Can Tapping Your IRA to Cover Taxes on Roth Conversions Make Sense? Yes!

Another Remarkable Finding Based on MaxiFi's Roth Conversion Optimizer

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Economics Matters -- Blog/Podcast/Financial Riddler/MaxiFi Puzzler

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IRA Withdrawals Can Help with Roth Conversion Cash-Flow Problems

Roth conversions can be a super powerful way to lower your remaining lifetime taxes. But, as explained here and below, taking full advantage of this major tax-saving opportunity can involve large conversions in the short term, which spells higher short-term taxes.

If you don’t have enough regular assets to cover the extra taxes, temporarily lowering your spending is one option. But another answer is using traditional IRA or other tax-deferred assets — assets beyond those being converted — to help cover the extra conversion-related taxes.

Yes, doing so requires paying taxes on the IRA withdrawals. But funds left over after making those tax payments can be used to pay the taxes arising from your conversions. Before illustrating this point using my company’s MaxiFi Planner Roth Conversion Optimizer, let me provide a quick overview of the software and its ability to handle Roth conversions.

MaxiFi Planner

MaxiFi is 32 years in the making. It does economics-based financial planning, teaching you how much you can sustainably spend, how to safely raise your living standard, how to make education, career, housing, retirement, and other economic and lifestyle choices, how to properly diversify your investments, and how to combine investment and spending strategies to experience only upside living-standard risk despite investing in the market.

MaxiFi simultaneously, precisely, and instantly solves the highly complex, interconnected equations of finance — equations developed by the fathers of finance over the past Century. It does so using patent-winning, advanced economics computation methods, many of which I’ve pioneered during my long research career as a professor of economics. The calculations are precise to the dollar.

MaxiFi’s basic household version costs only $109. But it’s the only financial planning tool that can correctly answer basic, let alone highly complex financial planning questions. The optimal level and timing of Roth conversions is among the most complex such questions.

MaxiFi’s Roth Conversion Optimizer

Back in November, my company rolled out MaxiFi’s Roth Conversion Optimizer. It calculates how much to convert each year to minimize your lifetime taxes. This is a very complex problem involving the following seven factors:

1. Standard federal income taxation

2. State income taxation

3. Medicare Part B IRMAA taxation

4. Reduction in future RMDS permitting great tax-free asset accumulation

5. Federal income taxation of Social Security benefits

6. State income taxation, in certain states, of Social Security benefits

7. Reduction in regular assets and, thus, federal and state, regular asset income

Mathematically speaking, the optimal Roth conversion problem is highly non-linear, meaning Go Big or Go Home — convert large amounts in the near short term even at the cost of far higher short-term taxes — is often the optimal solution. The reason is simple. The sooner you convert the more years you’ll have to reap the tax gains from conversions. That doesn’t mean convert everything immediately. But it does mean to get your conversions rolling.

This prescription — take large doses of antibiotics for a week, not minute doses over a year — differs dramatically from conventional wisdom. The conventional view is to adopt a conversion plan that equalizes your tax bracket through time. Doing so is never the right answer. Indeed, as you can check by manually entering alternative conversion strategies in MaxiFi, converting on this basis can raise, not lower, your lifetime taxes.

Solving Roth Conversion Cash-Flow Problems Using IRA Withdrawals

Consider a hypothetical friend of mine named John. John is 62, single, childless, retired, and lives in Delaware in a paid-off, $500K house with $12,500 in annual property tax, insurance, and maintenance expenses. John’s maximum age of life is 100. He’ll receive a $50K nominal pension starting at 70. He has a $1.25 mil in an IRA, which he’ll start smoothly withdrawing — constant real annual withdrawals — at 63) and $500K in a brokerage account. John’s been a good earner. If he takes Social Security this year, he’ll receive $2,895 a month real, i.e., inflation adjusted.

Finally, John invests in inflation-indexed Treasuries yielding a 2 percent real return and makes two assumptions — inflation will run at 2.5 percent and the Tax Cut and Jobs Act of 2017 will be renewed. One other key thing. John intends to die in his house or use it to cover end-of-life nursing or other medical care.

The two charts below show John’s base discretionary and fixed spending plan as well as his lifetime budget. John’s lifetime budget confirms that MaxiFi’s annual discretionary spending is affordable given John’s resources and his fixed spending obligations on taxes and housing.

Raising John’s Lifetime Discretionary Spending

It took less than one second to run John’s base plan. When I first started designing ESPlanner, the download precursor to MaxiFi, I thought a case like John’s would take a year to run!

