Published October 6, 2021
Tax deferral is a wonderful thing. Until it’s not.
Tax deferral is a wonderful thing. Until it’s not.
Sometimes investors have to embrace short-term pain for long-term gain. When it comes to Roth conversions, the up-front sacrifice can be well worth it. But exactly when to convert to a Roth depends largely on your individual financial situation. There are three crucial questions to answer when you’re considering a conversion, namely:
In this episode of The Adviser You Can Talk To Podcast, Andrew Busa and Rick Winters answer those questions and address other key considerations, including why early retirement may create opportunities for conversion, the importance of tax diversity in retirement, and the Roth IRA’s role in legacy planning. Click the button to decide whether a Roth conversion is right for you! Or, to learn more about the nuts-and-bolts of Roths vs. traditional IRAs, try our Roth basics podcast or our special report on Roth conversions.
Hello, this is Andrew Busa and I’m a financial planner here at Adviser Investments and we’re here with another The Adviser You Can Talk To Podcast. Today I am fortunate to be joined by my colleague Rick Winters. He is a vice president at Adviser Investments.
Hey Rick good to have you back. We’ve gotten together a couple of times on these episodes, glad we could do it again.
Yeah, absolutely. It’s going to be fun.
So the last time we did an episode about Roth IRAs this was called “All About Roth IRAs.” We had a general conversation about why we like Roth IRAs so much, how they work. After that episode we did get some feedback from listeners who wanted our thoughts, kind of more specifically on how we approach Roth conversions, that is converting money from a traditional IRA or a qualified account into a Roth.
Yeah, we did get quite a bit of feedback and it got the down to the opportunity.
[Crosstalk 00:01:44] If you’re considering a Roth conversion, you’ve been doing all the right things. You’ve been maxing out your savings into your 401(k), oh by the way the company matches you, that goes in pre-tax and then profit sharing if you’re lucky enough to participate in that, that goes in pre-tax. Well, if you’re young or even now have just started and have been taking advantage of that max, pretty quickly that 401(k) can get really, really large. And you’re like great I’m saving all this money now I’m reducing my taxes, that’s money I’m just socking away. Well, guess what? If you’ve been investing wisely, let’s say you’re being more aggressive, and markets tend to spend a lot of time near all-time highs. You might be building yourself a really, really big tax problem.
Because all that pre-tax savings eventually the government wants you to start taking some money out and you have to pay that tax on that.
It’s sort of “tax deferral is a wonderful thing until it’s not,” to that point today it’s all about how to approach Roth conversion. So in order to do that we’ll give you three questions today to consider whether a Roth conversion is right for you or not. Also, just generally here in this episode, we’re going to go ahead and assume you’ve listened to our previous episode about Roth IRAs. That kind of covers the basics about how Roth’s work, why we like them so much, or that you have a general understanding. And we will also link a special report in this episode that covers the basics of Roth IRAs if you have questions there.
Really the two takeaways we hope you take from this podcast are number one, why Roth conversions are so powerful and number two, whether or not a Roth conversion is right for you.
Having said that, always check with your CPA, your tax preparer, your adviser when it comes to hard numbers. This episode it is not meant to give you an exact dollar figure of how much makes sense to convert. This is general in nature and more really strategic than anything else.
Alright so let’s get into these three questions. So the first one, what will future tax rates be and what are your taxes now? The reason we lead with this question is because a conversation around Roth conversions should always start and end with taxes. Why? Because you have to pay taxes in the year you make the conversion.
Yeah that’s exactly right, it’s a form of tax arbitrage. You’re looking at your current situation and now this environment’s a perfect example. We know, written into the law right now, that a couple years down the road we’re going to be dealing with a higher tax rate. So if you expect your income to be the same, even just a few years from now, the most likely you’ll be paying more in taxes on that next dollar worth income. So you could be considering right now whether alright well, I’ve actually got an extra $50,000 in this bracket that I’m in that’s going to go away, maybe I should be looking at ways to try to take advantage of that. So it’s a form of that tax arbitrage or that bracket top-up strategy to give you a name you can hang your hat on.
Yeah exactly. This is kind of thinking about your tax rate today, taking advantage of that, paying tax now for some benefit later on.
Yeah simple, another way to look at it is pay the taxes when they’re the least.
Yep, exactly. So we think about current tax law versus future tax law. You mentioned that we don’t have a political crystal ball here but are taxes going to be lower than they are today? I think it’s safe to say they probably won’t be and even if they stay the same you still might be better off by doing these conversions. And if they go higher, you’re really definitely going to be better off in most cases if you go about this the right way.
So Rick, let’s talk about a few examples about where you can be opportunistic with your taxes here.
