How long until Your Roth Conversion Pays Off? “Breakeven” Age

 In this episode of Your Retirement Guide, George Jameson, CFP® breaks down the concept of the “breakeven” age for Roth conversions. Learn how long it typically takes for a Roth conversion to pay off—and what factors can speed up or delay the benefits. 

 Welcome to "The Retirement Guide" Podcast! I'm your host George Jameson, owner of Capital Wealth Group, a Fee Only Advisory firm. Whether you’re nearing retirement or already retired, Join me each week as we explore the world of retirement planning and equip you with the knowledge and tools you need for a successful retirement.

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This is for education only.It is not tax, legal, or investment advice. Before  acting on any information consult your tax, legal, or investment advisor.

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Transcript

George Jameson: 0:18

Welcome to my podcast. I'm George Jameson, founder of Capital Wealth Group, located in Columbia, South Carolina. Today we're diving into a question, how long until your Roth conversion pays off? In other words, what's your break even age? With all the buzz around Roth conversions these days, it is easy to get caught up in all the hype, but is a Roth conversion truly in your best interest? Most of you have heard about Roth conversions, but today we're gonna break down the concept of the breakeven age to give you one more data point to help you determine if a Roth conversion is right for you. Now, right off the bat, it's important to understand that there isn't a magic number, a single average age, where a Roth conversion suddenly becomes the right move or not. The age at which the benefits of a Roth conversion outweigh the initial cost is different for everyone, and it may not even be a concern to you. The breakeven age depends on a lot of different factors, and again, every situation is unique. The only way that I'm aware of to get an educated guess is to use professional financial planning software like the one I use called Right Capital. It will easily give you the break even age and tax savings based on the number of assumptions. The key is, are these realistic assumptions or not? You can play around with the different assumptions, which I highly recommend doing to make sure the Roth conversion is right for you. Before we go into detail in determining the breakeven age, let me quickly explain Roth conversions for those who don't know. So simply put it's when you take money from a retirement account where you haven't paid taxes yet, like a traditional IRA or 401k and move it into a Roth IRA, the catch is when you do this, you have to pay income taxes on the amount you convert in that very year. It is often best to pay the taxes from after tax dollars, but that's for another day. The potential upside is that once the money is in the Roth IRA, it grows tax free, and then you can make qualified withdrawals tax free as well. So you're essentially paying taxes now, hoping to save on taxes later. This leads us to the idea of a breakeven point, which is when the financial benefits of converting a traditional IRA or 401k to a Roth IRA outweigh the immediate tax cost of the conversion. You'll usually do the conversion when your tax rates are low and you expect your tax rates to be higher later on, also, Roth IRAs are not subject to RMDs, which can significantly improve the long-term benefits of conversion, especially for estate planning. For many of us in our fifties and sixties who are approaching retirement, we've been putting money into our tax deferred accounts for years, like traditional IRAs and 4 0 1 Ks, 4 0 3 Bs and so on. Of course, we get a tax deduction now in these accounts and then the money grows tax free. But later on, when you start taking money out, you have to pay ordinary income tax on that amount. You can of course start taking money out each year at the start of retirement or when it makes the most sense for you. But when you reach age 73 required, minimum distributions start, and now you are forced to take out funds and pay taxes. This is especially true for those who have over a million dollars in tax deferred accounts. Those big withdrawals, especially when you hit RMD Age, can really push you into a higher tax bracket. So one of the big perks of starting Roth conversions early in retirement is that it lets you manage your taxable income. And often at the beginning of retirement, if you plan correctly, you can be in a very low tax bracket and by converting just enough each year while you're in this low tax bracket, you can avoid receiving a large tax bill when your RMD starts at age 73. Bypassing the jump into higher tax brackets. In many cases, this approach can lower your overall tax bill by hundreds of thousands of dollars or more over the course of your retirement. Some of the key unknowns you have to take into account are what will taxes look like in the future? Another big one is how will your investments grow within the Roth IRA If they do well, you'll reach the break even point much sooner than if the investments grow slowly. Let's look at a hypothetical example. Let's say Bill and Sally samples age 65 and 63 have a million dollars in their tax deferred accounts. And then they have 300,000 in a taxable account. And they can use some of this for the conversion taxes. And let's say they'll get an estimated 5,000 per month combined on social security starting at age 70. So they decide to convert up to the top of the 12% tax bracket. Assuming the assumptions come to fruition, they could see about a million dollars more in tax adjusted assets over their retirement lifetime. They'd save roughly$200,000 in taxes and might need to pull about 1 million less from their tax deferred accounts. Since Roth IRAs don't require minimum distributions and right capital projects, they will break even around age 83 Please remember, this is just a simple example. Your break even age, may be earlier or later, and a Roth conversion may or may not make sense for you. Now, here's where the complexities of Roth conversions really come into play. They're not a one size fits all solution. You've gotta think about a whole bunch of variables, not just your life expectancy. But also how your assets are invested and how fast they'll grow. You need to consider both today's tax rates and what future tax brackets may look like. You need to consider how much money you need to live on if you plan to spend all of your RMD each year, or do qualified charitable donations with your RMDs. A Roth conversion may not be in your best interest at all, no matter how big your IRAs and 4 0 1 Ks are today. And of course, there's a question of your heirs and what tax situation they may face down the road. Some of this information is just unknowable, like your returns. Even if a Roth conversion saves you a significant amount of money in taxes over your lifetime, again, it may take years for those savings to make up for the extra taxes you paid up front. And it can also be really tough psychologically speaking to shell out more in taxes today to save for tomorrow. However, conversions can be a very powerful tax saving strategy and makes a lot of sense for a lot of people. Now, back to the break, even age. While the break even age is a helpful concept for understanding the financial mechanics. It's not the only, or even the most important factor. The decision to do a Roth conversion often comes down to when you want to pay taxes. Do you want to pay them now with a Roth conversion or later with traditional IRA withdrawals? And then what will your tax brackets look like now and in the future? What will your returns look like? Now until your RMDs kick in. What are the projections for the investments you own over the next decade or two? Until you hit RMD Age? And then at what tax rate do you want to pay taxes? If you believe your tax rate will be lower now than in the future, A Roth conversion makes sense regardless of the breakeven age. Ultimately, determining whether a Roth conversion is right for you and what your break even age might be, involves a personalized analysis of your current and projected financial situation. Including tax rates, retirement goals, retirement spending, and so on. And using financial planning software really can help you decide if a Roth conversion is right for you, when to do them, and how much to convert. I hope this was helpful, if you're still unsure whether a Roth conversion makes sense. When to do it or how much to convert? Consider a 30 minute complimentary consultation with myself. We'll help you decide on a strategy that fits your goals and makes the most sense for you. You can go to my website to schedule the call@capitalwealthplan.com or click the link below. Happy planning and have, great day.