Social Security Optimization By Itself

It took two seconds for MaxiFi to robo optimize John’s Social Security collection decision. The picture below shows that waiting till 70 to collect increases John’s lifetime discretionary spending (the present value of his annual discretionary spending through age 100) by $232,183 — about three years of after-tax pay based on John’s pre-retirement earnings — and his annual discretionary spending by $8,395. Note that taking Social Security at 70 doesn’t cause John a cash-flow problem. His annual discretionary spending remains smooth. But it’s also 10 percent higher over each of the next 38 years, if he makes it that long.

Roth Conversion Optimization By Itself

What if John takes Social Security immediately, but optimally Roth converts? As the charts below show, there’s a $70,258 lifetime discretionary spending gain. The optimal conversion plan? It entails converting $726,274 of John’s IRA, with $431,921 converted this year, $176,937 converted next year, and $117,416 converted the year after.

Joint Social Security and Roth Conversion Optimization

The next charts show the impact of John optimizing over both Social Security and Roth conversion decisions. Joint optimization produces a whopping $346,559 in extra lifetime discretionary spending. And this comes with no risk! In the parlance of Wall Street, MaxiFi produced a massive amount of alpha.

Joint optimization generates an extra $44,118 in lifetime spending compared to the sum of its parts. I.e., $346,559 exceeds the sum of $70,258 and $232,183 by $44,118. The reason is clear. Roth conversions lead to higher federal taxation of Social Security benefits (Delaware, btw, doesn’t tax Social Security.) if you’re receiving benefits when you do the conversions. Converting when taking Social Security also kicks up John’s IRMAA premiums, which start at 65. Hence, waiting to collect makes Roth conversions far more tax efficient.

John’s optimal conversion plan is very different now. It entails converting $294,893 this year, $201,873 next year, $145,494 in 2027, and $118,350 in 2028. That’s $760,610 in total or $34,336 more in total conversions than in the case John optimally converts, but takes Social Security early.

Also, the conversion are now spread out over four, not three years. In particular, this year’s optimal conversion is $201,873, not $431,921. One can, by the way, check manually that MaxiFi’s Roth Conversion Optimizer is minimizing your lifetime taxes. You just set up an alternative profile with a different path of conversions and compare the two sets of results.

The Rub — John’s Cash-Flow

As the above, right-hand-side chart shows, joint optimization — waiting till 70 to collect Social Security and converting $760,610 prior to 70 — leaves John short of cash (regular assets) to cover this higher tax bills and maintain his spending. Since John told MaxiFi to withdraw his Roth money last, he’s also constrained between 70 and the year he starts Roth withdraws. In that year, his taxes and IRMAA payments drop precipitously. If John goes with this plan, he’ll need to reduce his annual discretionary spending by $12,234 through age 70. That’s an eight-year, 14 percent living-standard hit compared with the base plan.

Additional IRA Withdrawals to the Rescue

Suppose John accelerates his non-converted IRA withdrawals by withdrawing an extra $75K per year for each of the next eight years. Voila! John’s cash-flow problem is gone! Compared with the base plan, John can spend $7,508 more annually prior to 70 and $13,982 more annually after 70. And, get this. John’s increase in lifetime spending from joint optimization combined with accelerated IRA withdrawals is only slightly lower — $338,257 versus $346,559 — than when he doesn’t accelerate IRA withdrawals.

Do Try This At Home

Tens of millions of households hire Wall Street’s financial advisors or main street’s CPAs to help make major financial decisions, including getting the most out of Social Security and Roth conversions. Virtually none of these “professionals” holds an advanced degree in economics or finance. Their forte is separating you from your money — letting them, at high cost, manage your money while delivering, with high probability far lower returns than you can earn by investing in low-cost index funds.

You have three options. One is to kick yourself in the tush, cough up $109 for MaxiFi Basic or $149 MaxiFi Premium, and run MaxiFi on your own. We provide outstanding customer support, weekly office hours, and an extensive Learning Center for any help you may need. Tens of thousands of people have used MaxiFi all on their lonesomes. You can too!

The big danger in running MaxiFi by yourself is becoming addicted. What could be more fun than finding ways to safely raise your living standard? If you need additional encouragement, watch and read these roughly 130 testimonials.

Software adverse?

We have a range of services including having me run MaxiFi for you. I hypothetically provided hypothetical John my Concierge Service and netted him $335,757! He hypothetically thanked me profusely.

Option three is asking your professional advisor or CPA to run MaxiFi for you. If they refuse, here’s the button to click: