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Why You Should STOP Doing Roth Conversions · Retirement Answers

• 0:00
  Jacob: Roth conversions are a powerful tax planning opportunity for retirees. But what if I told you that they could actually be hurting you and forcing you to pay more in taxes if they're done incorrectly? And I bring this up because a couple weeks ago, was speaking with the gentleman and he presented his plan around Roth conversions and how he was doing everything and how he's going to convert everything over to Roth over the next five years. And his ambitions were pure and his thoughts were definitely in alignment with my philosophy. I want to help people pay the tax that they legally owe to the IRS, but we don't want to leave a tip.
• 0:30
  As we were talking through his conversion plans, it dawned on me that this is an all out blitz to convert everything to Roth, and it might not be the best solution. So Jacob, what do you mean? I thought Roth was good. I thought more Roth was better. And yes, love tax free money.
• 0:44
  And that's the point of doing Roth conversions in the first place. But what if you could have tax free money that wasn't in a Roth? Now, that sounds interesting. So let's play this out and talk about this here today on the Retirement Answers podcast. If you're new here, my name is Jacob Duke.
• 0:57
  I'm the host here of the Retirement Answers podcast. I'm really glad to have you. Welcome. I hope this is helpful content as you evaluate your retirement or if you're already in retirement. And if you are enjoying the show, I really would appreciate it if you left a rating and review there on Apple Podcasts or Spotify.
• 1:10
  It helps other people just like you find the show and benefit from these same discussions that we're having. So let's go ahead and jump in and talk about maybe why you shouldn't convert everything to Roth and how you can actually access money out of your tax deferred sources completely tax free. So if you've never heard a Roth conversion really quickly, it's whenever you pay tax on money that you move from a traditional or tax deferred source, such as a traditional four zero one ks or a traditional IRA or a SEP or a simple has to be tax deferred, meaning you've not paid taxes on it yet. When you convert that and that word convert there just means to pay tax to get that money and move that over into a Roth IRA, which is then tax free, and you can access that money in the Roth IRA after certain rules are met. Again, I've other podcasts specifically on Roth IRA rules, so I'm not going to talk through them here, but that's the basis of a Roth conversion.
• 1:57
  Now, whenever it comes to retirement and the thought around this, the idea is how can we move money from this pre tax source being a traditional type account over to a post tax source being a Roth account. So the idea here is to do this at low tax rates so that you can pay lower lifetime tax bill. And this has become quite the talking point or quite the strategy for retirees, because myself included, but almost every financial planner out there is helping people do Roth conversions and navigate them correctly. But it's become a hot topic in terms of taxes, because in general, most people don't like paying more taxes than they otherwise have to. Obviously, if you want to, you can absolutely donate to the national debt number and see if we can reduce that down.
• 2:37
  So your efforts are appreciated. But if you do not feel inclined to give your hard earned money to someone or some entity that has spent more than it should, then that's where tax planning comes into play. And that's why we do what we do around this. Now, what's become an issue in my opinion with Roth conversions that everyone is trying to do them all the time every year, no matter what, because they heard me or anyone else talk about Roth conversions, how they can be beneficial for you. The keyword there is that they can be beneficial for you, but they're not always beneficial for everyone.
• 3:05
  Even for those who would benefit from Roth conversions, converting everything to Roth is probably not the best idea. Here's an example to help you kind of think through this with me. Let's say you're 60 years old and you plan to retire at 62, and you've got $2,000,000 saved and you know, million and a 0.5 of that is tax deferred. So you're like, I might have some issues with taxes down the road because of RMDs, Required Minimum Distributions, which is why people think about Roth conversions in the first place is because those forced distributions, once you reach either age 73 or 75, depending on your year of birth, you will have to begin taking money out of your tax deferred accounts at that point, whether you need the money or not. Basically, it's a forced taxation on your tax deferred money is what's happening there.
• 3:46
  So instead of being forced to take money out in the future and potentially pushing you into higher tax brackets and causing you to pay Irma surcharges and pay higher tax rates on your Social Security and everything else, maybe paying before then by converting this money to a Roth and choosing when you pay taxes is a smart move. So again, this is a very beneficial and helpful strategy, but the reason this is sometimes taken out of context or not helpful is because people are trying to convert everything they have to Roth in a short amount of time. In fact, whenever you think about this, I'm going to show you why having money in a tax deferred source is actually tax efficient. So back to our example of you being 60 retiring at 62, maybe you're making 200 plus dollars a year because you've been working in your career, you've got a good job, and obviously, you are at the tail end, so you're making the most you probably ever have. Depending on if you're married or single, you could be either the 22% bracket or the 24% bracket with that income.
