Welcome back to Friends Talk Financial Planning! In today’s episode, Bridget and John discuss the strategic world of Roth conversions. Wondering when the best time is to convert your traditional IRA to a Roth IRA? Or maybe you're unsure when it’s better to hold off? We cover it all!
Key topics discussed: Ideal times to consider a Roth conversion, especially during low-income years. The concept of "tax bracket arbitrage" and why it’s essential. Detailed explanation of Roth conversions and their tax implications. Strategic Roth conversions for younger individuals and those nearing retirement. The impact of inheritance rules and tax rates on Roth conversions. Estate planning and tidying up your financial legacy through Roth conversions. Tax bracket considerations pre-and post-retirement.
Why It's Important: Understanding Roth conversions can save you a considerable amount in taxes over time, provide tax-free growth for your investments, and offer peace of mind for your future financial planning. Whether you're just starting your career or planning your estate, these insights can help guide your decisions.
Resources:
- Alliance of Comprehensive Planners: https://www.acplanners.org
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- John Scheer’s Practice: https://www.trinfin.com
Connect with us on LinkedIn:
- Bridget Sullivan Mermel: https://www.linkedin.com/in/bridget-sullivan-mermel-a72620/
- John Scherer: https://www.linkedin.com/in/johnmscherercfp/
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TRANSCRIPT:
Bridget: Roth conversions, when to do them, when to not. That's our conversation today on Friends Talk Financial Planning. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. And before we dig into the question, to convert or not to convert, I want to remind everybody to hit that subscribe button. That helps other people find this information on YouTube. And with that, I'm looking forward to jumping. But I think this could be a pretty quick conversation. When to do it or when not to? Always do it, then we can stop the conversation. Just do the Roth conversions.
Bridget: I don't think it's that easy. There is an easy part, and that is when you're young and you think you're going to be making more later, but you happen to be in a low-income situation that year. So you lost your job, you’re between jobs, your income just happens to be low that year but you think that you need to be cranking it up again. Taking a year off, taking a professional gap year, sabbatical, whatever, unpaid. Those are good years to think about it because the Roth conversion strategies, in my opinion, hinge on saying, “I'm in a lower tax bracket now, and I'm going to be in a higher tax bracket later.”
I call it tax bracket arbitrage, but that's getting a little fancy. Anyway, with that gap, I'm in a low bracket now, I'm going to be in a high bracket later, that's a great year for a Roth conversion. And so, when you're young, you're maybe not positive you're going to be in a higher tax bracket later. But for instance, when I started my first business, I thought, well, I'm starting a business, so I'm not making a lot, but I have some money in the bank.
John: Right.
Bridget: Well, let me do some Roth conversions.
John: So, hey, let's jump in. I love that you called the jargon police on yourself when you were talking about arbitrage. That is a very sexy word to use at a cocktail party. Pull that one out even if people don’t know what you're talking about. It sounds good, but let's just make sure people know what we're talking about. And again, if you're a longtime viewer, you've seen these sorts of topics before, but what we're talking about is saying, listen, I've got money inside of a regular IRA. I took a tax deduction for putting money in my 401(k) or 403(b) or IRA. Now I'm going to choose to take that money out, take a distribution, and put it into a Roth IRA.
When I do that, there's no 10% penalty for taking it out early, but I have to pay taxes on all that money. So if I have $100,000 in a regular IRA, and I convert that to a Roth IRA, on my tax return for this year, it'll look like I made $100,000 of taxable income. But then it goes into the Roth IRA. And just to be really clear, that's what we're talking about in the question. I love how you framed it, Bridget, as in using tax arbitrage. But saying, listen, if I can pay taxes on that $100,000 at this level and in the future my tax bracket is going to be at this level, I might want to pay taxes here, so I don't pay taxes here in the future. That's sort of the deal.
Bridget: Yeah. And I really like it if you're in a 12% or 10% bracket, more so than if you're in the higher brackets, because there's a pretty big leap. So right now, the tax bracket goes from 12% to 22%. And I've been in the business for decades, and I can say there's generally a leap. The exact numbers change, but between 10% or 12% and then 22%, that's 10%. That's worth playing around with.
John: Yeah. More of our clients are closer to retirement or in retirement, so I really appreciate that idea of, hey, when I'm starting in my career, I'm younger, I'm in between jobs, this can be a good idea. And I say this all the time to friends, listen, you lose your job, something happens, when else do you have time to kick back and enjoy it for a little bit? There's nothing wrong with taking six months off and not sweating the thing. But when I’m in that spot, now I've got a lower tax bracket. That could be the time to do that because I know I'm going back to work next year at some point.
That thought process, I think, is a really awesome way to approach it. Typically, when we're talking about Roth conversions, it's people who are approaching or in retirement, and now they can choose to make taxes voluntary or not. I have more flexibility. I don't necessarily have to do anything from a tax standpoint, but I could. How do I think about that? And here’s one of the big things for us in thinking about this. And Bridget, you go back a long time in this world.
When these Roth IRAs first came out in the late nineties, then the Roth conversions came out, and there was a lot of talk in our world professionally. Bridget and I go to conferences and these sorts of things. And a lot of the talk is, everybody should do Roth conversions. You should convert all this to Roth, because look at all this tax-free money you have. And Bridget's making that grumpy face at me here, but that's the thing. And I'll tell you that for many years, I said, “Well, we'll kind of see.” I call it the bird in hand theory. I know the taxes that I pay today.
