Could a Roth IRA Conversion help you save money on taxes?
Mr. Brown worked for the railroad since he was 18 years old. After more than 40 years of hard work, tough labor, and long hours, he was getting ready to pull the trigger on retirement since he had reached his 60th birthday a few months ago.
Mr. Brown was single with no kids, so he needed just enough income to cover himself and his dog, Rover. His company had a pension, for which he became eligible at age 60, so this would be his only fixed source of income throughout retirement since it replaced his Social Security. The only asset he had was a large 401(k) that he accumulated over his working years with his employer, which contained a large amount of company stock. He believed that his pension alone would cover all living expenses, so he did not plan to make withdrawals from his investment. Mr. Brown came to us to find out what to do with his 401(k) and how to handle taxes if they become a problem for him down the road.
- In our meeting with Mr. Brown, our first step was to get to know him a little better while discussing his goals throughout retirement and his anticipated cash flow needs. After determining that Mr. Brown had sufficient income from the pension alone, we talked about his investments and how they could possibly play a factor in supplementing retirement income. We learned that his 401(k) was his only investment outside of what he held in bank accounts, so we recommended rolling that into a Traditional IRA, giving Mr. Brown more flexibility regarding investment and withdrawal options, and more control on how the company stock would be handled going forward.
- Our next step was to perform a tax analysis to determine the tax bracket that he would be in throughout retirement. Unlike the stock market and interest rates, taxes are a predictable measure in an individual’s financial situation that can be reduced if handled properly and efficiently. Understanding that his 401(k) would theoretically continue to grow, he would be liable for a large amount of taxes by the time he needed to withdraw money from his account. However, there is a strategy we use quite often to control the taxes being paid so that we can ultimately reduce the tax liability from large tax-deferred retirement accounts while allowing continuous optimal asset growth. Based on the findings of our tax analysis, we discussed Roth conversions which would allow us to systematically convert funds from the Traditional IRA to a Roth IRA over time. We explained that we would analyze the amount to convert from the Traditional IRA into the Roth IRA each year. This strategy enabled us to control how much taxes were paid on the inevitable distributions from the Traditional IRA.
- Finally, we talked about his estate planning needs, and, while his situation is fairly simple, we explained that it is important to have appropriate beneficiaries listed on his investment account(s) and an updated will.
- Regarding taxes, our approach with Roth conversions allows us to effectively use the tax code to help reduce his overall tax liability while ultimately allowing for tax-free growth of assets in the Roth over time. We converted a portion of his Traditional IRA each year into the Roth, thus minimizing the tax he would owe on any distributions while staying in his current/projected income tax bracket.
- We periodically sold portions of his railroad stock in order to diversify his portfolio based on his risk tolerance and time horizon.
- We helped him name appropriate beneficiaries on his Traditional IRA and Roth IRA so that his asset will pass through to the desired parties efficiently and effectively without going through probate. Any property he owns needed to be listed in a will, which was established with a lawyer. We provided assistance in this meeting to act as a translator for the client if any questions were to arise.
- Over time, the Roth conversions minimized his overall tax liability by a significant amount, and the distributions from the IRA are now growing tax-free as opposed to being deposited into a taxable account.
- His portfolio is well-diversified (while keeping a portion of company stock) designed to ride out the inevitable ups and downs of the market with reduced volatility.
- His will has been updated and all assets are titled with the appropriate beneficiaries.
- We continue to meet on a regular basis to update his financial situation and discuss any needs/goals that may change.
The preceding case study is for illustrative purposes only and may not be representative of the experience of other clients. Actual performance and results will vary. This case study does not constitute a recommendation as to the suitability of any investment for any person or persons having circumstances similar to those portrayed, and a financial advisor should be consulted regarding your specific situation.