I Tested 3 Roth Strategies on a $2M IRA - The Obvious Ones Lost

Half the internet will tell you to convert your whole IRA to a Roth before RMDs start. The other half will tell you don't convert at all because you're just prepaying a tax bill that may never come. Well, I ran both scenarios on a $2 million IRA and they both lose six figures to a third option. And the reason it wins has nothing to do with your tax bracket. Let me introduce you to Gary and Marilyn. They're both 62 years old and they both retired this year. They have $2 million in traditional IRAs and $400,000 in a brokerage account. They live in Florida, so there's no state income tax to escape here. Every dollar these three strategies save is federal. If you're in a state that taxes retirement income, your numbers are actually going to look even better than theirs. Whatever is left at the end of their lives will go to their only son. Now, they spend $110,000 a year after tax, and that includes their health insurance. That number rises with inflation every single year, and it is identical in all three strategies we're going to talk about today. Marilyn is the lower earner, so she turns her Social Security on now at age 62 once she retires. Gary, he waits until 70 to turn his on. That split is deliberate, and we'll come back to that later in the video. Strategy 1, no Roth conversions at all. This is a plan that Gary and Marilyn were headed for before they changed anything, and it's the strategy that most people follow without realizing there's another option. With this strategy, Gary and Marilyn spend the taxable brokerage account first, because that's what everyone told them to do. They leave the IRA alone so it can keep growing tax deferred, and they take RMDs when the IRS finally makes them. There are no conversions and nothing aggressive about this strategy. It is the sensible sounding thing for them to do. And it costs them $840,000 in total lifetime taxes at an average rate of 13.4%. It is the worst lifetime tax bill of the three scenarios we're going to discuss today, and the first reason it's so bad shows up at age 75. By spending the taxable account first, they leave that IRA alone for 13 years. So by the year they both turn 75, the brokerage account is empty and everything they own sits inside those two IRAs, which grew to about $2.17 million. That is the year RMDs begin. The IRS takes the balance, divides it by a number off a life expectancy table, and hands them the result. For Gary, that's $57,400, and for Marilyn, that's $30,900. Together, they're forced to pull $88,200 out of their IRAs. But they didn't need all that extra income. By age 75, Social Security paid them $74,100 per year against $110,000 of spending. So they actually only needed $35,900. So they needed about $36,000 and the IRS made them take $88,000. So they pay tax on the whole thing and they spend what they actually need. Then they take that $27,700 difference, which was money that they never asked for and had no true use for at the time, and they push it into a taxable brokerage account because they thought that that was the smart thing to do. Now, that account then throws off taxable dividends and interest every single year for the rest of their lives, which just adds to their future tax bills. This is what RMDs really do. It doesn't just tax you once, it sometimes pulls out two and a half times what you needed. Taxes it on the way out and then parks the remainder somewhere that gets taxed again just every single year after that. And that's only the first way that this strategy costs them. The second one is actually worse, but it doesn't arrive until Gary turns age 82, and it's the reason the do no Roth conversions strategy really fails. Now, I'll come back to that in a bit. Strategy number two, convert everything. So somebody hears strategy one and does the obvious thing, which is to get it all out of the IRA as quick as possible. So they move all $2 million into the Roth IRA as fast as they can. And it works in the narrow sense. It costs $675,000 in lifetime tax instead of $841,000 in lifetime tax with strategy one, with its do no Roth conversions. The average tax rate drops from 13.4% to 10.5%, and there's also no required minimum distributions ever. And that second problem that I just teased above, the one that arrives when Gary turns 82, well, that one never happens at all either. So converting everything beats doing nothing by about $166,000. If those are your only two options, then you should convert everything and go live your life. But those aren't the only two options. Against the strategy I'm going to show you next, the converting everything strategy costs them $183,000 more in taxes. That money that leaves the household and never comes back. And now what does that extra tax buy them? Well, nothing actually. Their son just ends up with only $34,000 more when they both pass away. The other $149,000 went to the IRS for no reason. Strategy number three, convert up to the Medicare one bracket. So this is the plan Gary and Marilyn are actually now running. Every single year, starting now, they convert up to the first Medicare surcharge line and stop. For a couple, that line sits at $218,000 of income. They pay the tax from the brokerage account, never out of the IRA, and they keep doing it year after year until the traditional IRA is empty, which for them happens to be around age 79. And here's what it looks like on their actual tax return. Their income lands at $218,000. Their tax bill is about $29,600, which is an effective tax rate of 12.9%, and their Medicare surcharge is $0 because they never cross the line. It's the same number and the same tax bill for about 17 years in a row, and the fact that it is neither clever nor complicated is exactly why this works. This strategy costs $492,000 in lifetime tax. Their average rate goes from 13.4% down to 8.3%. Compared with the do no Roth conversion strategy, it saves them $349,000 and leaves all of that behind for their son, or they could certainly spend that during their lifetime. Against the convert everything strategy, it puts $183,000 back in their own pockets. Now, there's a wrinkle in the first three years. Medicare prices your premiums off of your tax return from two years earlier. Gary and Marilyn are 62 right now, and they do not go on Medicare until age 65. So the conversion they do this year at age 62 sets a premium for the year they turn 64, a year when they're not on Medicare at all. It costs them nothing. This is the one year of their entire retirement lives with no Medicare ceiling above them. The conversion they do next year at age 63 is a completely different animal. That one sets the very first Medicare bill they will ever receive, and they won't see that bill for two more years.