I don't know the taxes I'm going to pay tomorrow. How do I think about that? I'm not convinced that we should all convert everything that we have in IRAs to Roth IRAs. But in the last five to ten years, there have been some significant tax law changes that have made me think a little bit differently about that. And one of them is that tax rates have gone down, and then they've gone down again. I keep on saying I think taxes will go up, but, golly, they keep going down. Maybe they keep going down. I don't know. But, geez, we're in a pretty low tax rate environment. At least, I think.
But then the other big one for me is the inheritance rules. And we did a recent episode on inheriting an IRA. But it used to be that any person who inherits an IRA can stretch out the distributions over the course of their lifetime. And when somebody is 40, they've got 20 or 30 or 40 years to spread out that tax hit. Now, the rules say when somebody dies and I inherit an IRA, I have ten years to take all that pretax money out. And, if there's a million dollars, you can do it simply in your head, it's $100,000 a year of extra income coming in that I have no choice on when to take.
So, lower tax rates for me and this compressed timeframe (we can't spread that in that inherited IRA out) leads me to say, hey, doing a Roth conversion and putting more money where all the future growth is going to be tax free has appeal. And we can get into this discussion about what's the right thing exactly to do. For me I don't know exactly, but there’re fewer downsides in my mind.
Bridget: So if you're in the luxurious position of being able to do estate planning, that means you've got some money. I call this tidying up your estate. So you're thinking about, oh, how would my heirs like to do this? Would they like to stretch it out just over ten years, or would they like to get this tax free? The first question I have before people do this is, do you have enough money? Are you going to run out of money?
So if you know you're not going to run out of money, then I start thinking about, okay, does this make sense? Because if you might run out of money at the end of your life, you might pay very little or low taxes, just because you might have high medical expenses or a variety of other things. So again, if I'm sure you got more money than you're going to spend, then I think Roth conversions and tidying up the estate. And it’s not like you have to do everything. You can do smaller amounts.
John: I'll go back to that idea of arbitrage. Hey, am I going to be in a lower tax bracket or a higher tax bracket? And I wanted to point out to viewers that if you're in the same tax bracket all the way along and when your kids inherit the money, they're in the same tax bracket, his stuff doesn't make any difference. It’s literally six or one-half dozen. You pay the same amount of taxes. It all works out. I've done the math. It's when there are changes in tax brackets. So what's the risk?
I do a Roth conversion now at my tax bracket of 22%, or whatever number it is. And at some point in the future, I'm in a lower tax bracket. As you just said, Bridget, I got long-term care costs in a nursing home. My tax bracket goes way down. My kids have an occupation where their tax bracket is way down. I've paid taxes at this level, and I could have taken it out at this level way down the road. That's the risk. The advantage is I pay taxes at this level, and in the future, my taxes or my kids’ taxes are at this higher level.
And I know that you and I, Bridget, think about this in terms of the tax law today and let's operate under that methodology, which I think is the right way to do it. But there are people that say, geez, tax rates have to go up. As I said before, I've been saying that, so eventually I'll be right, like a broken clock. Eventually I'll say taxes have to go up, and they will. But it can be one of these things for folks where if you go, listen, what's the downside?
Well, if somebody's in a lower tax bracket in the future, then I'm not making a great decision by doing the conversion today. What are the chances of that? Not zero, but for many of our folks say, “Well, there's not much of a chance based on what my kids do for a living.” And then what are the chances that taxes go higher in the future? And some people go, “Oh, golly, they're going to raise taxes.” Like I said, I tend to think so, but we'll find out.
So it can be one of these things where if there's only a little bit of downside, only if somebody's in a lower bracket, and geez, there’s an upside, I'm really afraid of higher tax rates in the future. I don't think you should mortgage your future based on what you think might maybe happen down the road, especially based on politicians. At the same time, if you go, listen, it doesn't hurt us on one side, and maybe it gives us some gain, I don't know if there is or not, but maybe there's some upside.
Having some diversification from a tax standpoint can be a good idea. We all talk about having a little bit of your investment pie in different buckets, stocks and bonds and all those sorts of things. From a tax standpoint, if I can do that and not have much in the way of downside, that's where I think it can be appealing for folks.
Bridget: Okay, so we've talked about when you're first starting out, and now we're talking about the other end of the spectrum, the people who are trying to tidy up their estate. And they're thinking about, okay, what is this gonna be like for my heirs? But then I also think there's another group with Roth conversions, and that is people who have retired.
So they don't have this big income train coming through with their wages, but they haven't started taking Social Security and/or required minimum distributions (RMDs) from their IRAs so they can have a few years where they might say, “Well gee, it's like I'm paying zero tax.” I celebrate when people are paying 12% tax, not when they're paying zero tax. So we move them up a little bit to convert some and then they pay 12% on that, especially when we know they're going to be in the 22% or 24% bracket later.
John: Yeah, I love that. Thanks so much for pointing it out. Think about this. When I'm working, I'm in the 24% bracket. Now I'm living off cash in the bank and different things; I got zero taxes. But in two or three or four years when I have to start taking money out of my IRAs to live off of, I'm going to be back in the 24% bracket. That's exactly what you described. I don't want to see you paying zero.
Let's pay some taxes at 12% instead of 24%. That's a great middle ground here. That’s a really important point to bring out and I think that's maybe a great place to wrap things up, and close on this discussion of Roth conversions. Again, I'm John Scherer. I own a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: I’m Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. John and I are both accepting new clients, but we're also members of a nationwide organization, ACP, or the Alliance of Comprehensive Planners. So if you're looking for an advisor in your area, you can check out acplanners.org.
John: And don't forget to hit that subscribe button.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.
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