Roth to the Rescue!

We know the SECURE act decimated stretch IRA’s, so what’s a mother to do? In thinking about this problem once again the solution is to play growth against taxes. An IRA generates ordinary income tax as money is removed, and it is governed by RMD. So a typical RMD on a 2M IRA looks like this

At age 80 the 2M has grown to 2.4M and the RMD is $126K. If you’re pulling 50K from SS your taxable income is 176K. If you’re MFJ, 176K is in the 24% bracket. At 90 you’re RMD looks like this

193K plus SS growth at 2% inflation means you make 61K in SS or 254K total and your tax bill is 43K/yr. Your IRA is still worth 2.15M You and your spouse die at 91. So the 2.15M is transferred to your kids, who then have 10 years to clean that IRA out. Tis means your heir has to remove 290K/yr from the IRA to get the job done

Lets say your kid makes 200K/yr. That means for 10 years he/she will be making close to 500K/yr and paying 117K/yr in taxes almost triple the 43K you were paying. Bummer! Right?

This is where Roth conversion comes into play. If you can get the 2M in the IRA down to 500K the taxes are much more manageable. A 500K portfolio would play out like this.

With the same 50K SS your taxable would be 81K and your MFJ taxes would be 6,147 based on the standard deduction. Your portfolio would be worth nearly 600K. At age 90

If SS at 90 is still 61K your taxable income is 109K barely into 22% (you leave 12% at 104K MFJ standard deduction) and your taxes would be 10,000. The portfolio is worth 535K at age 90. You and the Mrs both die at 91. This means your heir needs to disperse about 73K/yr over 10 years to clean out the account

Same 200K/yr makes his/her income 273K/yr and the tax burden only 48K a substantial savings over the previous 117K.

When the Roth is inherited there are no taxes to be paid and the Roth has the same 10 years to be cleaned out. Lets say you pulled just enough WR from the Roth to keep the 1.5M steady during your 20 years of RMD so 1.5M gets transferred. 10 years later that Roth would be worth 2.7M to your heirs tax free

That’s how you transfer wealth to your kids under the present SECURE tax regimen without annuities or Donor funds. The advantage is you get to use your money for you as cash flow during your life and your kids get a windfall when you pass. I estimate a tax free 4% WR on 1.5M will generate 60K/yr in income over the course of 20 years at 6% growth plus you will be taking the RMD on the IRA and SS. You pay minimized taxes during your life, since with Roth conversion all the taxes get paid sooner instead of later. Later costs more in taxes because of the progressiveness of the tax code and RMD percentages. You do pay all the taxes you owe, but you get to adjust those to your benefit not the governments benefit. If you want to convert even more you can take more out of the IRA over and above the RMD amount but just keep the total taxable income under 104K/yr. The excess money above the RMD amount pulled from the IRA can be put in the Roth to gather interest or you can just live on that extra money and have a smaller WR on the Roth.

The trick to this is efficient Roth conversion BEFORE RMD, and the trick to that is planning well in advance of actual retirement. Much of this blog has been devoted to understanding Roth conversion.

13 Replies to “Roth to the Rescue!”

  1. MD on FI/RE,
    I am concerned that both stocks and bonds will drop in value in the next crisis, versus the historically highly negative correlation. Have you considered using BIL for the 84% bond allocation in your safe portfolio used to siphon from when there is a negative return in the other more risky portfolio ?

    1. I use a variety of duration including EDV TFT TIP and SHY to balance my bond holdings. In deflationary times I load up on TFT and EDV and in inflation I move more to TIP and SHY. Fidelity allows these ETF’s to be traded at no cost and since it’s inside of an IRA there is no tax, so it’s just a matter of pushing the sell and buy button. The total allocation stays the same but the mix of funds can vary. I can even go to cash in this allocation or buy some gold if I get really freaked out. BIL fits in this profile as well

  2. Thanks for clarifying your bond holding method. I read through all of your blog posts after discovering your site a couple of days ago, and appreciate you taking the time to share your knowledge. I am a Chemical Engineer with MBA, retired 8 months ago at age 55 with no side gig. I drank the Cool Aid and maxed out pretax 401k contributions through my entire career, and now must convert aggressively (filling 24% bracket) to avoid high RMD taxes, high Medicare premiums, potential widow’s tax trap, and potential (likely) higher Fed tax rates after 2025. I have found and RightCapital software to be helpful in modeling all of the variables (budget, taxes, Social Security, Roth conversions, etc). has been useful in creating a robotic rules based portfolio to avoid my lizard brain built in behavior bias. I hope you keep posting – the candor and lack of fluff is refreshing.

    1. Eric

      You’re very kind. Over the course of my blog my attitude towards FI and FIRE has changed from a return based maximizing perspective to risk management. I have more than enough money so I don’t have to leverage what I have in an attempt to make more and meet some theoretical “number”or some theoretical “WR”, I just need enough to meet my expenses no matter what. If you look at a Galton board on youtube, and think about a Gaussian curve and imagine yourself as a ball falling down the decision matrix, you have to ask what do I need to do to be a ball that lands in the top half of the distribution. If you land in the top half by definition you win. The probabilities of landing in the top half change according to making the right decisions on the way down. The game isn’t over till you’re wife is dead. If she’s 60 and has 30 potential years to live, investing 1000 dollars today means she will have $5700 at her disposal when she is 90 @ 6% return, so it’s correctly managing the $1000 today that assures you wind up above the mean, and the tools that exist today like Monte Carlo analysis give you a leg up on properly playing the odds. So my take is pretty quantitative and not so much narrative driven. I have no problem re-evaluating the data and choosing a path that has a higher probability of success.

