Are you Ready to “Deal with the Devil”?

July 22, 2021

Most everyone knows that when you reach age 72, you have to start taking money out of your Individual Retirement Accounts (“IRAs”) and pay tax on it.  These funds were created as 401(k) or IRA contributions and they saved you tax when you made the contributions.  But when you made the contribution you probably didn’t realize you were making a “Deal with the Devil (aka the IRS).”  You saved taxes then, but the contribution would grow for decades and when you took it out over time, you’d be paying lots of income taxes on that money.  And, if you didn’t take it all out in your lifetime, your beneficiaries would have ten years to take the remainder out and pay income taxes on that as well.   Furthermore, due to inflation and possible rising income tax rates you could be paying a huge tax rate and huge amount of tax.  Without changes, the “Devil will get his Due.”

We’re pleased to report that, if you want and the circumstances are right, you can break the Deal with the Devil and you and your family can be far better off in the long run.  The key is converting the IRA(s) to Roth IRAs- an option that is available to all taxpayers at any time.

A Roth IRA is created when a taxpayer decides to “Settle up with the Devil.” Money is moved from an IRA to a Roth IRA and the amount converted is taxed as ordinary income.  Currently, once this transfer occurs, there is no going back.  You owe the tax.  However, the Roth funds now grow tax-free forever.  No Required Minimum Distribution (“RMD”) at age 72 and beyond. If you die, you can leave the funds to your spouse and the Roth funds will continue to grow for his or her lifetime. And, when the second of you passes, the beneficiaries receive the Roth funds and are required to distribute them within 10 years, just like an IRA. However, the Roth bequest continues to grow tax-free for as long as the funds are not distributed. Hence, the general strategy is for the beneficiaries to hold on to the Roth assets and distribute the money, after it has grown tax-free for the full ten years, on the 10th anniversary of the passing of the final owner.

Let’s give you a hypothetical example. A couple retires at age 65.  They have $1 million in IRAs.  They will take social security at age 70. Assuming they live to age 100 (successful individuals age 65 have a better than 50% probability to reach 100) and do no Roth conversion, they will take RMDs for 28 years. During that time, inflation will grow at 3% per year and their balanced investment of the IRA funds will grow 6% per year. In all, the IRA grows $3 million over 35 years in our example, RMDs total $3.3 million and at age 100, when the second of the couple passes, the IRAs still have $700k of value in them. Our hypothetical couple has paid $1.1 million in income taxes on the IRA RMDs. Roughly 33% tax. And, this is in a state (like IL, FL, TX, TN and others) that does not tax IRAs or Roth conversions.  To add insult to injury, their beneficiaries have to pay tax on the undistributed IRAs of $700k. Let’s assume that tax is at least 30% or $213,000. If so, Uncle Sam has collected over $1.3 million of taxes on the IRAs.

Now, instead, what happens if this couple converts all of the IRAs before age 72. Because the funds are still growing, they need to convert $170,000 to Roth each year, a total of $1.2million.  Their tax on that is only 24%.  Remember, when they start the conversions, they are not taking social security and are living off after-tax money or small part-time income. So, the total tax is $290,000.  The money grows tax-free until age 100 and then the beneficiaries get the funds and can let them grow another 10 years tax-free.

Okay, you doubters will say, “But you had to pay tax on the Roth conversion earlier than you paid tax on the RMDs!”  That is correct. However, if we do a net present value (“npv”) analysis using a 6% cost of money (our hypothetical investment return), the npv of the RMDs plus beneficiary tax is $426,000. The npv of the cost of the Roth conversions is $259,000.

But that’s not the end of the story and analysis.  What happens to the RMD money until age 100 and what happens to the Roth conversions until age 100 and beyond?  Here’s where the devil comes back into the picture.

The RMDs, starting at age 72 are invested and grow at 6% per year in taxable funds. And, yes that appreciation is taxed.  Let’s say at 25%.  The net accumulation of the RMDs after tax at age 100 is $6.2 million and add in another $575k for the remaining IRAs minus tax that the beneficiaries get. Call it $6.8 million The Roth conversions grow longer and tax-free and at age 100 are $8.2 million.  And, if the beneficiaries are smart, they will let the Roth money grow another 10 years tax-free, which at 6% would mean a $14.6 million inheritance.

The Roth conversion doesn’t work for everyone.  But, as shown here, where it applies, Roth conversions can be a huge benefit for you and your heirs. With taxes likely to rise in the future and inflation continuing, it makes sense to see if you are ready to break the Deal with the Devil.  We do these analyses for our clients as part of our Total Wealth Management Program using our proprietary, developed in-house software.  For those of you that are not clients yet, we’d be happy to confidentially review your personal circumstances at no cost and determine the possible benefits of you breaking the Dealing with the Devil and doing Roth conversions.  Give us a call.

Detterbeck Wealth Management is a fee-only financial planning / wealth management company with offices located in Palatine, IL (Chicago area) and Charleston, SC areas serving clients locally and across the country. To contact us about setting up an appointment, please see our contact us page