When To Do Roth Conversions (Married With A Pension)

(Every now and again, I receive an email that is a great guest post. This one about Roth IRAs for younger folks is one of those…enjoy!)


All you in your 20’s and 30’s out there listen up!

If you’re just starting out in your career and making over $60K you’re probably smart with a good head on your shoulders.  Even if you are earning less, try and work these rules into your budget plans as soon as you can, and yes you are still smart for listening to ole Josh.  Let’s start you off right.


Just Starting Out

Rule Number One: After you get your first paycheck open a Roth IRA account and start contributing to it monthly!  I would suggest a larger reputable established brokerage firm like Vanguard, Fidelity, T Rowe Price, etc.

Rule number two:  Hopefully the company you work for offers a 401K plan with company matching contributions, most do.  Sign up to contribute as much as you can to the company 401K but at the beginning make sure you contribute enough to get the “full” company match.  If you don’t you’re just leaving money on the table.  I would suggest that your contributions go into a Roth 401K if it’s offered.  The company match will have to go into the tax-deferred 401K plan but that’s ok, we’ll deal with that later.

Rule number three:  When, not if, but when you quit your job to go to work at a better job for more money, transfer your Roth 401K funds into your Brokerage Roth account (See rule one).  Then transfer the tax deferred 401K funds to your new jobs 401K plan.  There’s a reason for transferring these tax deferred funds to the next companies tax deferred 401K plan and not to a Standard IRA account and we’ll cover that later on.  Then setup your 401K options with the new company like you did with your last job (see rule two).  Rinse – Wash – Repeat…


What to Do When You’re Making Good Money

“But Josh!  Now both the wife and I are making BANK (over $193,000 income a year for 2019).  We are making too much money to contribute to our Roth IRA and we both are maxing out our 401K plans so we can’t contribute any more there either.  Yet we still want to save more for retirement so that we can retire early!  Is there anything else we can do before we open another Brokerage account and have to start paying taxes on those dividend earnings and capital gains.”


Backdoor Roth

Why yes, yes there is!  Since you and your wife can no longer contribute to your Roth brokerage accounts, you both can use the Roth Backdoor Conversion method to add more funds to your Roth IRA account at your brokerage firm.  How you ask?  This is how.  You open a Standard IRA account with the same Roth brokerage firm using after tax money to fund the account.  Do not invest this money!

For 2019, under the age of 50, the maximum you can contribute to a Standard IRA is $6,000.  This number will probably rise in the future.  As soon the money clears and is available in the account you would do a Roth conversion and transfer the money into your Roth brokerage account.  Because you already paid taxes on the money you will not have to pay any taxes to do the conversion.  Thus the legal Roth Backdoor conversion method…

The IRS has special rules when dealing with tax-deferred Standard IRA accounts that mingle both tax-deferred funds and after tax funds so it’s better just not to deal with that at all.  But there are other reasons for transferring your tax-deferred 401K funds to your next job and not to your tax-deferred Standard IRA and we’ll cover that later.


Fully Funded ALL Retirement Accounts

“Ok Josh!”  That sounds great and right now everything is maxed out and working smoothly.  We still have a few dollars left to save.”  Well you can always contribute more to an HSA account or open a regular brokerage account then invest in Bonds or CDs.


Looking at Retirement

“Sup Josh?  We are getting closer to age 55 and want quit our crappy jobs soon!  Got any suggestions on how to avoid any sort of early retirement penalty”  Now it’s time to explain why you were told to move all of your tax-deferred 401K fund from your old company plan to your new company plan each time you switched jobs.


Post-55 Rules

When you turn 55 you can quit your job (provided you’ve run the numbers and have enough money saved) and start taking distributions from that last companies 401K plan without incurring a 10% penalty from the IRS for early withdrawals.  The withdrawals have to come from that last company plan that you worked for.  You cannot leave money in other company 401K plans that you have worked for in the past and withdrawal without penalty.  That is why you were told to transfer those tax-deferred 401K funds to your new company each time you switched jobs.  The amount just keeps getting bigger over time and is in one location.

The best rule of thumb is to withdrawal from your Tax-Deferred accounts first for as long as you can.  Retiring at 55 I would personally would make sure that I had enough money in my tax-deferred 401K account and cash on hand to make it until 59.5 years of age.  If there’s plenty to cover that and then some, you would still withdrawal from your tax-deferred 401K account first.  If your 401K plan is plentiful but lacking in investment options, you can always transfer “PART” of your 401K funds to your tax-deferred Standard IRA account at your brokerage firm in order to get better investment options.  Once your tax-deferred 401K funds have run out (after you are over 59.5), you can then start distributing for your tax-deferred Standard IRA.  Depending on how much money you have left in your tax-deferred accounts will determine when you want to start doing Roth conversions before you turn 70.5 and RMD’s kick in.


