump from approximately $43,000 at age 78 to approximately $57,000 at age 78. The IRA account withdrawals increase by 3% each year plus income tax at a rate of 30% until they are projected to be approximately $70,000 at age 85.
Exhibit 2 assumes a staged Roth IRA conversion, with annual conversions of $50,000 from age 50 through age 53 and a final conversion of the balance of the contributory IRA account at age 54. Unlike Exhibit 1 in which there are no withdrawals from the nonretirement investment account before age 65, annual withdrawals of $15,000 for four years plus a final projected withdrawal of approximately $11,000, for a total of $71,000, are required to pay the income tax attributable to the annual Roth IRA conversions. After age 54, there are no further withdrawals required from any of the investment accounts to pay for income taxes since (1) the contributory IRA account is depleted at age 54 as a result of the Roth IRA conversions resulting in no RMD’s or other taxable withdrawals from this account, and (2) there is no income tax attributable to withdrawals from the Roth IRA account.
Per Exhibit 2, as a result of the age 50 – 54 withdrawals from the nonretirement investment account required to pay the income tax liability attributable to the annual Roth IRA conversions and the annual living expense distributions of $30,000 increasing by 3% beginning at age 65, this account is projected to be depleted at age 70 at which time the Roth IRA account will begin to be used to fund the difference. At age 71, a projected withdrawal of approximately $36,000 is taken from the Roth IRA account. This increases by 3% per year until the projected withdrawal amount is approximately $54,000 at age 85 which is approximately $16,000 less than the contributory IRA account projected withdrawal amount at age 85 per Exhibit 1.
Exhibit 3 is a comparison of the projected investment account values at each age for the “No Roth IRA Conversion” (Exhibit 1) vs. “Roth IRA Conversion” (Exhibit 2) scenario. Given all of the assumptions used in both scenarios, the total investment value of the “No Roth IRA Conversion” scenario is projected to be greater than the “Roth IRA Conversion” scenario from age 50 through age 80, with the projected difference increasing from approximately $74,000 at age 54 following the completion of the staged Roth IRA conversion to approximately $99,000 at age 69. The projected difference decreases each year until age 81 when the total value of the “Roth IRA Conversion” assets is projected to begin to be greater than the “No Roth IRA Conversion” assets.
Once again, as stated earlier in this post, it needs to be emphasized that the results of the two scenarios presented in this blog post cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate for a particular situation. Furthermore, a detailed analysis needs to be prepared by a qualified retirement income planner for every potential Roth IRA conversion. Some lessons, however, can be derived from this exercise that can be applied to individual planning scenarios that will be the subject of next week’s post.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.