In Part 1, we outlined how high income professionals who respond appropriately to tax incentives can easily find themselves with a majority of their retirement nest egg in tax-deferred accounts. Left unchecked, this imbalance can lead to tax-inefficient withdrawals in the form of required minimum distributions (RMDs).
Compounding a bad situation, inheriting tax-deferred retirement accounts can saddle the surviving spouse with higher RMDs precisely when the transition to single filer status places the survivor in a significantly higher marginal tax bracket. Roth conversions at opportune moments offer a chance to defuse the tax bomb before it detonates.
In Part 2, we'll explore some simplified examples to illustrate when and whether Roth conversions make sense for full- and part-time physicians. Physicians with a lower expected income in 2020 due to COVID may find that this will be a good year to Roth convert a portion of their tax-deferred retirement accounts.
Always Run The Numbers
For most physicians in their peak earning years, Roth conversion is a bad idea, because they will be paying taxes at a higher marginal tax rate than they would likely encounter in retirement. The exception might be when a physician encounters a lower income year.
Planned low-income years might include academic sabbaticals or going part-time prior to full-retirement. Docs who cut back are ideal candidates to put in place a gradual Roth conversion strategy.
Unplanned low income years include our current situation, with the COVID pandemic unexpectedly reducing income. Roth conversions might be successfully undertaken by a physician in a stable financial situation (not about to get divorced/married; large existing emergency fund; large habitual gap between income and expenses).
Take a theoretical single-income family with one physician spouse earning $300,000 in a typical year. Please note this is a simplified version for illustration purposes. Always review any plan with a trusted CPA for validation prior to execution.
Assumptions:
- Tax-free state
- Married Filing Jointly (MFJ) status
- Spouse does not earn income.
- Federal MFJ tax brackets for 2020 shown below
| 10% | $0–$19,750 | 10% of the taxable income | |||
| 12% |
|
$1,975.00 + 12% of excess over $19,750 | |||
| 22% |
|
$9,235.00 + 22% of excess over $80,250 | |||
| 24% | $171,051–$326,600 | $29,211.00 + 24% of excess over $171,050 | |||
| 32% | $326,601–$414,700 | $66,543.00 + 32% of excess over $326,600 | |||
- Our doc has $500k in a taxable account, $1.5 million in tax-deferred retirement accounts and $50k in Roth accounts.
- Our doc is in her mid-40s and saves $19,500 in a 401k as well as maxing out personal and spousal backdoor Roth IRAs.
- Takes standard MFJ deduction of $24,800
- Our doc earns $300k of W2 income in a typical year.
Full-Timer, Typical Year
In a typical year, our doc's taxable household income will be $300,000 - 19,500 - 24,800 = $255,700.
In a typical year, her annual federal tax bill will be $29,211 + [24%*($255,700-$171,050)] = $49,527.
Note that while her marginal tax rate (tax rate paid on the next dollar of income) is 24%, her effective tax rate (taxes paid / taxable income) is $49,527/$255,700 = 19.3%.
Roth conversions could potentially fill up the remaining space in the highest marginal tax bracket, but 24% is not a terribly good rate at which to be taxed. If our doc decided to proceed anyway, she has an additional $326,600 - $255700 = $70,900 of space remaining in the 24% bracket. While that's a lot of space, the conversion would be taxed at 24%*$70,900 = $17,016. Ouch. Most physicians would not Roth convert in the 24% tax bracket..
Full-Timer, COVID Year
Due to COVID, let's say that in 2020 our doc takes a 33% haircut and now expects an annual income of $200k in 2020.
She still makes her 401k contribution and takes the standard MFJ deduction, resulting in a COVID-year taxable income of $200,000 - 19,500 - 24,800 = $155,700.
In this COVID year, her annual federal tax bill will be $9,235.00 + [22%*($155,700-$80,250)] = $25,834.
Her marginal tax rate is 22% while her effective tax rate is $25,834 / $155,700 = 16.6%, significantly lower.
The remaining space in the 22% bracket is $171,050 - $155,700 = $15,350. Not a huge space, but a reasonable rate at which to Roth convert some of the 401k money. Note that to do these conversions, she needs to have sufficient funds available to pay tax on those conversions. The tax on the Roth conversion will come to 22%*$15,350 = $3377.
Part-Timer, Typical Year
Now let's see how a part-timer compares, both in typical and COVID years, in terms of Roth conversion space. We'll assume our part-timer is working 60% of a full-time equivalent in the same specialty as our full-time doc, for a typical year salary of $300,000*60%=$180,000.
In a typical year, our doc's taxable household income will be $180,000 - 19,500 - 24,800 = $135,700.
In a typical year, her annual federal tax bill will be $9,235.00 + [22%*($135,700-80,250)] = $21,434.
Her marginal tax rate is 22% while her effective tax rate is $21,434 / $135,700 = 15.8%.
Her remaining space for a Roth conversion in the 22% bracket is $171,050 - $135,700 = $35,350. The tax on the Roth conversion would come out to $7,777. Not awful.
Part-Timer, COVID Year
We'll give our part-timer a similar COVID haircut of 33% for an expected 2020 income of $120,000. Now things get interesting from a Roth conversion standpoint.
Our doc's taxable household income is reduced to $120,000 - 19,500 - 24,800 = $75,700.
Her annual federal tax bill will be $1,975.00 + [12%*($75,700-19,750)] = $8,689.
Her marginal tax rate is 12% while her effective tax rate is $8,689 / $75,700 = 11.5%.
