What is a Roth Conversion?
A Roth conversion is the process of transferring money from a tax-deferred account to a Roth IRA, where the growth will not be taxed. Thus, Roth Conversions provide an opportunity to move money out of a pre tax account, pay tax at times that are favorable to you and not the IRS, and get the money into a Roth where it will never be taxed again.
What are the assumptions underlying the Roth Conversion Explorer?
The Explorer will solve for one of four strategies
How do the Goal Based Strategies work?
When choosing the highest estate value strategy and the lowest lifetime tax strategy, the Explorer will cycle through hundreds of iterations of projections and identify a series of conversions that achieves the stated goal.
The Explorer will inform you if it is not able to provide a plan that achieves the goal compared to your current plan.
There is, though, a threshold which limits annual conversions to your plan’s maximum effective tax rate. This means that you may be able to achieve a higher estate value strategy or lower lifetime tax rate manually with your own manual plan or one of the Rule Based strategies.
How do the Rule Based strategies work?
The rule based strategies (Tax Bracket Limit and IRMAA Limit) will respect thresholds and may result in a lower estate value or higher lifetime tax liability depending upon the limit you choose. So you may see a negative result but you will not receive a message stating that they could not find a better solution for you, rather you will always see a result because you have set the threshold.
The tax bracket limit strategy will fill the bracket each year for as long as possible, so it’s a front loaded strategy. The IRMAA bracket strategy will flow through your entire plan and fill up the lowest tax brackets from age 63 through longevity age before moving on to the higher bracket, so it’s more of a smoothing strategy.
How are the pre-tax source accounts chosen?
You do not have the ability to directly select source accounts.
The Explorer makes an assumption that all Traditional IRA accounts and all other pre-tax accounts are eligible for conversion. This may be an issue if you have non-eligible tax-advantaged accounts modeled in your plan. In that case you should exclude the account from the withdrawal strategy.
The Explorer’s logic for selecting source accounts is to select the pre-tax account with the highest rate of return, as this provides the most tax-free growth. If there are multiple accounts with the same rate of return, the order factors in your withdrawal order settings:
With Traditional withdrawal order: accounts are prioritized alphabetically by account name.
Under the Custom withdrawal order: (available to PlannerPlus members): accounts follow the specific order you've defined through the drag-and-drop interface in the Money Flows section.
How are the destination Roth accounts chosen?
If you don't currently have a Roth account in your plan, the system will create one for you with the default rate of return of 8.08%. If you'd like greater control of the rate of return, you may want to create a placeholder Roth account prior to running the Explorer.
We recommend carefully reviewing the rate of return assumptions on your pre-tax and Roth accounts. If the Roth account has a higher rate of return, that often comes with increased volatility and a wider range of outcomes with higher potential upside but also greater downside risk in the Monte Carlo simulation.
What are the Tax Payment Options?
The Explorer's suggestion for Roth conversions depends on your answer to "Is it okay to pay for the tax liability of Roth conversions with converted funds?"
If you select Yes, the Explorer will suggest conversions that use funds from pre-tax accounts (conversion proceeds).
If you select No, the Explorer will NOT suggest conversions that utilize funds from pre-tax accounts (conversion proceeds).
When the Optimized Plan is applied to your scenario, the initial assumption is that taxes are paid from funds outside the IRA (after-tax funds). Taxes are paid according to our established plan order of operations, your chosen withdrawal strategy, and withdrawal order. Should additional funds be needed, the Planner will then use funds from pre-tax accounts (conversion proceeds).
If you would like to model the tax coming from the source account, you have a couple of options.
You may want to exclude the after tax accounts from withdrawals so that pre tax accounts will be tapped to fund taxes once the after tax accounts are depleted. We don't suggest increasing the conversion modeling to account for this.
If you wish to leave the after-tax accounts open to pay expenses, you should model the Roth Conversion as a Transfer to a Roth account. And then add a Transfer from the Roth account to a cash account that funds expenses.
Additional Details
Savings balances are not tax adjusted. Pre-tax account balances, which may incur a tax liability for a surviving spouse or other heirs, are not adjusted in Boldin's calculations. In real life, $1 in a Roth account may provide more "spendable money" than $1 in a pre-tax account. This is not taken into consideration in the software.
The Roth Conversion Explorer strategy removes all future modeled Roth Conversions in your Plan before generating a suggestion.
If your after-tax accounts have a higher growth rate than your tax-deferred accounts, the Explorer may not suggest an optimized plan because allowing the after-tax money to grow may result in a higher net worth.
Roth conversions will not be suggested if the tax payments reduce the after-tax funds below the protected amount specified in your plan. And, (when using the rule-based models only,) Roth conversions will not be suggested if the tax payments lead to an unfunded One Time Expense, Disbursement, or Transfer. You may want to run the Explorer prior to adding those items. You always also have the option of including One Time Expenses and Disbursements in the recurring budgeter to avoid this issue.
The software does not feature the Affordable Care Act/Premium Tax Credits. You may add the reduction in/loss of tax credits due to conversions as an expense.
Roth Conversions do not satisfy RMD requirements.
What are the Assumptions around conversions prior to age 59.5?
The Explorer does not consider Early Distribution Penalties or the 5-year rule.
The Explorer will not suggest conversions in your 401k prior to age 59.5 when you have income linked contributions directed to the 401k.
If you do not have enough funds in after-tax accounts to cover the tax liability prior to age 59 ½, conversions will not be suggested.
Prior to age 59 ½ the planner will drain 100% of your taxable assets to pay the taxes and you may be subject to a penalty for early withdrawal. This is not accounted for in the Planner but you will get a coach alert. After age 59 ½ the optimized plan will utilize converted assets to pay the taxes on the conversion after after-tax assets have been depleted.
How are current year conversions taken into account?
If you have made a partial conversion early in the year, enter the conversion in the prior month and the Explorer will surface your remaining opportunity. Once the date of a conversion is past, the tax liability will remain but you must adjust your account balances.
It's essential to use your own discernment and consider your investing and planning temperament prior to executing any financial strategy. We also recommend that you validate your strategies with a tax professional or your tax software prior to taking action.
You may also want to explore our standalone Roth Conversion Calculator.