Debulking an IRA with Yearly Roth Conversions to Decrease Lifetime Taxes
I’m coining a term: Debulking an IRA. This is a useful concept in Retirement planning.
Often, folks don’t have huge legacy goals which requires them to optimally convert most of their pre-tax accounts to Roth. Or, they have at least some charitable intent, and don’t mind leaving a legacy of pre-tax money. The charity doesn’t mind—they don’t pay taxes when they inherit pre-tax money!
The decision whether or not to perform a series of yearly partial Roth conversions is usually not a difficult one. How much to convert, however, takes earnest consideration.
What is the optimal amount of partial Roth conversions to do during your Tax Planning Window?
When you are not sure, let’s look at the idea of Debulking an IRA to minimize lifetime taxes.
Let’s start simple. You have brokerage accounts, pre-tax accounts where you deferred paying taxes during your working years, and Roth accounts where you have already paid the taxes.
Having tax diversification means you have money in all three types of accounts. You can pull money from your brokerage account yearly and optimize your capital gains over your lifetime. Or, you can pull money from your pre-tax accounts yearly and optimize the tax bracket you are in that tax years. And finally, you can pull Roth money yearly for spending goals with no tax implications.
In order to control future tax rates of both your ordinary income (which is usually pre-tax accounts in retirement), and your capital gains (which you can do through specific lot identification in your brokerage account), you need to have some tax diversification.
At retirement, you have a certain amount in all three accounts. Usually, it is usually not optimal. You can try to do Roth contributions to your retirement plan while working, but this can be painful and expensive during your peak income years. Or, more optimally, your 401k may have a Mega Backdoor Roth option, which is a great way to stuff away after-tax money that you can convert to Roth. But you have what you have when you retire. Generally, those who earned a lot of money have too much in pre-tax and not enough in Roth.
In retirement, during your Tax Planning Window, you have the ability to control your taxes! You get to decide what account to pull from, and that, in turn, controls yearly tax liability. Using a series of yearly Partial Roth Conversions, you can pay taxes now on your pre-tax accounts, obviating the need to pay taxes on them in the future. This gives you tax diversification when you hit 72 and you have to start taking Required Minimum Distributions from your pre-tax accounts.
Required Minimum Distributions will force you to pay taxes in the future at a rate you “know” now. I put “know” in parenthesis due to the legislative risk of tax rates in the future. But, you have to plan with what you have. Doing some debulking of the pre-tax accounts via partial Roth conversions gives you tax diversification in the future to face the changing times.
Debulking your IRA means doing tax bracket arbitrage now to get tax diversification.
Tax Bracket Arbitrage
The point of Roth vs. Pre-Tax is Tax Bracket Arbitrage. Pay taxes when they are the lowest!
During your peak income years, this means deferring the taxes via pre-tax retirement accounts.
During your Tax Planning Window, this means paying the taxes while your lower tax brackets are exposed due to no other sources of ordinary income.
The goal is the same: pay the least amount of taxes on every dollar you earn. Either pay the taxes on your income now, or defer your income and pay later when you do a Roth conversions, or when you hit Required Minimum Distributions.
Misunderstanding Tax Bracket Arbitrage and the Time-Value of Money
A common complaint I hear during the Tax Planning Window—but why pay taxes and lose that money for future investment? People are often reluctant to raid their brokerage account to pay taxes, because they take that money out of equities and bonds in order to pay taxes. Wouldn’t they be better off just to keep that money invested rather than pay taxes? People think that the time-value of money means that paying taxes now destroys future gains because that money is gone. Wasted.
One-word answer: Fungibility. You are going to pay taxes on that money now or in the future, the only thing that matters is the bracket in which you are in now and in the future.
It seems like people understand this concept during accumulation but not during de-accumulation. Not a big surprise there, as accumulation is much easier conceptually than de-accumulation.
During accumulation, we know if you have the same tax bracket now and in retirement, a contribution to traditional or a Roth is equivalent. There are many blog posts out there codifying this as a fact of mathematics. Either you pay taxes on a smaller amount that then grows tax free, or you don’t pay taxes now but allow the account to grow and pay taxes and a larger amount. In the end, you have the same amount after-tax.
During de-accumulation, the same series of facts hold true. You can pay taxes on the seed or the crop. If you pay taxes now, you have more after-tax money later. Or, you can defer paying taxes during your tax-planning window and pay more in taxes later on a larger amount later. The only fact that matters is the tax bracket you are in now vs. later.
If you are going to be forced into a high tax bracket with Required Minimum Distributions, use some of your after-tax money to pay the taxes now at a lower tax bracket. Use tax-bracket arbitrage to your advantage.
Debulking an IRA to Minimize Taxes
So, we now understand that you can minimize your taxes over your life by taking advantage of tax bracket arbitrage. The goal is to provide you some tax diversification.
But if you aren’t going to spend all of your money in your lifetime, we have to understand your goals in order to decide who is going to pay the taxes.
If you are going to leave money to your heirs, you might want to do more Roth conversions if they are successful and going to inherit money in high income tax brackets. Remember, they will pay taxes over 10 years now since the death of the Stretch IRA, so they will pay for your pre-tax inheritance at their highest marginal tax bracket. If, on the other hand, you have a starving artist as an heir, they very well may have a lower tax bracket than you. In that case, minimize Roth conversions to debulk your IRA enough to save on taxes during your lifetime.
If, on the other hand, you are going to leave money to charity, they love to have your pre-tax accounts as they do not pay taxes on it. In that case, you also minimize your yearly partial Roth conversions to optimize the taxes you pay during your lifetime. Debulk the IRA just enough.