Married, Before RMDs, With Pension

In this scenario, we’ll assume our fearless couple has $30,000 of other income starting when the husband turns 60.  We’ll assume that the husband has a pension, with a 50% survivor benefit. 

Now, please understand, it matters NOT what the source of this income is, pension, annuity, part time job, interest income from bank accounts etc.  Other than municipal bond income, qualified dividends and/or Long Term Capital Gains, it’s all taxed the same on the Federal Level. However, even municipal bond income is included in the provisional income rules which determine how much of your Social Security will be subject to tax.  

Side note: I am not including state taxes in these scenarios as each state is unique when it comes to taxation during retirement.  I refer you to my short book “State By State Guide To Taxes For Retirees” for more detailed information. 

So, remember, we’re starting out with husband at 60 years old, wife 56. Both will live until they are 90.  Husband has $500,000 in an IRA, which is entirely invested in the S&P 500 Index. Husband’s Primary Insurance Amount is $2,900, wife’s is $1,000.  Husband is going to file for Social Security at Full Retirement Age in which wife will file for her Spousal Benefits. 

Their total expenses are $4,000 a month. I KNOW I’m going to get people say “but what about health care… What about property taxes….what about RMDs… etc.”  Folks, it matters not what is included in that $4,000 a month expense for this simple scenario. We’re just trying to solve for if these people should do Roth conversions, that’s it. Assume ALL their expenses are included in that $4k a month, to include health care. (By the way, I use $5,000 a year as a health care expense per person in retirement.  So it goes without saying that their health care expenses could be included in their $4,000 a month expenditures.)

They want to know if they should do any Roth conversions.


Do Roth Conversions?

First thing we do is look at the scenarios for not doing any Roth conversions.   As you can see in Graph 1 below, their taxes gradually go up each and every year, from about 5% for the first 10 years in retirement, to 10% in the middle of retirement to well above 15% upon the death of the husband. 

Graph 1

While Graph 1 shows a visual of the taxes increasing it doesn’t do nearly a good enough job of showing the actual taxes paid.  Percentages are meaningless it’s the dollar amount that is important to know. Why do you think financial advisors only quote their fees in percentages after all?  1% seems a whole lot less money than $5,000 no?

In Graph 2 below you’re going to see the actual taxes paid as this happy, retired couple age.  Notice in 2050, the tax payment was $39,449. Yet, the very next year 2051, it jumps to $49,441. That’s a huge increase!  Hmmm….wonder what caused that?  

Well if you’ve been following me at all you’ll know that’s the Widows Tax Trap in all its glory.  A 25% increase in taxes to the surviving spouse. Awesome huh?

Graph 2

Graph 3

Oh but the fun doesn’t stop there.  Look at Graph 3; Not only does the survivor pay 25% more in taxes, but she pays much more on $40,000 LESS income!   


Income-Related Monthly Adjustment Amount(IRMAA) 

Oh, but the hits just keep coming.  Look at that Total Inflow column on Graph 3. See where it shows $189,952?  Guess what else will happen here? The surviving spouse will no doubt be subject to the dreaded IRMAA, where she’ll have to pay ever-increasing premiums on her Medicare.  

Yay, politicians who designed the tax code!  Really looking out for Americans aren’t you? By the way, this is a completely bi-partisan shakedown. Both parties have allowed this type of fraud to exist for decades. 


Financial Plans are Not Static

Now you might be wondering why some of the information is different in Graph 2 and Graph 3.  That’s simply because I am using real-time data on the value of that S&P 500 fund. The share prices change and when that happens the results change too. This is another reason why you never “set it and forget it” when it comes to your retirement plan.  I assure you your plan results will change, and maybe drastically within a calendar year’s time. 

You also may be wondering why the info in Graph 3 is so much crisper looking than what is showing in Graph 2. That is simply because I found an extension in the Google Chrome Book extension store that allows you to edit screenshots and yet still keep the clarity.  It’s called Chrome Capture and is awesome! Took a few hours for me to find this wonderful piece of software. But man do I ever love it. 

All right, now let’s go down to Graph 4 and see what the net results for our fearless couple’s legacy.  Notice the circle. That’s the Traditional IRA balance they’re leaving to their heirs. ALL TAXABLE as ordinary income to the heirs.  

The taxable accounts are tax-free due to the Step-Up-In-Basis rules.  While that is wonderful, our couple had to pay tax on all that money while they were alive in the form of interest income, dividends and capital gains.  Would have been much preferable in a Roth.  

Graph 4

Convert 35,000 per year to Roth

What you’ll find in Graph 5 below is the tax visual when these folks begin converting to Roth during the first year of retirement.  

Note the drop-off in taxes when the IRA is fully converted. However, because they have a pension, they will always have some tax liability.  I tell clients all the time, the pension essentially acts to wipe out your standard deduction. As such, any income you receive above and beyond the pension, will be taxed and will also force you to have to pay taxes on Social Security. 

