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Roth Conversion Planning: A Step-By-Step Approach

A reader writes in, asking:

“Can you describe exactly the steps you would take to determine whether a Roth conversion makes sense? I understand conceptually that they are advantageous when your tax rate is low, but can you elaborate on how exactly you would figure that out, as well as how to determine how large of a conversion to do?”

What follows is my process for retirement account distribution planning, including Roth conversions.

There are two broad stages to the process:

  1. Creating a “dummy” plan (or maybe you could call it a “default” plan), and
  2. Making improvements to that plan.

Making a Dummy Plan

By a “dummy” plan, I mean a plan in which every year you:

  • Do no Roth conversions.
  • Spend first from wages/earnings, required minimum distributions, Social Security, pension income, dividends/interest coming from holdings in taxable accounts, and only then from further distributions from tax-deferred accounts.
  • Take just enough out of retirement accounts in order to a) satisfy your RMDs and b) provide sufficient dollars to satisfy the desired level of spending, after considering taxes.

What we want to know is what your marginal tax rate (for ordinary income) would be in each of the next several years, under such a “dummy” plan. Note that we are concerned with your actual marginal tax rate, not just the tax bracket that you’re in.

The software I use for this process is Holistiplan, which I think is excellent, but it is priced based on the assumption that it’s being used in an advisory capacity for many clients rather than for an individual household. For most individuals doing DIY planning, a reasonable option is to use tax prep software to prepare hypothetical returns. (Note though that if you do not have experience preparing your own returns, there’s going to be quite a learning curve.) I sincerely do not think that a spreadsheet is a good tool for calculating your marginal tax rate, as it’s quite a challenge to create a realistic tax model that includes all the relevant factors.

For each year, you’re going to create a scenario/return in your tax modeling software, and then start recording the results in a spreadsheet.

For each year, see if you have enough after-tax income to satisfy your desired level of spending. (So this calculation is basically: wages/earnings, plus RMDs, plus Social Security/pension income, plus investment income from taxable accounts, minus taxes — and compare that to your desired level of spending.) If that level of income isn’t enough, increase tax-deferred distributions until it is enough. Remember, we are not yet including any further distributions from retirement accounts.

Then repeat the process for each of the next few/several years. (As I’ve mentioned previously, I don’t think there’s much value in going very many years into the future.) For each year, be sure to include any appropriate adjustments for changes in circumstances, such as:

  • The larger standard deduction for people age 65+,
  • Wage/self-employment income ending/declining due to retirement or partial retirement,
  • Social Security income starting, or
  • Selling your home.

If you’re married, it’s important to also run “only one spouse alive” scenarios under the dummy plan as well, to see what the marginal tax rate would be after one of the two of you dies.

Note that this whole analysis requires making some guesses and estimates. For instance, you’ll have to decide whether to assume the tax bracket structure is allowed to revert back to pre-Tax Cuts and Jobs Act levels at the end of 2025, or whether the current structure will be extended. And you’ll have to make assumptions as to portfolio performance, for the sake of determining RMDs.

Making Improvements to the Plan

With this “dummy” plan in place, take a look at how your anticipated marginal tax rate changes over time. A pattern that is very common for people in almost-retired or recently-retired scenarios is something along these lines:

  • Marginal tax rate falls once income from work stops,
  • Marginal tax rate increases once Social Security begins,
  • Marginal tax rate increases further once RMDs begin, and
  • (For married couples), marginal tax rate increases further once one of the two spouses dies.

From here, the goal is basically to “smooth out” your marginal tax rate. That is, we want to move income out of years in which you have a higher marginal tax rate and into years in which you have a lower marginal tax rate. The tools with which we can shift income from one year to another are:

  • Shifting income earlier by doing Roth conversions, or
  • Shifting income later by satisfying spending in earlier years via Roth accounts or liquidating taxable holdings with significant basis.

For years in which it makes sense to do Roth conversions, you have to decide how much to convert. To do this, first identify the next few thresholds (for the year in question) at which your marginal tax rate would increase. These could be the top of a tax bracket, an IRMAA threshold, the thresholds for Social Security benefit taxation, the bottom of the phaseout range for a particular deduction/credit, or the threshold at which the 3.8% Net Investment Income Tax kicks in.

Then determine exactly what your marginal tax rate would be after hitting that threshold. If that higher marginal tax rate is higher than the marginal tax rate you expect to face later, then you want to do Roth conversions up to (but not beyond) that threshold. If the marginal tax rate beyond that threshold is still below the marginal tax rate you expect to face later, then you probably want to do Roth conversions up to the next threshold. Of note, this is something of an iterative process, because as you do more and more conversions in the earlier years, it can result in your marginal tax rate in the later years being reduced (because RMDs will be smaller).

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