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Now that we’ve decided on Robert’s retirement date, age 62, and his Social Security claiming age, age 70, we can start to analyze different tax strategies.
The approach I take is to look for ways to reduce the liability side of the household balance sheet. For Robert and Denise, that means looking at their projected tax liability, IRMAA, and health care premiums and determining whether there are opportunities to reduce those costs throughout the plan.
Important: We are planning based on what we know today regarding the tax code. While I show the total projected costs for each strategy, it is important to remember that these are projections and estimates. They should not be taken literally.
The likelihood of seeing multiple tax code changes throughout a 20- or 30-year retirement is high. Predicting exactly what those changes will be, however, is nearly impossible. The goal is not to predict the future perfectly. It is to identify the opportunities that exist today and build a strategy that can be adjusted as circumstances change.
For Robert and Denise, there are three scenarios I want to compare.
We don't implement any Roth conversions or additional tax strategy.
This is what I refer to as the base plan. It gives us a starting point to compare against.
Any adjustments we make from here should be because we're projecting that they will improve the long-term plan.
The second option is to ignore the potential ACA premium tax credit savings and begin Roth conversions immediately.
This means intentionally increasing their taxable income in the early years of retirement, paying the associated taxes today, and moving more money from their tax-deferred accounts into Roth accounts.
The tradeoff is that the higher income can reduce or eliminate the ACA premium tax credit, meaning they would pay more for health insurance before Medicare begins.
The third option is to keep their income low enough to qualify for the ACA premium tax credit during the first few years of retirement.
Once they are no longer able to qualify for the credit, we can then begin implementing Roth conversions.
This gives up some of the opportunity to convert money early, but it allows them to capture potentially significant health insurance savings in the meantime.
So the question becomes: Which opportunity is more valuable to them?
When I'm evaluating planning decisions, I tend to frame them as red, yellow, or green.
If something falls into the red category, it means we really don't want to do it.
A green decision is the opposite. It's something that the analysis shows we should implement.
Yellow is where many planning decisions fall. There is a tradeoff, and the numbers can help us understand the options, but there isn't necessarily one obvious answer.
For Robert and Denise, this is a yellow decision. There are benefits to both approaches, and we need to look at the entire plan rather than just one piece of it.
There are four main metrics I prefer to look at when comparing these choices:
Here are the results:
Disclosure: The amounts shown above are estimates and projections based on assumptions and information presented in the case study. Actual tax liability, ACA premium tax credits, and other tax-related outcomes will vary based on individual circumstances, future tax law, income, deductions, credits, and other factors. These figures are provided for illustrative purposes only and should not be considered guaranteed or exact.
The funded ratio is particularly useful here because we're not just looking at the size of the portfolio. We're also looking at the liabilities that portfolio is expected to fund throughout retirement.
If we can reduce future taxes, IRMAA, or health care costs, we reduce the liability side of the balance sheet. That can strengthen the overall plan even if we're not adding another dollar to the portfolio.
One of the things I look at is the projected trajectory of their different account types.
Robert and Denise start with approximately $500,000 in their taxable account, $2.2 million in tax-deferred accounts, and $300,000 in Roth accounts.
If we don't implement Roth conversions, their tax-deferred accounts remain relatively large.
Eventually, RMDs begin. Because their tax-deferred balance is so large, the required distributions can become larger than what they actually need to spend.
The excess money then gets pushed back into the taxable account. This can create an unnecessary tax liability later in retirement.
That trajectory is one of the reasons Roth conversions become attractive in the first place.
When we begin converting money from the IRA to the Roth accounts, we are intentionally paying taxes today in exchange for moving more of the portfolio into tax-free Roth assets.
The taxable account is depleted somewhat faster to cover the tax burden, but the tax-deferred balance also declines.
Over time, this can mean fewer future RMDs, less taxable income from those RMDs, and more assets remaining in Roth accounts.
In Robert and Denise's case, the projection shows that implementing Roth conversions improves the plan compared with the base plan.
The question is when and how much to convert.
This is where the planning gets more interesting.
Robert retires at 62, and Denise is slightly younger. That gives them several years before both are on Medicare.
During those years, they may be able to keep their income low enough to qualify for the ACA premium tax credit.
For Robert and Denise, the projected savings are approximately $8,000 per year.
They have enough in their taxable account to fund the first few years of retirement, which gives us the ability to keep their income relatively low during this period.
But there is a tradeoff.
If we keep their income low to capture the ACA credit, we're giving up some of the opportunity to do Roth conversions during those same years.
So we're essentially deciding how much value to place on the tax savings today versus the potential tax savings later.
The green decision is that we should implement tax planning and Roth conversions.
When we compare either Roth conversion strategy to the base plan, the projections show improvement in the overall plan. We see lower projected lifetime costs and an improved funded ratio.
The yellow decision is the magnitude and timing of the Roth conversions.
If we strictly followed the numbers, starting Roth conversions immediately would produce the lowest projected combined cost of taxes, IRMAA, and health care premiums.
But planning isn't done in a vacuum.
In my experience, it can be difficult for people to stomach increasing their taxes today through Roth conversions while also paying higher health insurance premiums at the same time.
The middle ground that many people find more comfortable is to keep their income low enough to capture the ACA premium tax credit during the early years of retirement, and then begin Roth conversions once they can no longer qualify for the credit.
For Robert and Denise, that is the approach I would initially plan around.
The important part is that this doesn't mean we're done with the analysis. Roth conversions are something we'll continue to evaluate year by year as their income, portfolio, spending, tax law, and health care costs change.
That's really what tax planning in retirement is about.
We're not trying to find one perfect answer today. We're identifying the opportunities, understanding the tradeoffs, and building a strategy that can adapt as the plan unfolds.
Potentially, but I wouldn't make the decision based solely on the belief that tax rates will be higher in the future.
A Roth conversion means paying taxes today in exchange for moving money into a Roth account, where qualified withdrawals can generally be tax-free in the future.
If future tax rates are higher, paying today's tax rate could be beneficial. But the analysis is more complicated than simply comparing today's tax rate with a potential future rate.
You also have to consider the size of the conversion, the tax brackets you're filling today, the effect on ACA subsidies or Medicare IRMAA, the investment growth of the converted assets, and how much money you actually expect to withdraw in the future.
The right question is usually not, "Will tax rates go up?"
It's, "At what tax rate does it make sense for me to move money from tax-deferred to Roth today?"
Yes. Roth conversions generally increase your income for purposes of determining eligibility for the ACA premium tax credit.
That means a Roth conversion can potentially reduce the amount of premium tax credit you receive, or eliminate it altogether.
This is one reason the years between retirement and Medicare can require careful planning. You may have an opportunity to do large Roth conversions, but you may also have an opportunity to receive significant health insurance subsidies.
Those two opportunities need to be evaluated together.
Roth conversions can increase your income and potentially cause you to pay higher Medicare premiums through IRMAA.
This is particularly important because Medicare generally uses income from two years earlier to determine whether IRMAA applies.
That means a Roth conversion made today can potentially affect Medicare premiums in a future year.
The goal isn't necessarily to avoid IRMAA at all costs. Sometimes paying additional IRMAA today can be worthwhile if the Roth conversion meaningfully improves the long-term plan.
No. In fact, I generally think Roth conversions should be evaluated year by year.
Your actual income, investment returns, spending, tax law, Social Security income, RMDs, Medicare premiums, and other factors will change over time.
A good retirement tax strategy gives you a framework for making those decisions rather than locking you into one conversion amount for the next 10 or 20 years.
Beau Kemp, CFP®, RMA®
Founder, Financial Advisor
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