Yeah, absolutely. So I mentioned a couple of examples of things that may be happening in someone’s life that would make it a good opportunity to consider a Roth conversion. One of my favorites is if you’re fortunate enough to be in a situation where you can retire early.
Early nowadays is actually still like 65.
So the idea that you retire at 65 between age 65 and 70, you have the ability to control whether you take social security or not, and you’re not required to take distributions from your tax-deferred IRA and retirement savings until 72. So if I did my math correctly that leaves a five- or seven-year period where you, depending on if you’ve saved into your various pre-tax, post-tax taxable buckets, could work with your professionals to actually try to take advantage of those lower tax brackets.
That’s one of the most powerful, you go from earning a big salary paying a lot of taxes, your top tax rates to earning no income on W-2 or any other sources and maybe just relying on investment income, that gives you complete and total control over that tax bracket.
Absolutely. On the other end, you’re kind of talking about the late career phase. Think about early in your career, so when you’re first starting out in your twenties, in your thirties you’re probably going to be in the lowest-ever tax bracket that you will be in, in your career. Hopefully once you get into your mid and late career you’re in your high-earning years, these are potentially opportunities where you could convert a little bit of IRA income into a Roth. And once it’s in a Roth, again keep in mind, a little bit of review, it’s never going to be taxed again. So you have so much time to let that money grow tax-free.
Yeah, the younger you are that compounding effect is so much bigger. And most often, just kind of making a general statement here, is that if you look at our portfolios and with our clients, we invest those Roth assets the most aggressively.
Obviously if we can put something in an account that we can grow. So if you’re young and you have not saved into the Roth, remember this is a Roth conversion discussion, and you’re now in your late twenties and foresee a huge increase in income over time, maybe it’s time to go back. You’re making the rent payments, you’re filling the fridge, you’re able to entertain yourself and living life, but still if you have the opportunity to convert now, it would be from some of those old IRA savings or 401(k) savings that you’d made this would be a very good consideration. I think they’re in the best position to be able to take advantage of a Roth conversion.
Right and then I know you talk about sometimes these kind of random opportunities that pop up throughout someone’s career.
Yeah, you have this job transition. If you lose your job, which is not a good situation for most folks.
But at the same time, we don’t want to miss the opportunity that it creates. So yep, get right back in the saddle of trying to find a job. But if we’re going to find that it’s a low-income year for you that might be the opportunity to convert. Take a sale of a business. If you’ve been working, making a bunch of money and obviously the year you sell the business and have a huge capital gain is not the year to be considering the Roth conversion. But next year when it’s a clean playing field, that’s a great opportunity.
Because the way that the brackets are set up for most people, is you can have a lot of breathing room. I guess any tax bracket bothers most people.
But there are the difference between a 22% tax bracket and 37% is some big bucks.
Yeah for sure. So let’s move on to question two here, and that is when will the money be needed? So time horizon, it’s always an important part of figuring out your investment strategy, we talk about that a lot, and it’s important for this conversation as well when you’re thinking about Roth conversions. Generally, we typically see the best outcomes here when you don’t anticipate needing to touch the money you convert for at least 10 to 15 years. That’s not always the case, but that’s usually where we’ll see the breakeven.
Yeah. Good rule of thumb.
So timeframes being important, let’s assume why would I go shorter than that 10- or 15-year timeframe? Well maybe I was in that situation where I retired early and I’ve got that low income, and I can convert a bunch of money and then use that Roth conversion. When I turn 72 to balance out the living off my required minimum distribution but I don’t have to go and take more out of my IRA, I could be using some of that Roth savings to balance out my income and keep me in that low bracket. So now prior to retirement I was trying to push myself up and use up that low bracket, now I’m in the situation where I’m using the Roth to keep myself in that bracket. So that’s a period where you may find that tax arbitrage again to your advantage.
Another reason that sometimes the shorter timeframe may work is, because I had mentioned a little bit earlier, is that people do invest IRA money with knowing that they’re going to have to take required distributions. That money’s coming out whether you need it or not. When you have to take that required distribution from the IRA it’s a lot different taking that RMD when you’re 72 versus when you’re 85. The required distribution is significantly larger, one because your IRA most likely has had more time to grow, and two because you’re older, the divisor you’re using to calculate your distribution makes it so much larger. So that conversion at age 67, 68, reducing your IRA so that there’s less money to grow in it would help reduce your required minimum distribution when you’re older. We can also use that Roth account to balance out your income cash flows to make sure that every dollar you touch is not taxable to you. That’s why it’s so important to talk the professionals you work with, talk to us. I mean we work on this daily, this is some of the most fun I have in my job.