Graph 5

But as you can see in Graph 6, the taxes they pay are significantly lower later on in life than what it would have been without doing the Roth Conversions.  However, the Widows Tax Trap remains. 

Graph 6

Tax Free > Tax Deferred

But because they did the Roth Conversions, the vast majority of their liquid wealth is in the Roth, which means it’s ALL TAX FREE.  Tax free to them while alive, tax free to heirs at death. Graph 7 shows us what their liquid estate is upon death. Nearly $4million going to heirs, tax free, in the Roth. Another $1.3 million in a brokerage account that the heirs will receive tax free too. 

So, without doing the Roth conversions, the heirs received $4.97 million, of which $945,000 was taxable to them at Ordinary Income Rates. 

After doing the Roth Conversions, though, the heirs received $5.26 million, ALL TAX FREE!

I’ll let you determine which is better?

Oh, in case you’re wondering what I’m using for a rate of return on the S&P 500. It’s 7.5% with a standard deviation of 16%.  I figure 2-2.5% dividend yield plus a 5-5.5% earnings growth year over year. Thus 7.5%. Nothing fancy there. And that is NOMINAL TOO, i.e., before inflation.  I use a 3% inflation rate as well. 

Graph 7


Actual 1040 Tax Forms

Now let’s go to the fun stuff and look at the actual 1040’s shall we?

Graph 8 – no ROTH conversions

In Graph 8,above, we are looking at the 1040 for 2050 which is the last year the husband will be alive.  Notice in box 5a they have $102,765 of Social Security income, of which $87,350 is subject to tax (box 5b). 

Also notice Line 7, which is their Adjusted Gross Income(AGI).  It’s a LARGE number, even adjusted for inflation, of $305,000. Will that amount put them into IRMAA? I can’t say for sure, as this is 30 years away and the IRMAA rules are much for favorable for a Married Filing Jointly couple than a widow.  But it’s getting close. 

Now scroll down to Line 15 and you’ll see their total tax.  $39,181 is not chump change. Before anyone asks about Line 9 QBI, please understand QBI is for the Trump Tax Bill and will potentially go away in 2026.  When it does, the code will revert back to Pre-Trumpster and that number on Line 7 actually is personal exemptions even though the form still says QBI. There are no more personal exemptions under the Trump Tax Bill.

Take a look at Graph 9. Notice anything different? Husband is now dead and thus Social Security income dropped by $25,000.  85% of Social Security is still subject to tax though. A bit less on Line 4B due to the pension income dropping in half, the RMD amounts being reduced a bit due to the wife being 4 years younger too and another year of around 7.5% growth on the IRA. 


Can’t File as a Qualifying Widow

Also look at Lines 8 and 9. Standard Deductions and Personal Exemptions lowered by 50% due to only being a Single Taxpayer no longer Married Filing Jointly.  No…the surviving spouse is NOT a Qualifying Widower! I can’t tell you how many people think she’ll be able to file as one. She will file as a single taxpayer. 

Graph 9

Finally, look at line 15: $49,158 in total taxes due.  Nice…

So, what can we do about this?  Well let’s take a look at what happens when these fine American taxpayers do some Roth Conversions. 


Ric Edelman says…

“But Ric Edelman says don’t convert to Roth,” I can hear the peanut gallery scream.  Yeah, and he’s absolutely wrong!

Graph 10 – With Roth 

Line 5b gives us a nice introduction in the beauty of Roth Conversions.  Instead of 85% of the Social Security benefit being taxable, now only 66% is.  That may not seem like much but that means $22,000 LESS in taxable income. 

Secondly, look at line 4b.  Notice that $30,000? That’s the pension and nothing else.  Why? Because it’s all been converted and Roth IRAs have no RMDs.   Thus there is nearly $100,000 LESS of taxable income here. 

Finally, look at line 3b.  After Roth conversions there is only $19,714 here.  Before Roth conversions there was $52,657.  

So, all in all, with the Roth conversions in 2050 their AGI drops form $305k to $134k. That is $171k LESS in ADJUSTED GROSS INCOME which means $33k LESS in taxes!

Graph 11

Unfortunately, after the hub dies, the wife will still be in the Widows Tax Trap.  Her taxes more than double all the while her AGI drops a bit. But still, $14k in taxes with the Roth conversions vs. $49k without doing any conversions is a no-brainer.


Want a $400,000 Tax Cut?

With Roth Conversions, this couple will pay a total of $293,644 in Federal Income Taxes over their lives. 

Without?  $685,267

In conclusion the benefits of doing Roth conversions even when one has a pension are:

  • Higher Net Worth during life
  • Higher Legacy to heirs at death
  • Hundreds of thousands less taxes
  • Less likely to fall into IRMAA
  • More control 

Oh, but don’t you worry…we’re FAR from being done yet. We’ll next run a married couple in their 70’s.  Is it too late for them?  

Later we’ll do single taxpayers in their 50s, 60s and 70s too. 

So stay tuned!

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