Roth Conversions are a Deferred Income Annuity
Roth conversions are a little like deferred income annuities.
A DIA, or deferred income annuity, is a contract where you pay an insurance company a lump sum now in exchange for a future stream of income.
Social security is a DIA, too. Interested?
Let’s talk about how Roth conversions are a deferred income annuity.
What is a DIA?
DIAs, aside from QLACs, are not very useful currently, given a multitude of factors. The primary of these factors, however, is low-interest rates, so stay tuned if DIAs might get more attractive in a new interest rate regime.
Social security is a bit like a DIA. That is, when you build a bridge to defer social security, you buy a DIA with the money you spend in lieu of your social security after age 62. That is, between 62 and your full retirement age, you buy a DIA from social security at 6% every year you delay. Then, after your full retirement age, the government rewards you with an 8% DIA by waiting until 70.
The fundamentals of a DIA include a lump sum payment and an expected future income stream.
With social security, the lump sum payment is the money you spend instead of taking social security each year. The future income stream is delayed retirement credits to your social security primary insurance amount.
With Roth conversions, the lump sum payment are the taxes you pre-pay, and the future income stream is the expected future reduction in taxes for you and your heirs.
Let’s dive in. How is a Roth conversion similar to a DIA?
How is a Roth Conversion Similar to a DIA?
A Roth conversion is pretty similar to a deferred income annuity.
How is a Roth conversion similar?
With a Roth conversion, you opt to pay taxes now. It is like insurance in case tax rates go up in the future. You pay taxes now at a known rate so that you might pay less in taxes in the future when RMDs begin.
Instead of giving an insurance company a lump-sum payment, you are paying the government taxes you don’t need to right now. And that is important to understand. You (or your heir) will eventually owe taxes on this money. This money is called IRD—Income in Respect to the Decedent. You are dead, and taxes will be paid.
And instead of a future income stream, you are (likely) going to pay less in taxes in the future once RMDs start. Instead of taking a percent every year once you are 72 (as Required Minimum Distributions force you to do), you are taking the same percent out of a smaller pot. Your IRA has been shifted to the tax-free Roth. More Roth less pre-tax when you are 72 means you pay less in taxes.
Not only do you pay less in taxes, but you also pay less at your marginal rate.
And the only thing we know about taxes is that the rates will change in the future! If congress is predictable, we know they will mess with both short and long-term tax rates,
Think about this: with a Roth conversion, you make a lump sum payment now (taxes this year) to reduce future RMDs. This reduces the amount of money you must pull out each year from your retirement accounts and thus limits the “top” of your income which is exposed to the higher tax brackets.
With Roth conversions, you pay with after-tax dollars, but you are saving at the marginal rate in the future, not the effective rate (which is what you pay your tax dollar at in the present).
How Much do You Get Paid to Do a Roth Conversion?
So, if a Roth conversion is a little bit like a DIA, what is the payout? That is, how much do you get paid by doing a Roth conversion?
Let’s find out!
Above, you can see a large one-time Roth conversion as the green spike in taxes.
We are looking at how much you are expected to pay in future federal and state taxes with and without Roth conversion. With a Roth conversion in green, you pay about $43k more in taxes once on your conversion of $100k.
In blue, note what you pay without the Roth conversions.
Without the Roth conversion, you are expected to pay more in taxes once RMDs start at 72. You can see that reflected in the difference between the two lines above, which slowly increase over time (reflecting the increase in taxes you save over time as the withdrawal percentage rises with age.
Let’s look at RMD age more closely.
How Much do Roth Conversions Save in RMDs?
So, how much do Roth conversions save in RMDs?
Above, you can see what taxes are expected at 72, RMD age. You can see that you might save $2.4 k the first year that RMDs are due.
So, that is essentially a 2.4% return of your 100k Roth conversion.
However, a more accurate way to look at this is to think about taxes specifically.
For example, above, we paid about 43k about ten years before this “savings” of taxes.
Remember, money saved is the same as money not spent, which is income essentially.
That is, if you pay now for future savings, that’s like an annuity!
Roth conversions are like a deferred income annuity. In this case, we paid $43k to get a $2.4k “payment” 10 years later. This is a 5.6% return on our principle! Take that SPIA! Or, more accurately, take that DIA. And most accurately, take that 4% SWR.
Roth Conversions are like a DIA that Gets Better with Age
Roth conversions are like a DIA that gets better with age.
Let’s look at age 80. Expected tax savings then (above) is $4.4k. This is a 10% return at 18 years out.
As I said, it gets better and better the older you get.
And don’t forget, it is good for the kids, too!
Roth Conversion is like a DIA for Your Kids
If your kids are in high tax brackets, then Roth conversions are a great idea as often you can convert them at lower rates than they will pay over their 10-year inheritance. (Remember there is no more Stretch).
If your kids are likely to take the whole IRA out the year you die, Roth conversions are also a grand idea.
Only if you have charitable intent, or a lot of heirs (you can spread it out to many different inherited IRAs with many different beneficiaries), or a low-income heir (who can essentially pay less in taxes over ten years than you would during a Roth conversion).
Summary – How Roth Conversions are Like a Deferred Income Annuity
So there you have it! You pay cash now in extra taxes to do a Roth conversion.
This is insurance – you are pre-paying your taxes so that you never have to pay them again.
This is good because you expect your liability to grow over time (your investments get larger), and you are expected to take more and more out every year (via RMDs increasing over time). And don’t forget the big whammy.
The big whammy is that you don’t have to guess what future tax rates will be once you pay taxes. The only thing we know about congress is that they will play around with the tax code and make it more convoluted than it already is.
Remember to get your tax break and do Roth conversions, if indicated.
Above, you can see that Roth conversions are like a deferred income annuity. Since you pay less tax in the future, you have more money! A stream of cash in exchange for pre-paying taxes now.
Using planning software, you can compute your IRR on your Roth conversion. I don’t think I can do the math, but I’m sure someone can!
Now, people often call social security an “annuity” when they are talking to folks who think an annuity is a four-letter word. An annuity is simply an exchange of a lump sum for an income stream. A deferred annuity means you pay now in exchange for a future income stream (one or more years, usually around ten years or more).
With social security, we know you get a 6-8% yearly increase (depending on if you are before or after full retirement age when you claim). So with social security, the longer you defer your income stream, the more you get.
With Roth conversions, you might get better returns than you can with a DIA.