      Recently I started trading some Roth money using a system based on fractal math and rates of change (second and third derivatives) which is designed to front run the economy. It’s more of a hobby than a primary control over my portfolio, but trading the system has about a 72% likelihood of success so trading the system directly informs my perception of risk and understanding risk is how you become a ball in the upper half of the distribution. The system is data driven and takes into account the machines (algorithms) that run the market these days. You can’t think faster than a machine but you can place yourself in a spot where you can benefit from the action the machine causes. Risk management in FIRE land usually means to put your money in stocks, never sell and when the crash comes, let the train run you over and presume the market will recover. It may recover but there is a probability it won’t recover as well, or may take longer time than you have to recover. Homey don’t play that game anymore. You gain advantage by asset allocation into non correlated assets and by choosing assets that do well in given environments life an inflationary environment or a deflationary environment so that’s how I came up with the bond scheme. The past year I was long EDV and inflation was dis-inflationary and I made money. I sold most of the EDV in OCT and went to a shorter duration of 2 yr and TIPS since the rate of change on inflation is now inflationary. It’s like playing hockey, you have to skate to where the puck is going to be if you want to control the puck.

      As my thinking evolves I plan to publish on the evolution. Good luck on your Roth conversions. Till 2025 are the years to make that happen!

  3. MDonfire,
    You are the only person I have interacted with who brought up fractals. Love it ! One of my favorite books is The (Mis)Behavior of Markets, A Fractal View of Risk, Ruin, and Reward by Benoit Mandelbrot. I could only find it used from a library liquidation in the Midwest. I highly recommend it.

    I did not fare well in 2000, and 2008 was no picnic. At this point massive draw downs are not an option. The bulk of my investments are in a blend of tactical asset allocation methods which have a history of very low drawdowns and limited upside. The key is to avoid losses. There is no need to hit a home run. Avoid losses realizing you will miss some of the upside. The rest in ultra safe short term govt securities (BIL), Managing risk is top priority.

    As important as this subject is, I too am appalled at the oversimplification by the FIRE community. This is a complex multi-variable problem to solve, and should not be taken lightly. There is no chance for do over !

    Looking forward to future posts.

  4. Happy New Year Gasem!!

    We have to cash out the whole tax deferred accounts upon the death of the last spouse in Canada. There is no handing anything over to heirs. The whole thing gets taxed fully on the terminal return. Nice eh?!!

    That is why I am shoving all bonds into those accounts. I am using these to balance my risk and for tax mitigation strategies.

    1. HNY MB!!

      Tax deferred has always been a scheme to fund the government. Before IRA there were pensions and once you croaked there was nothing, With IRA the government essentially set themselves up an annuity. I think this worked OK till the boomers started retiring and the government realized they needed an extra squirt of juice to pay those government pensions, so they compressed the speed at which the annuity pays them off through the secure act. It just so happens that this year is the year that more boomers are projected to be retired than projected to be working. If you believe “they work for you”, you’re on drugs!

      Always a joy to her from you

  5. MDonFIRE,
    I was looking at possibly buying a SPIA, but your posts utilizing Monte Carlo analyses made me realize I could easily create my own annuity. A 75% SHY, 25% SPY portfolio with monthly withdrawals matching a USAA SPIA lifetime payout for a couple’s lifetime (40 years to age 95 in the scenario I chose) has a 9213/10,000 survival rate. No need for an insurance company. And since this would just be a supplemental “policy” beyond my core investments and in addition to a pension and future social security, the 8% failure rate is not a concern. Thanks for prompting this thought process via your posts.

  6. An 85% IEF, 15% SPY gives 9979/10,000. Less equity but longer bond duration. After 30 year bond bull run, SHY is probably a better way to go.

    1. SHY at present is likely better. Watch out for inflation and negative interest rates. When I bought EDV it was flying but has since cooled off

  7. Gasem,

    Every time I read one of your posts on strategically Roth conversions and avoiding hosing my wife in the event of my premature death, I feel like you’ve offered a telescope with which to view the oncoming train.

    We also front-loaded our tax deferred accounts, and are exploring strategies to lower our tax burden that will offset Roth conversions, although we are unlikely to pull it off before Eric’s anticipated 2025 deadline.

    May the Mrs. and I both be fortunate enough to live to age 91…



    1. May God grant u both that fortune. I happen to fall in the 2025 window, but this isn’t a comparison between what one person does with respect to another. This is a comparison of what one person is doing compared to what is possible, and how to optimize what is possible. That takes some pencil sharpening and ciphering and study. Eric brought up Mandelbrott and his book The Misbehasvior of Markets, also a favorite of mine. Fractal geometry is a complex subject but it is a useful language. It brings into focus that reality is predictable all the way up until its not. Failure happens systematically and then all at once. Failure eventually becomes catastrophic and exponential but before that it comes from erosion which is a linear thing.

      The FIRE equation is a simple line equation Y = MX + B Y = your presumed budget. X = your nest egg M = the leverage on your future to make Y happen and B is a fudge factor. If Y = 40K and X = 1M the steady state means M = .04. .04 is the leverage. if inflation is 3% M = .07 If the economy drops in half X goes to .5M and inflation is still 3% and M = .14. This is what SORR means the line equation has a non linear slope and non linear things are called second order. If M varies according to some Gaussian function things are still predictable. If M varies according to a power function then things go crazy. Our whole financial narrative in FIRE land revolves around the market behaving in a Gaussian way with reversion to the mean. The upshot is M is not a constant but a variable and as a variable it is liable to misbehave and screw up the distribution. One solution is to force M to be a constant. You do that with a short duration and a big + B, so a 20 year retirement and a fuse portfolio to take up the slack if M misbehaves. I’ll write an article on this it’s quite interesting. In the mean time may you and the Mrs hit 91 with cash to spare in the coffers.

Leave a Reply to Eric Schoellkopf Cancel reply

Your email address will not be published.