• 4:40
  But the question is this, why would I convert today at 22 or 24% federal tax, not even including any state taxes that may apply? Why would I do that today whenever I could pay 10 or 12 or even 0% taxes here in just a few years. That would make sense, right? You'd be paying a higher tax rate today to convert that money to Roth while you're still working because you have this high income, because your Roth conversion is going to be taxed as normal income, it just goes on top of whatever other income you have. Now, if we push this just a couple years down the road, let's say you're now 62 and you're retired and technically have no income because you've not started social security, you don't have any pensions, and you have this $22,500,000, whatever it is at this point, and you've got a decent chunk of that over half is tax deferred, and a portion of that's cash or that maybe is Roth, a portion of that is maybe some brokerage or taxable investment account money, but you still realize you have a Roth conversion opportunity maybe, and so you don't want those RMDs in the future, and so you're thinking, what if I just converted everything to Roth?
• 5:38
  What if I moved everything, this 1.5 plus million dollars to Roth over the next three or four years? That would be awesome, right? Because then I don't pay taxes on that ever again, and I have to worry about RMDs, don't have to worry about anything. And the the idea is is pure in thought, meaning I understand what you're trying to do, but to convert everything is not tax efficient. And here's why.
• 5:59
  If you're married, you have standard deduction. If you're single, you have a standard deduction. So everyone has a standard deduction when they file their taxes and as it's currently constructed, it's 30,000 and 15,000 depending on your marital status, but you could have it a little bit of extra on top of that if you are age 65 or older. So whenever you think about that standard deduction, here's what I want you to think of that as. That's the 0% tax bracket.
• 6:23
  Okay, so it starts at 0% on the first. Let's assume that you're married filing jointly. The first $30,000 is at 0% of taxable income. So you have a 0% bracket of zero to 30, and then anything above that up to $53,008.50. So 30,000 to $53,008.50, that's the 10% bracket if we're talking married filing jointly, and it obviously goes from there.
• 6:43
  Most people don't consider that as the 0% bracket. So here's the point I want to make. If you have taxable money, taxable income coming to you, the first 30,000 is completely tax free. So why would we want to waste or not use that first bracket of the 0% or even the second third brackets of the 10% in the 12%? Because those are relatively cheap overall, especially throughout history in terms of taxation.
• 7:10
  So the 10 and the 12% brackets along with that standard deduction, we'll call the 0% bracket. Those three brackets are the ones we want to use every single year, because we can't find them anywhere else, especially while you're working and making really good income. You couldn't even think about having an effective tax rate of 12% or less. Here's the point. Maybe you shouldn't convert everything to Roth, you should figure out how much you should convert to Roth so that your RMDs along with your other potential income sources in the future are potentially going to be taxed at that 0% rate because it's a part of your standard deduction that you get to use.
• 7:44
  And obviously, the standard deductions can change everything in the tax code is written in pencil. So I understand that all this can be changing in the landscape moves and shakes on us all the time. But all we have to go on is what we have right now. And so if we make our plans, we can change them over time as we go. But I want to think about right now today and the opportunities we have in front of us.
• 8:02
  So you might be thinking Jacob, how how is a 0% tax rate on my RMD even possible because of the standard deduction? Because, you know, I've got social security that's going to be there as well. And, you know, that's going be taxable, right? And so whenever we think about this, it doesn't make sense that it's even possible, but it actually is. Let's assume a few things.
• 8:21
  Let's assume that you're, you know, at RMD age, so you're 75 plus, and you've got a $30,000 RMD, and then you also have a social security of $60,000 combined, let's assume you're married, so 30,000 each from social Security. So it's a $90,000 total income coming into you. So 60 from Social Security and 30,000 from a traditional IRA via RMD. Now, we remember back to some of the episodes I've done on how Social Security is taxed, at least currently, this is obviously up for debate, and there's a lot of conversation around Social Security taxation. But right now, not all of your Social Security is taxable.
• 8:56
  In fact, at most 85% of your Social Security is taxable at any given point. And that percentage is based on how much other income you have. So we had to find what's called a combined income, run that through the combined income tax brackets. I'm not going to go through it in-depth here because I've done other episodes explaining exactly how Social Security taxation works and what you need to be thinking about. But I want to make this point really quickly.
• 9:19
  Whenever you have you have $60,000 of Social Security income and $30,000 of IRA distributions because of that RMD, only $19,600 is going to be taxable out of that $60,000 of Social Security income. Okay, well less than half of your Social Security benefits are actually going to be subject to taxation. So $19,600 is how much of that 60 that you're going to pay income taxes on. And now that we found how much of your Social Security benefits are actually subject to taxation, we can add in your IRA distributions of $30,000 which brings your total adjusted gross income to 49,600. Now, what we can do next is we can apply today's standard deductions to this and say, well, we can take 30,000 because we're married filing jointly.
