The Decision
Marty and Anita are weighing the pros and cons of converting their SEP-IRA to a Roth IRA. Both are retired, and they have recently learned that when they reach age 73, the IRS will require them to start taking required minimum distributions (RMDs) from their SEP account. They have a few years before RMDs kick in, so they want to see how a Roth conversion would affect their strategy down the road. 1The Background
Marty, 67, spent most of his career as a consultant, earning independent contractor 1099 income. He created a SEP-IRA several years ago, which is now worth about $500,000. Anita, 67, participated in her company’s 401(k), which has a balance of around $50,000.Pro tip: Under SECURE 2.0, your RMD age depends on your year of birth. For example, RMDs start at age 75 for individuals born on or after January 1, 1960.
Together, they’re preparing to start their Social Security benefits next month, which will form the base of their retirement income at roughly $4,500 a month. They are most excited about the $200,000 they’ve accumulated outside of accounts earmarked for retirement. They know they have a lot of flexibility with that money they have put aside.
Their goal is $8,000 a month in retirement income. Social Security is going to cover roughly 60 percent, and the other $3,500 a month has to come from somewhere else.
“The point is that accumulating the money is only part of the equation,” writes Mick Owens, author of the book Diamond of Life: The Five P’s of Success and Significance. “The distribution phase is equally important.”
The Questions
In six years, Marty and Anita will be required to start RMDs for their SEP-IRA and their 401(k). They realize that once RMDs begin, their flexibility narrows. When they reach 73, the withdrawal amount will be determined by an IRS formula, not by what they need each year. They also realize that in six years, their accounts could be larger, which means larger RMDs. Their questions start to become more pointed and focused:
- How will our Social Security benefits be taxed when we’re 73 if we are taking RMDs?
- If we do a Roth conversion, how would that money that we convert be taxed?
- Is a Roth conversion done in stages, or is it an “all or nothing” proposition?
The Strategy
After review, Marty and Anita decided that they wanted to convert the SEP money into a Roth IRA over time. They are interested in moving smaller amounts over the next six years, which they believe will be more manageable because each conversion is taxable in the year it happens.
The appeal is more than taxes; however, it’s also about exploring the estate management opportunities they can use with a Roth account. Money in a Roth that has met the five-year holding requirement has no future tax obligation attached, and if any of it passes on to their children, it may arrive with more favorable tax treatment.
But there are tradeoffs to consider; every conversion brings a tax bill, which may come from the $200,000. A strategy that involves reducing that “cash cushion” can be a psychologically difficult decision.
“If any of you lacks wisdom, let him ask God, who gives generously to all without reproach, and it will be given him.” James 1:5
The Action
In this hypothetical, Marty and Anita decided to move ahead and start the conversion process with $75,000 this year. They’re prepared to convert roughly $75,000 in the following years. Marty and Anita have estimated that the SEP-IRA could grow to more than $600,000 by age 73, which could mean a first-year mandatory withdrawal of more than $20,000. By converting gradually, the SEP-IRA shrinks to a more modest balance by age 73, while the Roth balance increases over time.
Did you know? The original owner of a Roth IRA isn’t required to make mandatory withdrawals.
Our Perspective
With Marty and Anita, the conversion decision trades current liquidity for future flexibility. The exact structure of the conversion strategy would depend on several factors, including Marty and Anita’s complete income picture, Medicare premiums, other sources of income, and how those factors may change year by year over the six-year period.
This case study gives a high-level overview of how we walk clients like Marty and Anita through building a retirement income strategy. We’re not tax experts, but the good news is that we are associated with cfd Tax Preparation & Bookkeeping. If you want to learn more about the taxes due with a Roth, we encourage you to speak with your tax, legal, or accounting professional or ask our tax planning department. They might be able to help.
Visualizing income year by year can help bring the cost of waiting into focus. Deferring Roth conversions hands the wheel over to rigid tax formulas, locking clients into mandatory RMDs and Medicare Income-Related Monthly Adjustment Amount (IRMAA) cliffs they can no longer control.
Back-of-the-Napkin Approach
As the year draws to a close:
- Calculate your taxable income and subtract that amount from the upper limit of your tax bracket. If you don’t know where to start, we can help. Otherwise, you can consider asking your tax, legal, or accounting professional for some help.
- The remaining amount is how much you can convert this year while staying in the same tax bracket. This isn’t a limit, but it’s more of a guide to help you see the trade-offs.
- Repeat in the following years. However, keep in mind your account value fluctuates depending on market conditions, so anticipate changes.
1. After reaching age 73, you must begin taking required minimum distributions from a SEP-IRA, traditional individual retirement account, or other defined contribution plans in most circumstances. Withdrawals are taxed as ordinary income. If a withdrawal is taken before age 59½, a 10% federal income tax penalty may apply.
Roth IRA distributions must meet a five-year holding period and occur after age 59½ to qualify for the tax-free and penalty-free withdrawal of earnings. In other circumstances, such as the death of the owner, tax-free and penalty-free withdrawal can also be taken. Additionally, the original Roth IRA owner is not required to take minimum annual withdrawals.