Finally, as an advanced planning technique, what if you did the Psuedo-Stretch? This is where you name a CRUT as benefit as your pre-tax account in order to replicate the Stretch IRA for your heirs. Remember, you can have the charitable beneficiary of your CRUT be a family DAF, thus keeping the money in the family forever. How much debulking of the pre-tax accounts do you want to do there? As this is an advanced planning technique, I will leave it for you at home to answer.
Wow. Let’s now move on and look at some examples in Debulking an IRA.
Debulking an IRA in Action
Let’s set up an extreme example. We have a solo 65-year-old who did well and has a large IRA. She either wants to leave it all to charity (and thus everything left over in the pre-tax account at 90-years old when she dies will be counted as tax-free), or she wants to leave it to an heir in the 50% combined tax bracket. How much should she convert every year?
How Much to Convert when Debulking an IRA
Again, how much you convert depends on how much IRA you want left over when you die. You are almost never better off converting everything to a Roth, because you always want to have enough money to fill at least your standard deduction. Even if your goal is to leave money to charity, if your RMDs are right about at your standard deduction, you are winning. (If you are over a little, the obvious thing to do is a QCD!).
Where as if you know your heir is going to pay taxes on 50% of the inheritance (say they are in the 37% tax bracket and state taxes are 13%– hello California!), you might want to convert it all in one year! But that is not tax efficient either, as you are paying 37% on the bulk of the conversion. What if you could do yearly, partial conversions in the lowest tax bracket possible and get most of it converted? That is the way to give the least amount possible to Uncle Sam in taxes.
Let’s see how that looks.
Debulking the Extremes
In Figure one, you can see how yearly income stacks up against future tax brackets.
The 10% bracket is really small and you can’t really see it well. Above that, the 12% tax bracket becomes the 15% tax bracket in 2026 when the Tax Cut and Jobs Act Expires.
Above that, you can see the 22% tax bracket becomes the 25% tax bracket, and the income level adjusts in 2026 as well. This is much better seen in the 24% tax bracket, which becomes the 28% tax bracket and the income into allowed into that bracket is also quite a bit higher.
On the top, you can partial Roth Conversion planning for an Heir in the 0% tax bracket. In green, you can see the baseline with no Roth Conversions. Note that taxes increase at 70 when you are forced to take social security, and at 72, Required Minimum Distributions kick in. These RMDs increase over time and eventually force you above the 28% tax bracket. In blue, you do Roth conversions yearly to fill the 22% tax bracket. This keeps you out of higher tax brackets in the future. When all is said and done, your 0% tax bracket heir has $165k more in after-tax money by pursuing this strategy.
Next, look at the lower example. Here, green is still baseline. Now, however, your 50% tax bracket heir requires you to fill the 24% tax bracket yearly with Roth conversions. And, in 2026, you start to fill the 28% tax bracket. You can see that by doing this, you eventually run your pre-tax account out of money by the time you are 85. Doing this means you will have $1.5M more in after-tax money for your heir.
Let’s see how this looks at the end.
IRA Debulking Goal: After-Tax Savings
Again, the goal is to have the most amount left over after taxes are paid by both you and your heir.
Above, the top two circles show the plan for the 0% tax bracket heir. On the Left, with minimal Roth conversions, you see that 31% of the portfolio is left in Roth accounts. There is $8.6M to give away. On the Right, without Roth conversions, there is only $8.4M to give away. Since you don’t pay taxes on either account, the difference is pretty minimal. There is no after-tax adjustment necessary.
On the bottom, we have the 50% tax bracket heir. On the Left, we have 100% of the of the money tax-free! No further taxes are owed, and the portfolio balance is higher! On the Right, you can see quite a bit of the money is in the taxable bucket, which is good to leave behind as it gets a step up in basis. But there is still quite a bit of tax-deferred (or pre-tax) money that will be taxed at the highest marginal rate. After your heir pays 50% taxes on the remaining balance in the pre-tax account, there is $1.5M more left over by completing Roth conversions.
Finally, let’s look at the taxes you pay during your lifetime.
Taxes While You Are Alive
Figure 3 shows the taxes you pay while you are alive. The shapes and colors are pretty similar to what you saw in figure 1. However, on figure 1, the y-axis shows how much income you take every year. Now, in figure 3, the y-axis is how much you pay every year in Federal Taxes.
On the top, again we have the 0% tax bracket heir planning the 22% tax bracket Roth Conversions. You can see how much you pay in yearly taxes in green without Roth conversions, and in blue with Roth Conversions. Over the 25-year period, you pay $427k less in taxes.
On the bottom, we have the 50% heir doing 24/28% conversions. You can see you pay quite a bit more in taxes up front, but eventually your personal federal tax rate goes down to zero when you decimate the pre-tax account. In the end, you pay $734k less in taxes.
Debulking the IRA when there is No Extreme
So, yearly partial Roth conversions are usually indicated if you have a large amount of pre-tax money at retirement. If you can do it during your Tax Planning Window, that is idea.
How much to convert is not a black and white answer. Even if you knew what future tax rates are going to be, which you don’t, you don’t know how long you are going to live!
So, once you guess at how long you are going to live and what future tax rates are going to be, two of the most intractable questions in the world, you can estimate how much you want to leave behind in pre-tax money. This guess is how much of the IRA you Debulk.
If your heirs are likely to be in a high tax bracket, convert more. Debulk a lot of pre-tax accounts by doing more Roth conversions.
If your heirs are likely be in a low tax bracket, or if you want to leave it all to charity, Debulk less.
The point is, you get better tax diversification by using tax bracket arbitrage and doing a series of yearly partial Roth conversions. Not only does that save in taxes during your lifetime, it also leaves more behind for your heirs.
But it is a mouthful. From now on, let’s just say it is time to Debulk that IRA!