Economic and investment tradeoffs between traditional and Roth retirement account assets
This article discusses economic tradeoffs between traditional tax-deductible retirement account contributions and non-deductible Roth retirement contributions and conversions. It is helpful to understand the lifetime investment model underlying the comparison between tax-deductible traditional and Roth retirement contributions and converting to Roth after retirement.
For many people, their overall instinct is that Roth contributions should be financially superior to tax-deductible traditional account contributions, but this is not true for most people. Like a “bird in the hand,” for most people, the income tax savings provided by traditional retirement contributions at the outset while they are working and the appreciation on those tax savings over the years would be more valuable. Only in certain circumstances, will Roth contributions and/or contributions reduce traditional RMDs and associated taxes in retirement enough to have a greater financial benefit within a normal life expectancy.
Tax-deductible contributions into traditional IRAs and employer defined contribution plans allow you to reduce federal, state, and local income taxes at the beginning, in the year when a contributions is made. From an investment modeling standpoint you retain more cash at the outset by waiting to convert to Roth in retirement. Furthermore, these cash tax savings could appreciate and compound over the years in line with your asset allocation model.
The up-front tax reduction for traditional retirement account contributions is the government’s incentive to encourage you to save for retirement. In exchange for these initial tax breaks on traditional retirement account contributions, you must begin to take out income taxable RMDs at some point in retirement. RMDs are the flip side of that tax incentive coin.
Your RMDs are projected to begin either at age 73 or 75 depending upon your current age, and VeriPlan’s projections handle this difference automatically. The SECURE Act “1.0” of 2019 pushed the initial RMD age from 70.5 out to age 72. In December of 2022 the second SECURE Act 2.0, was signed into law. This second act raised the initial RMD age to 73 beginning in 2023. An additional provision provided for a subsequent increase in the initial age of RMDs to 75 starting in 2033. See the RMD section of VeriPlan’s yellow-tabbed Taxes worksheet for more information.
Pushing the start of RMDs out to higher ages, also pushes out the breakeven point on the comparison between the financial value of traditional contributions that reduce initial taxes and Roth contributions or conversions after the age that you retire. Later RMDs means a delay in the recovery of taxes in this taxation tradeoff. On the other hand, when the age at which RMDs begin is pushed forward, this tends to add additional lower income years for doing a series of lower tax Roth conversions when you plan on converting to Roth after retirement.
VeriPlan automatically projects you lifetime RMDs and taxes and takes into account your plans to convert to Roth in one or more year-by-year conversions
Your overall annual RMDs are calculated by totaling all assets held in traditional retirement accounts and dividing this sum by your actuarial expected remaining lifespan. As you age, the numerator declines and the annual RMD percentage increases. If you accumulate substantial traditional retirement account assets, RMDs can push you into higher income tax rate brackets, especially as you age into your late 80s and into your 90s, if you are lucky to live that long.
Specifically, RMDs are calculated using a standard formula that divides:
A) the end-of-prior-year total asset value across traditional retirement accounts by
B) the remaining number of years in your life expectancy.
Remaining years of life expectancy are based upon the IRS’s updated Uniform Lifetime Life Expectancy and Distribution Period Table used for purposes of determining RMDs. This Uniform Lifetime Life Expectancy table is based on “posterior” life expectancies, which means that given that you have lived this long, this is your remaining life expectancy. For example, if you actually lived to 100, then 6.4 years would be the remaining life expectancy for this table and would be the equation’s denominator. This means that the divisor never goes down to one, so annual RMDs never are 100% of the account balances.
To give you some idea of how RMDs change over time, the divisor is 26.5 at age 73 and 24.6 at age 75, which corresponds to 3.77% and 4.07%, respectively, of end of year traditional asset balances. At age 80 the equation’s denominator declines to 20.2, and RMDs rise to 4.95% of account balances. At age 85 the denominator is 16.0 and RMDs are 6.25% of assets. At age 90 the denominator is 12.2, and RMDs are 8.20% of balances. By age 95 the denominator is 8.9, and RMDs have increased to 11.24% of the then current end of year asset total. Especially when your portfolio’s asset allocation is more heavily weighted toward higher risk and return assets, your traditional retirement asset balance could keep appreciating. This is particularly true in the earlier years of retirement before RMDs and even after RMDs begin, when your RMD withdrawal percentages are lower.
Diminishing Returns to Roth Conversions in Retirement
If your analysis demonstrates that Roth conversions in low tax years would result in attractive positive outcomes in terms of projected total assets, you should also note the phenomenon of diminishing returns on Roth conversions and contributions. The goal should be to determine the optimum Roth contribution and conversion strategy, when converting to Roth after retirement. Converting all traditional assets to Roth assets is unnecessary and financially suboptimal.
For example, once you plan to convert some Roth assets and you find that to be attractive in terms of the projected the breakeven age, the conversion of additional traditional retirement assets will tend to push out the breakeven age — even if these additional conversions could be done at the same tax rate as before.
As more traditional retirement assets are converted, the projected total amount of remaining traditional retirement assets declines in relative terms and thus RMDs would also decline, lowering the value of each additional dollar converted and pushing out the breakeven age. In summary, the optimal amount to be converted is normally some fraction of total traditional retirement accounts assets and not the total.
Even a partial strategy to convert to Roth after retirement age can reduce or eliminate future Medicare IRMAA insurance premium subsidy reductions
In addition, you do not have to eliminate RMDs to eliminate Medicare’s IRMAA Part B and B subsidy reductions for those retirees with higher income. RMDs are part of the modified adjusted gross income calculation that affects IRMAA and VeriPlan’s Medicare IRMAA calculator features automatically take IRMAA into consideration in your projections. You can turn on the Medicare cost functionality on the yellow-tabbed Medicare worksheet and then look at the blue-tabbed Expenses graphic to understand whether your future RMDs might push your modified AGI into IRMAA territory. Also, you can check the IRMAA column to the right in the year-by-year Roth conversions table to gauge when Roth conversions might have reduced or eliminated future IRMAA adjustments. For more information see the IRMAA section below on this worksheet.
Because VeriPlan if a fully integrated lifetime cash flow projection model, it can automatically project and contrast the relative benefit of the front-end tax benefits of deductible traditional retirement contributions with the back-end Roth tax savings due to converting to Roth after retirement and lowering RMDs in retirement. Roth contributions while working and Roth conversions in lower tax rate years combine to reduce traditional retirement asset balances. Thus, greater Roth assets reduce the amount of income taxes that must be paid due to lower RMDs in retirement.
The question becomes whether lower income taxes due to reduced RMDs in retirement outweigh the upfront tax savings. In most cases, the breakeven point does not occur in within a reasonable expectation for a lifespan.
I produced these informational videos, which are available on YouTube about “How to Optimize Lifetime Roth Contributions and Roth IRA Conversion Taxes”
Video #1 — Overviews the best lifetime Roth contribution and conversion strategies for most people
https://www.youtube.com/watch/PaYC7MnX_9U
https://www.youtube.com/watch/Ij890zUr1OA