Yeah, these are kind of fun puzzles to think about. When we talk about general rules of thumb with timeframes and when you should touch the money or think about touching it, one thing that is going to affect the time horizon is really what is the actual tax difference versus when you convert to when you actually withdraw that money. The bigger the spread the more favorable it’s going to be for you, that just makes sense. Whereas if that conversion now versus the withdrawal later is pretty tight, you want to let that money continue to grow. So that’s a good coverage of generally how to think about time horizon here. Another thing we talk about in our past episodes, and I think it’s worth mentioning here again, is the idea of tax diversity in retirement.
Yeah, tax diversity in retirement is, and I did touch on a little bit earlier this idea, that if I only save money, and I see this a lot of times because there’s folks out there that have a pension, have social security and a large IRA or 401(k), and guess what all that income is? It’s not been taxed yet. It’s all coming in untaxed, you’re about to have no control over your income. So if you don’t think ahead earlier in your plans for retirement that, hey it might be nice to go on a trip with my family, and I may want to spend a little extra money, and I get a phone call from somebody saying, “Hey, I need to get $50,000.” That’s huge money but trips are expensive when you take the whole family, “to take my family on a trip.”
And I go “Oh, alright,” and they’re like, “I even got a deal on it,” you know?
And I go, “Oh well I’m glad you got a deal on it because now I need to take $75,000 out of your retirement account.”
“So you can pay for that trip,” and they go, “Oh, that’s not, what, how’d that happen?” So, because they don’t have after tax savings or that Roth savings, if you haven’t planned ahead and prepared for that, and this is where Roth conversion can come in, getting you to that place where that trip can actually be the $50,000 deal that you thought you were having.
Yeah the Roth definitely gives you more flexibility to pull from which again, speaks to invest in the Roth early in your career so you do have a chance to build that up. This is also a good time I think to touch on legacy planning here and why Roth conversions typically work very well in that sort of a conversation.
Yeah I mean more so now than ever. I don’t know how long these laws will stay, maybe they’re permanent. I think the current laws are now that certain beneficiaries, the majority of beneficiaries, there’s a unique set that will be able to continue to receive under the old lifetime distributions. But the majority of IRA beneficiaries now, mainly children of parents who’ve saved wisely will have to distribute their IRAs over a 10-year period.
And since we’re not talking about a $100,000 IRA that’s being inherited and having to take somewhere between $10,000 to $15,000 over 10 years is probably not causing too much of a tax problem.
But let’s make that a $3 million IRA, just to try to balance out the income over a 10-year period.
You’re taking somewhere between $300,000 to $350,000 a year. That’s on top of your already existing income.
That’s going to hurt.
Yeah, but if I inherited a Roth, which I still have to distribute over 10 years, but if I inherited it as a $2.5 million Roth IRA, well then I don’t even have to take it out any year. I could let it grow for 10 years tax free and then distribute it in year 10. Hopefully at that point it’s $4 million of tax-free money.
Yeah that’s sort of a good practice that you mentioned there I think, and if you are to inherit a Roth, again if you can afford to leave that untouched for those 10 years and just wait to take it all out, you give that money the chance to do what it’s supposed to do is that is grow tax-free.
Yeah and even if you can’t wait for 10 years and you need to grab $10,000 or $15,000 or $20,000 or some-odd thousand dollars it’s still tax free. The main point would be just to try to continue because you can’t inherit that money and then transition it over to your Roth IRA, that’s not allowed. So you have this 10-year period, it’s going to be out of that account and in a taxable account after that. Andrew, you and I have worked on a number of these cases together is where we’re working with a family, that’s even the best scenario where you’re including everyone in the legacy planning, and we spend a tremendous amount of time on these conversations. It’s so important to think about them because when you’re, I hate to say it, when you’re dead it’s too late.
Yes, for sure. To that point when you’re thinking about legacy planning in terms of doing something for the next generation, this could potentially trump everything else we talk about today, right. If you’re doing this as a pure legacy play you want to prepay taxes for your children by doing a Roth conversion, and you discover that you have enough assets to do that and that’s great. Then this could still make sense to you for you, even if you’re in a higher tax bracket, potentially you’re already taking out required minimum distributions, this could sort of be the ultimate reason why you want to do a Roth conversion.
Even at the max tax rates today. I would argue that it makes a lot of sense if you can see that your kid’s having good success and we have some general idea of what their income is and we plan, maybe not complete them knowing everything, but just have a real clear idea of what we’re trying to accomplish. We can do that real efficiently with the current matriarch and patriarch in the family or whoever’s in charge of the family.