Now for the silver lining of the low-income year. The remaining Roth conversion space is $80,250 - $75,700 = $4,550 in the 12% bracket (an absolute bargain) plus the full space $171,050 - $80,250 = $90,800 in the 22% bracket. If our doc decides to Roth convert up to the top of the 22% bracket, her tax bill for the Roth conversion will be 12%*$4,550 + 22%*$90,800 = $20,522. A significant bill to be sure, but for someone with a decently padded taxable account, this could represent a wise way to defuse the tax bomb ahead in a uniquely fortuitous low tax year.
Partial Checklist Prior To Roth Converting
A Roth conversion will not be right for every physician - this is a sophisticated financial move for a physician household that started out in a strong financial position before COVID hit.
- Can I predict sufficient income to cover my expenses for the coming year?
- Is my emergency fund (3-6 months of living expenses) full?
- Do I have sufficient cash equivalents on hand to pay the expected tax bill for this year's proposed Roth conversion?
- Do I expect my marginal tax rate to increase during retirement?
- For early retirees: Do I expect less favorable tax rates to take effect between the time I retire and the time I begin to take RMDs from my tax-deferred accounts?
This checklist is by no means complete, but should be considered a prerequisite to pursuing Roth conversions. If you are experiencing uncertainty regarding your ability to adapt to a reduced level of income, please get your financial house in order before you consider a Roth conversion. I'd welcome any suggested additions to the checklist.
This two-part post was not intended to be a comprehensive guide, but an introduction to Roth conversion strategies and a prompt to run the numbers on your personal scenario. Happy converting!
If you are navigating a personal or professional crossroads and seek assistance, I'd be grateful if you'd consider my burnout coaching service. Thank you.
Comments 3
As on of the “Docs who cut back” it’s good to examine the rarely discussed topic of Roth conversions beyond “it’s something to do once you’re retired”. I am three years into the process and yes it will be a long drawn out affair.
I agree with Always Run the Numbers so before even embarking on this journey you should run pre-tax savings through an RMD calculator to give an idea of how much you’ll actually have to draw out of your account when the time comes. My favorite is Schwabs: https://www.schwab.com/ira/understand-iras/ira-calculators/rmd
It hasn’t been updated yet to incorporate the change from 70.5 to 72 yrs for the start of RMDs, but it’s still a reasonable estimator allowing for average rates of return from 0-12%.
In your example of a doc in her mid 40’s with $1.5M in her 401k, using 5% as a ROR she’ll be subject to RMDs from $180K+ to >$400K if she makes to her late 80s and beyond. That doesn’t even factor in continued 401k contributions for as long as she continues to work.
TBH, unless you’re willing to convert into the 24% bracket you’re pissing in the wind if you have serious 7 figure $$ in your pre-tax account. For the past 3 years I have converted 6 figure amounts and the value of my 401k account is still about the same as when I started. This has also caused me to adjust my asset location. In the past I wanted highest potential growth assets in tax-advantaged accounts and put muni bonds in taxable, but now the bulk of my bonds are in the 401k and muni bonds are used to pay the extra taxes for Roth conversions. With bond yields now minimal, this has slowed the pre-tax account growth as intended.
One subject not covered is does your plan even allow this? If you’re younger than 59.5 yrs you can only do this if it allows non-hardship in-service withdrawals (if it does it may be limited to once a quarter or once a year) or has in-plan Roth rollovers. Even most of the solo 401k plans are deficient in this regard (eTrade is the only one that allows IPRR that I am aware of). As a part-timer with a solo 401k plan I had to go to a customized plan to be able to Roth convert (I also wanted to have the Mega BD Roth available, which is a whole different topic). Once you’re older than 59.5 yrs you can take qualified distributions so this problem goes away.
Gasem had a nice series of posts in his blog on this subject about a year and half ago. I’m not sure how he still feels about it now given his comment in the previous post but he does provide a lot of insight on this topic.
Author
GasFIRE,
You and Gasem are both my vicarious peeks for what lies ahead financially (at the very least, an aspiration of problems I hope to be lucky enough to face), and it was his series of posts as well as his comments that got me thinking about conversions to begin with. His Roth blueprint was a mind-blowing read, and his follow-up posts offer great insights into how to effect the type of plan he laid out.
You are completely right that checking the fine print on your plan is the first order of business.
I guess the real challenge is saving up several years of living expenses plus Roth tax hits in the taxable account, as Gasem did, in order to pull off the successful Roth conversion. We’ve shifted gears from maximizing tax-deferred contributions to building up our taxable stockpile, and it’s slower going than I’d thought.
Point about adjusting asset location to reduce the rate of growth within tax-deferred is another point well-taken. I was supposing the 24% bracket would not be needed in years with near zero reportable earned income, although that’s not likely going to be the case for many. Then again, perhaps my 401k is leaner than yours – may I be fortunate enough to require entering the 24% bracket in the future!
Appreciate your feedback and real-world reports from the front-lines of Roth conversion strategies,
CD
I was a child once too.
To believe that a bankrupt government will keep its promises on taxes for the future is naive IMO.
If history is any guide they will reneg and steal. That’s what governments do.
It’s worse than that actually.
There’s a good chance the Covid will usher socialists/extreme leftists to power.
And “wealthy Docs” (a few Mils) will have the surprise to be targeted with a wealth tax (that billionaires will easily avoid thru corporate and foundation structures).
Wanna bet?
Inflation, massive inflation, tax bracket creep and wealth tax can destroy a prosperous retirements faster than a nuclear bomb.
And on top of that we may have to apologize for the (our) privilege to pay.