In Part 1, we outlined how high income professionals who respond appropriately to tax incentives can easily find themselves with a majority of their retirement nest egg in tax-deferred accounts. Left unchecked, this imbalance can lead to tax-inefficient withdrawals in the form of required minimum distributions (RMDs).
Compounding a bad situation, inheriting tax-deferred retirement accounts can saddle the surviving spouse with higher RMDs precisely when the transition to single filer status places the survivor in a significantly higher marginal tax bracket. Roth conversions at opportune moments offer a chance to defuse the tax bomb before it detonates.
In Part 2, we'll explore some simplified examples to illustrate when and whether Roth conversions make sense for full- and part-time physicians. Physicians with a lower expected income in 2020 due to COVID may find that this will be a good year to Roth convert a portion of their tax-deferred retirement accounts.
Always Run The Numbers
For most physicians in their peak earning years, Roth conversion is a bad idea, because they will be paying taxes at a higher marginal tax rate than they would likely encounter in retirement. The exception might be when a physician encounters a lower income year.
Planned low-income years might include academic sabbaticals or going part-time prior to full-retirement. Docs who cut back are ideal candidates to put in place a gradual Roth conversion strategy.
Unplanned low income years include our current situation, with the COVID pandemic unexpectedly reducing income. Roth conversions might be successfully undertaken by a physician in a stable financial situation (not about to get divorced/married; large existing emergency fund; large habitual gap between income and expenses).
Take a theoretical single-income family with one physician spouse earning $300,000 in a typical year. Please note this is a simplified version for illustration purposes. Always review any plan with a trusted CPA for validation prior to execution.
Assumptions:
- Tax-free state
- Married Filing Jointly (MFJ) status
- Spouse does not earn income.
- Federal MFJ tax brackets for 2020 shown below
| 10% | $0–$19,750 | 10% of the taxable income | |||
| 12% |
|
$1,975.00 + 12% of excess over $19,750 | |||
| 22% |
|
$9,235.00 + 22% of excess over $80,250 | |||
| 24% | $171,051–$326,600 | $29,211.00 + 24% of excess over $171,050 | |||
| 32% | $326,601–$414,700 | $66,543.00 + 32% of excess over $326,600 | |||
- Our doc has $500k in a taxable account, $1.5 million in tax-deferred retirement accounts and $50k in Roth accounts.
- Our doc is in her mid-40s and saves $19,500 in a 401k as well as maxing out personal and spousal backdoor Roth IRAs.
- Takes standard MFJ deduction of $24,800
- Our doc earns $300k of W2 income in a typical year.
Full-Timer, Typical Year
In a typical year, our doc's taxable household income will be $300,000 - 19,500 - 24,800 = $255,700.
In a typical year, her annual federal tax bill will be $29,211 + [24%*($255,700-$171,050)] = $49,527.
Note that while her marginal tax rate (tax rate paid on the next dollar of income) is 24%, her effective tax rate (taxes paid / taxable income) is $49,527/$255,700 = 19.3%.
Roth conversions could potentially fill up the remaining space in the highest marginal tax bracket, but 24% is not a terribly good rate at which to be taxed. If our doc decided to proceed anyway, she has an additional $326,600 - $255700 = $70,900 of space remaining in the 24% bracket. While that's a lot of space, the conversion would be taxed at 24%*$70,900 = $17,016. Ouch. Most physicians would not Roth convert in the 24% tax bracket..
Full-Timer, COVID Year
Due to COVID, let's say that in 2020 our doc takes a 33% haircut and now expects an annual income of $200k in 2020.
She still makes her 401k contribution and takes the standard MFJ deduction, resulting in a COVID-year taxable income of $200,000 - 19,500 - 24,800 = $155,700.
In this COVID year, her annual federal tax bill will be $9,235.00 + [22%*($155,700-$80,250)] = $25,834.
Her marginal tax rate is 22% while her effective tax rate is $25,834 / $155,700 = 16.6%, significantly lower.
The remaining space in the 22% bracket is $171,050 - $155,700 = $15,350. Not a huge space, but a reasonable rate at which to Roth convert some of the 401k money. Note that to do these conversions, she needs to have sufficient funds available to pay tax on those conversions. The tax on the Roth conversion will come to 22%*$15,350 = $3377.
Part-Timer, Typical Year
Now let's see how a part-timer compares, both in typical and COVID years, in terms of Roth conversion space. We'll assume our part-timer is working 60% of a full-time equivalent in the same specialty as our full-time doc, for a typical year salary of $300,000*60%=$180,000.
In a typical year, our doc's taxable household income will be $180,000 - 19,500 - 24,800 = $135,700.
In a typical year, her annual federal tax bill will be $9,235.00 + [22%*($135,700-80,250)] = $21,434.
Her marginal tax rate is 22% while her effective tax rate is $21,434 / $135,700 = 15.8%.
Her remaining space for a Roth conversion in the 22% bracket is $171,050 - $135,700 = $35,350. The tax on the Roth conversion would come out to $7,777. Not awful.
Part-Timer, COVID Year
We'll give our part-timer a similar COVID haircut of 33% for an expected 2020 income of $120,000. Now things get interesting from a Roth conversion standpoint.
Our doc's taxable household income is reduced to $120,000 - 19,500 - 24,800 = $75,700.
Her annual federal tax bill will be $1,975.00 + [12%*($75,700-19,750)] = $8,689.
Her marginal tax rate is 12% while her effective tax rate is $8,689 / $75,700 = 11.5%.
Now for the silver lining of the low-income year. The remaining Roth conversion space is $80,250 - $75,700 = $4,550 in the 12% bracket (an absolute bargain) plus the full space $171,050 - $80,250 = $90,800 in the 22% bracket. If our doc decides to Roth convert up to the top of the 22% bracket, her tax bill for the Roth conversion will be 12%*$4,550 + 22%*$90,800 = $20,522. A significant bill to be sure, but for someone with a decently padded taxable account, this could represent a wise way to defuse the tax bomb ahead in a uniquely fortuitous low tax year.
Partial Checklist Prior To Roth Converting
A Roth conversion will not be right for every physician - this is a sophisticated financial move for a physician household that started out in a strong financial position before COVID hit.
- Can I predict sufficient income to cover my expenses for the coming year?
- Is my emergency fund (3-6 months of living expenses) full?
- Do I have sufficient cash equivalents on hand to pay the expected tax bill for this year's proposed Roth conversion?
- Do I expect my marginal tax rate to increase during retirement?
- For early retirees: Do I expect less favorable tax rates to take effect between the time I retire and the time I begin to take RMDs from my tax-deferred accounts?
This checklist is by no means complete, but should be considered a prerequisite to pursuing Roth conversions. If you are experiencing uncertainty regarding your ability to adapt to a reduced level of income, please get your financial house in order before you consider a Roth conversion. I'd welcome any suggested additions to the checklist.
This two-part post was not intended to be a comprehensive guide, but an introduction to Roth conversion strategies and a prompt to run the numbers on your personal scenario. Happy converting!
If you are navigating a personal or professional crossroads and seek assistance, I'd be grateful if you'd consider my burnout coaching service. Thank you.