• 10:03
  So 49,630 thousand, that's now $19,600 is left over. But since we're also above age 65, each spouse gets an extra $1,600 of standard deduction. Okay, so it's a minus another $3,200 in this scenario brings us down to $16,400 So what we've done there is we're making $90,000 in retirement at age 75 from Social Security and from the RMD of $30,000 but our total taxable income is only 16,400. And then if we can see today's tax rates, I'm not obviously able to project with the future tax brackets or rates would be, that would that would all fall within the 10% tax bracket, because that goes up to $23,800 of taxable income for married filing jointly. So the total taxes to be paid is $16.40 dollars So we take that $16.40 dollars of taxes to be paid and we divide that by our $90,000 of income, that is a 1.8% effective tax rate.
• 11:09
  Okay, so in that scenario, if someone had converted all of their tax deferred money at the even the 10 to 12 to 22 or 24% tax bracket, whenever they were in their 60s, and they didn't have the opportunity to pay a 1.8 effective tax rate in the future on their RMDs, then that's not optimal, right? You wouldn't want to convert everything in that scenario because your tax rate in the future, again, assuming everything stays like it is today, we have no idea, but assuming that that's the case, your tax rate in the future is going to be well less than what you could pay today. So the point here is this, you can actually and again, out of that $30,000 the majority of that's not being taxed, okay? Because your taxable income is only 16,000 and change, it's not $30,000 It's not even $90,000 because your social security is not taxed completely, only a small portion of it is. So the point in telling you about this is you have to have a Roth conversion plan that actually makes sense for you and your situation and actually project out what your tax rate could be over time because there's going to be ups and there's going to be downs in terms of what your effective tax rate would be.
• 12:17
  And you've also got to think about everything else. Is it worth paying IRMA early on in retirement once you're 65 and older to convert as much as you possibly can, right? Whenever you would never be paying IRMA in the future at all, even if you had those tax deferred sources of income. So here's the steps you probably need to take. Don't just take my advice in terms of Roth conversions and you should them or anyone else's and just say Roth conversions are great, everybody needs to be doing Roth conversions.
• 12:41
  What you've got to do is evaluate this for yourself, analyze your current income, what your future expected income will be, what the tax rates are today, what the tax rates could be in the future for you based on today's current tax rates, and then go from there and say, does it make sense to pay more tax right now compared to pay that tax in the future at a lower rate? Because the whole point of a conversion is to pay less tax, not to just convert it all to Roth. Once you've analyzed your situation, you can use some projection software's, you can figure out what your total tax liabilities might be both married filing jointly, but also for single, you've got to think through that and plan for it. And that's what I do every day with my clients as we we talk about Roth conversions, lot people come to me, Jacob, I want to do a bunch of Roth conversions. I'm like, okay, let's look at it.
• 13:22
  And then we will decide if they're actually beneficial, or when they should be done. So I wanted to share this thought with you today. Because, again, everyone's talking about Roth conversions, and everyone's trying to do everything they can to convert all of their money to Roth. And I'm telling you, that's not the best solution from a tax payment standpoint. You can actually pay less tax on your money in the future.
• 13:42
  And in fact, you could have another example I gave doesn't, you know, put you at 0% taxes paid, but it's pretty darn close. I mean, what was it? $1,600 or so is how much tax you're going to pay on $90,000. And even if you said $1,600 of taxes paid on $30,000 you would take that every single time. So if your RMD was even less than $30,000 probably 25,000, you might not pay any tax on the 25, nor on the Social Security at all.
• 14:09
  So we could run that math and you can and you can figure that out for yourself. Maybe it's a good homework project for you just to see how this works even more. But hopefully this helps you, it gives you some food for thought around Roth conversions and why they're yes, they're beneficial and helpful because the idea is to pay less tax over your lifetime, but don't go crazy. Actually think about it, process it, understand what's right for you specifically, and don't just take the blanket advice you hear and say I'm gonna do wrong conversions because that's what they said to do. It's the best thing for everybody.
• 14:34
  It's not always the best thing and you gotta be thoughtful about how and when you do them. So I'd love to hear your feedback. If you have a question, feel free to shoot it to me in an email. But also, if you have a question you want to have answered here on the Friday q and a that I do every Friday, you could submit those by using the link down in the description below. Thanks so much, and I hope you have a great rest of your week.