Today I’m kicking off a 2-part series on Roth conversions.
Specifically, here in part one, I’m breaking down:
- What a Roth conversion is
- How a Roth conversion works
- Why Roth conversions are so popular
If you’re ready to master the basics of Roth conversions, today’s episode is for you.
How to Listen to Today’s Episode
Episode Links & Resources:
- Retired or Close to It? Need a Retirement + Tax Analysis?
- Robo-Advisor Series
- 5 Reasons Not to Do a Roth Conversion
- Best Weekly Performance for U.S. Stocks Since November 2020
- UBS Acquires Wealthfront
Roth Conversions Part 1: What, How, and Who
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today, after countless requests, I’m kicking off a 2-part series on Roth conversions.
Specifically, here in part one, I’m breaking down what a Roth conversion is, how a Roth conversion works, and why Roth conversions are so popular.
If you’re ready to master the basics of Roth conversions, today’s episode is for you.
For all the links and resources mentioned today, head over to youstaywealthy.com/147.
Two quick updates before we get into it.
First, if you blinked, you might have missed that U.S. stocks are up almost 6% since last week's not-very-optimistic episode aired. I mention this to, once again, point out in real time how unpredictable markets are in the near term and why we don’t want to let current events lead us to make quick, irrational decisions.
Inflation ticked up higher last month, double-digit inflation could be around the corner, we have a war overseas, the Fed just hiked rates for the first time in four years, and yet the stock market just had its best weekly performance since November 2020. Stay focused on the things you can control.
Second, I’ve been meaning to share this for a while now, but for those who listened to my 2-part series on robo advisors last April, you might remember that one of my primary concerns for in going all-in with one was them selling to a large wall street firm. Much like Learnvest got swallowed up by Northwestern Mutual in 2015.
Well, it seemed to fly under the radar, but earlier this year in January, the big publicly traded brokerage firm, UBS, bought the popular roboadvisor, Wealthfront. Which, if you have followed Wealthfront from the very beginning, pretty much goes against everything they stood for, so it left many people and investors scratching their heads. Betterment is still standing, but my guess is we will see them go public or follow in Wealthfront's path here at some point.
Ok, with those updates out of the way, let’s talk about Roth conversions.
But before we talk about what Roth conversions are, let’s first address what they aren’t.
Roth conversions are NOT the same as Roth contributions.
Roth conversions are also NOT the same as backdoor Roths or mega backdoor Roths.
It’s very easy to get these these mixed up, especially since the words “conversion” and contribution are so similar.
The biggest difference between Roth conversions and Roth contributions is that there is no limit on the amount you can convert to a Roth, but there are limits for how much you can contribute to a Roth.
For example, you can convert $3 million to a Roth ira in a single year if you want to, but you absolutely cannot contribute $3 million.
Another difference is that anyone with a Traditional IRA can do a Roth conversion. But Roth IRA contributions are limited to people below a certain income threshold.
In other words, you can make $500,000 dollars per year and pursue Roth conversions. But you can’t make $500,000 per year and make Roth IRA contributions.
So, with that, what exactly is a Roth conversion?
A Roth conversion is the process of transferring money from a Pre-Tax Retirement account into an After-Tax Roth IRA.
Examples of pre-tax traditional retirement accounts include SEP IRA’s, Simple IRAs, and Traditional 401k’s. While inherited IRAs are TECHNICALLY pre-tax retirement accounts, they CANNOT be converted into Roth IRA’s.
So, let’s go through an example.
Let’s say Pete the Pilot has been working at Southwest Airlines for 30 years. (Fun fact, that’s my dad's name and he was a captain for Southwest for most of his career.)
Like my dad, Pete the pilot (who is totally hypothetical) was a good saver, and over those 30 years, he accumulated $1 million in his pre-tax 401k retirement account. Like most of his pilot friends, upon retiring, Pete rolled that $1 million 401k balance over to a Traditional IRA.
While Pete is excited about the $1 million he accumulated, he’s reminded that the $1 million doesn’t all belong to him. It’s pre-tax money, which means a percentage of it belongs to the IRS.
Pete the Pilot is used to making quick decisions at 30,000 feet going 500 mph and doesn’t want to sit around and wait for the IRS to slowly chip away at his money. He wants to pull the rip cord, pay his taxes, and move on.
So, without seeking any advice, Pete does a Roth conversion. He transfers (i.e., converts) $1 million from his Traditional IRA to a Roth IRA.
That $1 million is taxed as ordinary income, which means this thrusts Pete into the 37% bracket.
We’ll keep it simple, push state taxes aside for now, and estimate that Pete has to cut a $300,000 check to the IRS as a result of this Roth conversion when he files his taxes next April.
Thankfully, he has the cash in a savings account and uses that to pay the tax bill. Not a fun check to write, but now he has $1 million in a Roth IRA and 100% of it belongs to him.
Again, there are no limits on Roth conversion amounts, but that doesn’t mean you should convert hundreds of thousands of dollars or even millions of dollars all at once.
As noted, Pete’s $1 million Roth conversion that he did in a single year threw him into the 37% bracket and created a giant tax bill. Sure, all of his money is now in a Roth IRA, but he likely overpaid the IRS by doing a large conversion all in one year.
