How to Pull Off a $1.2 Million Roth Conversion While Earning $140K
Discover how a 69-year-old engineer can successfully convert a massive IRA to a Roth before RMDs begin. Learn about tax brackets, IRMAA, and legacy planning.
People with retirement savings in a traditional IRA or 401(k) often experience a moment of panic when their balances grow and they realize they'll soon be on the hook for required minimum distributions (RMDs). RMDs can not only create a tax headache but also have additional consequences, such as raising retirees' income to the point where higher Medicare costs apply.
That's what makes Roth conversions so appealing. By moving money from a traditional IRA or 401(k) into a Roth IRA, you can enjoy tax-free gains in that account, take tax-free withdrawals, and avoid RMDs completely.
That is the scenario facing a 69-year-old engineer with a full-time salary earning $140,000 a year, a case recently considered by financial experts. With RMDs looming at age 73, there's a narrow four-year window to move money into a Roth IRA before mandatory withdrawals begin. And while that conversion may be smooth sailing if you're sitting on a $200,000 or $300,000 balance, converting a $1.2 million account is a whole other story.
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The problem is that Roth conversions are a taxable event. If you convert one-fourth of your $1.2 million account per year over four years and continue collecting a $140,000 salary, your near-term tax bill could be huge. And you could end up costing yourself a lot more money in Medicare premiums if that conversion results in income-related monthly adjustment amounts (IRMAAs), or higher IRMAAs than what you're facing now.
That doesn't mean you don't have options, though. Here's how to pull off a Roth conversion under these circumstances.
Focus on tax brackets, not dollar amounts
If you're looking to convert a $1.2 million account before RMDs set in, you may be inclined to move $300,000 per year to achieve that goal. James Comblo, partner at Prosperity Capital Advisors, cautions that this approach may not work out in your favor.
"I would not divide $1.2 million by four and assume $300,000 a year is the answer," Comblo says. "Where I usually start with clients is by looking at how much room is available in each tax bracket. Filing status changes the entire calculation."
As Comblo explains, at a $140,000 salary, a single taxpayer is already in the 24% federal tax bracket before converting a single dollar. A married couple filing jointly, however, could land in the 12% bracket if they have enough available deductions.
In other words, depending on filing status, "the same salary can create two completely different conversion budgets and outcomes," Comblo says.
Running the numbers, we see that for a single tax-filer, adding a $300,000 conversion would push a meaningful amount of income into the 35% tax bracket. For a married couple, Comblo explains, most of that same conversion would fall into the 22% and 24% brackets. Only a small portion would reach 32%.
Social Security could complicate things
If you're 69 years old and earning $140,000 a year, you may not need Social Security. But the delayed retirement credits awarded to filers who hold off on taking benefits past full retirement age stop accruing at age 70. As such, that's typically considered the latest age to file for Social Security.
Comblo cautions that once Social Security starts, your taxable income increases, making it harder to stay within lower tax brackets during a Roth conversion.
"A Roth conversion can also cause more of the Social Security benefit to become taxable. The two decisions affect each other," he says.
A conversion could impact Medicare costs
Another issue with making a Roth conversion that is too large in any given year, says Comblo, is that it increases modified adjusted gross income.
"Medicare looks back two years when calculating Part B and Part D surcharges," Comblo explains. "A large conversion at age 69 could raise Medicare premiums at age 71."
IRMAAs aren't necessarily a reason to avoid Roth conversions, Comblo says. However, he advises, "It does mean the extra premiums need to be included in the calculation."
Re-evaluating the RMD "crunch"
Another thing Comblo cautions against is assuming leaving money in a traditional retirement account creates a crisis.
"A $1.2 million IRA at age 73 would produce a first-year RMD of roughly $45,000 under the current IRS life-expectancy factor," he explains. The taxes you pay on your RMDs may be lower than the taxes you'd pay on conversions.
Comblo also points out that starting RMDs at 73 does not end the Roth conversion window.
"The RMD has to come out first, and it cannot be converted," he says. "Once the required amount has been distributed, additional dollars can still be converted to a Roth. The planning becomes more complicated after 73, but the opportunity does not disappear."
Leveraging legacy goals
A Roth conversion may not be totally necessary in the situation above. From a tax perspective, leaving the money where it is could result in lower taxes.
In fact, Robert Jeter, CFP, founder and financial planner at Back Bay Financial Planning & Investments, LLC, says, "It's likely that they are in peak earnings of their career, and doing a Roth IRA conversion will almost certainly increase their lifetime tax bill."
But while a Roth conversion may not be the savviest move from a tax-minimization standpoint, Jeter says it could support an estate-planning goal — namely, reducing beneficiaries' tax liability.
"One of the best levers for Roth IRA conversions is talking about legacy goals as well as understanding the financial situation — specifically, the income situation of the beneficiaries," he says.
If your children, for example, inherit your Roth IRA, their distributions won't be taxable. If they inherit a traditional IRA, they'll owe taxes on their withdrawals, which they'll be forced to take so as to empty the account within 10 years. And if your heirs end up having to take those withdrawals during their peak earning years, at the family level, your total tax bill could be higher.
That, says Jeter, could make the case for a Roth conversion now despite having a large salary.
"I always categorize this as keeping money in the family," he says.
If your motivation to do a Roth conversion stems from wanting to leave a tax-free inheritance, one compromise is that your heirs could cover the conversion taxes with the understanding that more dollars would likely come back to them later, Jeter explains.
Four conversion strategies to compare
Ultimately, says Comblo, in this situation, there are four basic strategies worth looking at:
- Don't do any conversions. Let the IRA grow and take RMDs as required.
- Convert enough each year to fill the 24% tax bracket.
- Convert and use part of the 32% bracket, but only if the long-term projections support paying that rate today.
- Complete smaller conversions while collecting that $140,000 salary and do larger conversions once you're no longer working.
For each strategy, Comblo recommends comparing lifetime taxes, Medicare premiums, future RMDs, after-tax cash flow, the Roth balance at different ages, and what ultimately reaches beneficiaries, if that's important.
But ultimately, he says, "The conversion amount should come from the math, not from the size of the IRA."
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