Absolutely, yeah I love the point about making it a family meeting, having everyone involved. I think those lead to the best outcomes. Alright well, let’s move on to the final question that you should be thinking about. This one is a little bit more straightforward and easier to think about, but it’s worth mentioning, and that is where will the money to pay the tax on the conversion come from? So you can shoot yourself in the foot if you aren’t careful here, remember when you convert you have to pay additional taxes on that money you convert.
Paying the taxes from your IRA on a conversion makes this, it almost makes it not a strategy worth doing.
Because you’re losing so much ground and the tax difference would have to be significantly larger, and the outperformance would have to be significantly greater in the converted amount to try to overcome that tax hit. You converted a $100,000 you only put $60,000 or $65,000 or $70,000 in the Roth because you had to use the $30,000 to pay the taxes? Yeah. That doesn’t work.
Right. You can almost eliminate yourself from in the Roth conversion conversation if you think about that you don’t have outside funds to pay tax on the conversion. That is not part of the IRA.
Even bigger is most of the folks that we’re really trying to help with these conversions are younger too.
And if you’re younger than 59½ and you do a conversion and pay taxes out of it you’re going to get dinged with a penalty.
Ooh, that’s a really good planning point. That’s an easy one to miss.
So even if you were happen to be in a lower tax rate at that point, well that’s gone because now you just paid a 10% penalty.
Yeah ooh, talk about shooting yourself in the foot, that’s painful. So those are the three questions and we’ll review them before we leave the episode, but I want to spend just a few minutes talking about a few other kind of interesting planning points that we came up with as we were putting together this episode that didn’t really fit neatly into any of these boxes. So this will be kind of a lightning round.
I’ll lead off with this first one. We talk about your Medicare premiums for your part B and your part D plans, and we’ve talked about that in a previous Medicare episode as well but, those premiums are based on your income from two years ago. So when we think about Roth conversions you are creating more ordinary income for yourself. So this could increase your Medicare premiums if you cross a break point. So maybe you think about doing these conversions before age 62 or earlier, because if your Medicare starts at 65 and you do a conversion at 63 or 64, just expect that maybe your Medicare premiums are going to be affected for a little while.
Yeah, and so not to just have anybody shut down as with that as a concern is that there’s a really good chance that those additional premiums are not enough of a cost to feed into the advantage of doing the conversions, but don’t go in blind.
Definitely part of that complicated planning that we’re talking about, it’s all complicated when it comes to Roth conversions.
Another one that we want to consider here and please help me out because this is even more complicated. Roth conversions can actually increase your qualified business income (QBI). So if you’re a self-employed individual and you’re able to take advantage of some of the new tax laws that have been put in play over the last couple years, or since the QBI deduction is limited to the lesser of 20% of QBI qualified business income or 20% of taxable ordinary income before the QBI deduction, so if you have a very low QBI income, or sorry, a taxable ordinary income, you would use this to bring that number up and get a larger deduction.
And then a final one to think about, if you have a trust as the beneficiary of your IRA, suffice it to say you should review that if you haven’t since the SECURE Act passed, I’ll throw that in, make sure you review it. But the reason we mention it here is because if you plan on sticking with that, there’s even potentially greater benefit to think about doing these Roth conversions. Just again, as a legacy play, it will tend to make more sense based on how the laws are written now. Alright this is great, let’s just review the three questions again and we’ll go into our conclusion here. But number one, that is what will future tax rates be and what are your tax rates now. Number two, when do you anticipate needing the money that you convert? And finally, number three, where will the money come from to pay the taxes on that conversion? Rick, any big takeaways for you in this conversation?
I’ve got so many, but I’ll go with the one that says, “Hey we need to calculate out whether I’m going to do a Roth conversion or not.” I say, “Hey, pay the taxes when it’s least that’s all we need to do. We can run numbers but if you know that taxes are low now versus what you expect them to be in the future, this is the time to pay the taxes if you can.”
Makes sense, yeah. You know, it occurs to me as we were talking, so much of financial planning is short-term pain for long-term gain, and it’s not always pleasant. When you’re saving for retirement your whole life and you’re kind of doing all the right things. Again, but this is sort of another example of that, where it might not feel great to write a check to the IRS that you otherwise wouldn’t have in order to do a conversion. But if you run the numbers with us and your CPA, you might find that it really not only benefit to you but potentially the next generation.
This has been Andrew Busa and Rick Winters from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoy this conversation, please subscribe and review all of our episodes. You can always check us out at www.adviserinvestments.com/podcasts. Your feedback is always welcome. As you can see we took some feedback and we made an episode out of it. If you have any questions or topics that you want us to explore, please email us at info@Adviserinvestments.com. Thanks for listening.
Podcast released on October 6, 2021. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. Personalized tax advice and tax return preparation is available through a separate, written engagement agreement with Adviser Investments Tax Solutions..
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