We’ll get to Roth conversion strategies and how to properly implement them so they benefit you instead of the IRS, but first, let’s quickly address why Pete (and other retirement savers) love getting their money into a Roth IRA.
In general, there are three main reasons:
1. Roth IRAs grow tax-free, and money is withdrawn tax-free. If Pete’s $1 million grows to $2 million, he can withdraw that $2 million without paying the IRS a dime. This gives Pete tons of flexibility in retirement. If he needs a new roof on his house or needs some extra income, he can take funds from his Roth without worrying about a spike in taxes.
And remember, taxable income in retirement can also cause more of your social security to become taxable and increase medicare premiums. Because all of Pete’s money is in a Roth, he doesn’t have to worry about that.
2. Roth IRAs avoid those pesky Required Minimum Distributions (aka RMDs). As most know, at age 72, the IRS comes knocking on your door and forces you to start taking money out of your traditional pre-tax retirement accounts which, in turn, triggers a tax bill. Those RMDs can be quite large, depending on your account balance, and get larger every year.
In other words, your pre-tax retirement accounts are a growing tax liability. And again, those taxable RMDs (on top of other income you might be receiving) can cause social security to become more taxable and spike Medicare premiums.
3. Roth IRAs are easier and more tax efficient for your heirs to inherit. There are some rules to follow and understand, but in general, the funds can be withdrawn tax-free by Roth IRA beneficiaries.
To recap the three reasons why getting money into a Roth IRA is so desirable:
1. Your investments grow tax-free and can be withdrawn tax-free
2. You avoid required minimum distributions at age 72
3. Your heirs can more easily inherit a Roth IRA
The benefits of having money in a Roth IRA are powerful. And, while anyone with pre-tax money can do a Roth conversion, it doesn’t mean that EVERYONE should pursue this strategy.
In addition to the 5 reasons we covered in episode 145 earlier this month which I’ll link to in the show notes, here are four more situations where Roth conversions may not be appropriate.
1. If you’re under age 59 ½ and don’t have money outside of your IRA to pay the tax bill. Yes, technically you can pay the tax bill with the money being converted, but there will be a 10% penalty on the amount owed to the IRS. That’s because money withheld from the conversion to paying the tax bill is considered a withdrawal and not part of the conversion. Since you’re under age 59 ½, it would be considered an early withdrawal which carries a 10% penalty.
2. If you’re still working and earning healthy taxable income, you might hold off on a Roth conversion until you stop working and drop into a lower tax bracket. We don’t want to overpay the IRS like Pete the pilot.
3. If you plan to leave a good chunk of your IRA money behind at death and your beneficiary is likely to be in a lower tax bracket than you, it might be wise to skip converting the assets to a Roth while you’re alive and let your beneficiary pay the IRS at a more favorable rate when they inherit the money. Just remember that if someone other than your spouse inherits your IRA, they will have 10 years to withdraw the funds and pay the taxes, so take that into consideration.
4. If you have never opened a Roth IRA and think you might need the money in five years or less. If you have never had a Roth IRA, you’ll have to meet the five-year rule in order to withdraw earnings from your Roth IRA tax-free.
So, let’s say you’re 65 years old and convert $100,000 to your very first Roth IRA. That $100,000 grows to $150,000 in 4 years, and you need to withdraw the entire $150k balance to, let’s say, pay for a home remodel. Well, because you haven’t met the five-year rule, your $50,000 of earnings (or growth) in your Roth IRA will be taxable. So, those that have never had a Roth IRA and expect to need access to the growth of their money being converted before the five-year clock ends, might want to think twice about a Roth conversion.
To recap where we’re at here. We’ve talked about what a Roth conversion is (and what it isn’t), how a Roth conversion works, why getting money into a Roth is so desirable, and who might not be the best candidate for a Roth conversion.
In addition to who is a good candidate for a Roth conversion, the one big thing I haven’t highlighted yet is why Roth conversions are so popular to begin with, above and beyond the benefits of having money in a Roth IRA, and the added flexibility and tax-free growth.
The reason Roth conversions are so widely talked about in the retirement and tax planning community is because, if done correctly, the right person can potentially save millions of dollars in taxes over their lifetime. And we’re not talking about anything overly complex or illegal here.
The giant potential tax savings is all due to being proactive with your tax planning, taking control, and paying taxes when it’s most opportune for YOU instead of doing nothing and waiting for the IRS to come knocking on your door.
The way we measure the impact of multi-year Roth conversions over a retirement saver's lifetime is by calculating what we call their total retirement tax bill. In other words, how much are you going to pay the IRS from the date you retire through end of life.
Think of all the things that go into that calculation from dividends, interest, and cap gains, to periodic IRA withdrawals to supplement income, to RMDs at age 72, to social security taxation, and other income like real estate or pensions, and it gets even more complex when we are crunching the numbers for a married couple.
But it’s an important calculation, and with that estimated total retirement tax bill in our hands, we can then start to make educated and informed decisions with our money and engage in proactive tax planning to reduce the amount we pay Uncle Sam and keep more of our hard-earned money in our pocket.
And this is what I’m going to be sharing more about in part two next week, along with who is a good candidate for Roth conversions, and some of the common misconceptions retirement savers need to know about.
For the links and resources mentioned in today’s episode, head over to youstaywealthy.com/147.
Thank you, as always for listening, and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.