Roth Conversions with Optimal Withdrawals

In our posts from March and April, we discussed several aspects of Roth conversions. We showed that, if tax rates are higher in the future, Roth conversions can have a positive payoff. For tax-deferred assets, like pre-tax assets in a 401(k) or IRA, a retiree may pass some of these assets to an heir. The heir’s income tax rate determines the after-tax value of inheriting tax-deferred assets. This week’s post highlights the most recent software update made to our Optimal Retirement Income Calculator, which now includes Roth conversions and optimal withdrawals simultaneously!

How to model Roth conversions with Optimal Withdrawals

Roth conversions reduce tax-deferred assets by “converting” those assets in any year to a Roth account. Individuals performing a Roth conversion owe income taxes on the amount converted. But, the converted amount increases the individual’s Roth account assets, which a retiree can often access tax-free in retirement. One goal of generating tax-efficient retirement income is for optimal withdrawals to avoid large “spikes” in ordinary income. Our Optimal Retirement Income Calculator does this automatically and considers the tax rate of the heir under three distinct scenarios.

1. A retiree has insufficient funds to satisfy retirement income
2. A retiree has sufficient, but not excessive funds
3. A retiree has excess retirement funds

Excess retirement funds and the importance of your heir(s) tax rate

In scenarios 1 and 2, the top and middle portion of the image above, our calculator already finds the lowest marginal tax rate to efficiently distribute tax-deferred assets.  Consequently, our Optimal Retirement Income Calculator already provides a withdrawal strategy to utilize your tax-deferred assets efficiently. So, no additional tax-alpha is possible with a Roth conversion.  However, this is not the case in scenario 3 or the lower right portion of the image above.

When a retiree’s assets are far beyond what is needed to support their retirement income needs, many of their assets will eventually be passed to an heir. In this case, our Optimal Retirement Income Calculator previously left a significant amount of tax-deferred assets to an heir. With our latest software update, a new Roth Conversion Analysis includes converting tax-deferred assets to a Roth account “using up” the retiree’s tax brackets that are less or equal to those of the heir. For example, if your heir has an expected income tax rate of 25%, scenario 3 would perform a Roth conversion up to the 24% tax bracket. Doing so typically adds about 0.10% tax alpha. We encourage you to use our Optimal Retirement Income Calculator to evaluate possible situations for you or your clients. You can easily see if a Roth conversion with optimal withdrawals provides an additional benefit.