Chapters
Shownotes Transcript
Last year, I published an episode titled five reasons not to do a Roth conversion. In short, the five reasons shared were number one, shadow taxes, things like Irma surcharges and the premium tax credit. Number two, there's no undo button. So unlike contributions, you cannot undo a conversion. Number three, you lack the cash flow to pay the tax bill. Number four, you simply just don't want to do a conversion. And number five, you have future charitable giving goals.
Roth conversions are all the rage with retirees. Just about every retirement podcast, newsletter, blog, YouTube channel has content dedicated to this magical tax planning strategy, including this podcast right here. And look, I love Roth conversions. I think they can be wildly beneficial for the right person, but they're often talked about like they're a no brainer and anyone with pre-tax assets should be converting them to Roth and those who don't are making a big mistake.
Barron's recently wrote an article titled Roth IRA conversions, the best tax move you can make right now. Nerd wallet wrote one titled Roth conversion ladders can combat inflation. And then CNBC chimed in with another one that said now is the perfect time for young investors to do a Roth conversion.
While Roth conversions can be a great tax move and could be fitting for some young investors, the decision to convert isn't nearly as simple as these headlines often suggest. This strategy isn't a magic bullet or a no-brainer for everyone. There are a lot of things to take into consideration, a lot of moving parts, and a lot of nuances.
Skipping Roth conversions altogether likely will not break your financial plan. On the other hand, incorrectly pursuing them could create a massive tax drag on your portfolio, reducing the long-term success of your plan.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And to build on last year's episode, today I'm sharing three more reasons why you shouldn't do Roth conversions and or why it's okay to leave money in a pre-tax IRA. To grab today's show notes, which will include links to last year's episode, as well as the two-part Roth conversion series I published on the podcast as well, just head over to youstaywealthy.com forward slash 190. So
Roth IRA conversions are different than Roth IRA contributions. Let's get that out of the way first because it always causes some initial confusion. Roth IRA contributions are when you earn an income from working, you pay taxes on that income, and then you contribute a portion of those after-tax dollars to a Roth IRA. There are limitations on how much you can contribute and who can contribute. Roth IRA contributions are when you earn an income from working, you pay taxes on that income,
For example, if you're a single filer, you begin to get phased out of making Roth contributions if your modified adjusted gross income is above $138,000 here in 2023. If you're a single filer and you make $153,000 or more, you are completely phased out and you cannot contribute a single dollar to a Roth IRA this year. So Roth IRA contributions have limitations.
Roth IRA conversions, on the other hand, don't. A Roth conversion is the process of transferring money that you have inside of a pre-tax retirement account into an after-tax Roth IRA. Examples of pre-tax retirement accounts include traditional IRAs, traditional 401ks, SEP IRAs, and simple IRAs.
While inherited IRAs are technically pre-tax retirement accounts, just know that they cannot be converted into Roth IRAs. As noted, there are no limitations with Roth conversions. So if you have $1 million in a pre-tax traditional IRA,
You can technically convert all $1 million of it tomorrow into a Roth IRA if you wanted to. There's no age requirement or limit to the amount. If you want to convert every single dollar tomorrow, you can. The converted dollars will grow tax-free forever in your Roth IRA. You won't have to worry about RMDs at age 73 or 75. And if applicable, your heirs will inherit this nice pot of tax-free money.
The kicker here, as most know, is that taxes are owed on the amount of the conversion the year in which it's processed. So if you convert all $1 million to a Roth IRA tomorrow, you will pay ordinary income taxes on that $1 million just as if you earned that money working.
This $1 million addition to your taxable income would naturally drive you into a higher tax bracket and cause other assets and income to become more taxable as well. It could also likely result in you paying more taxes to the IRS over your lifetime.
Since there aren't any limitations to the timing or amount of Roth conversions, it's entirely up to retirement savers and the professionals that they work with, if applicable, to determine when and if and how much of a Roth conversion makes sense. I published a two-part deep dive series walking through how to evaluate Roth conversions last year. So if you missed it or you want to revisit it and brush up on all the nerdy details of this tax strategy, I'll be sure to link to it in today's show notes.
But in today's episode, I'm sharing three reasons why someone may not pursue Roth conversions, or in some of the cases, why it's okay if you skipped Roth conversions or you weren't able to convert everything before your opportunity runway ended. It can certainly make sense to convert some money to a Roth IRA at some point in time, but
But I often hear from retirement savers kicking themselves because they weren't able to convert every last dollar in time and they wish they started conversions earlier.
Roth conversions can be a great tax move, but as I'm sharing today, and as I shared in last year's episode, there are plenty of reasons not to do them and plenty of reasons why you may not want to convert every last pre-tax dollar. So reason number one, why you may not do a Roth conversion or why you might be okay leaving some money in a pre-tax IRA is that you can use your pre-tax IRA money as a creative way to tax efficiently, pay for long-term care expenses, and
later on in retirement. This strategy essentially takes advantage of the often overlooked or forgotten medical expense deduction, also known as IRS Publication 502. In short, medical expenses, including long-term care costs, can be deducted on Schedule A of your tax return. The full-length publication even has a clear definition of long-term care services, inclusive of a section dedicated to nursing homes.
Specifically, it states, quote, you can include the cost of medical care in a nursing home, home for the aged or similar institution for yourself, your spouse or your dependents. This includes the cost of meals and lodging in the home if the principal reason for being there is to get medical care.
It continues by saying that you can also include, quote, the cost of lodging not provided in a hospital or similar institution if it meets certain criteria. Simple things like the lodging has to be primarily for medical care. There has to be a licensed doctor there. It's not extravagant, etc.,
More often than not, when we do a long-term care analysis for a client, the conclusion is that we should skip buying long-term care insurance and instead plan on self-funding. In other words, if a long-term care event occurs, the cost will be paid out of pocket by the client instead of paying for and tapping into an insurance policy.
If you want to learn more about analyzing the need for long-term care insurance versus self-funding, I'll link to the series I did on this topic in today's show notes, which can again be found by going to youstaywealthy.com forward slash 190.
So when it comes to self-funding for long-term care, a helpful way to implement this into a financial plan is to carve out a certain dollar amount from retirement savings and put it in its own individual investment account, earmarked specifically for a future potential long-term care event.
This allows the client to keep the money invested, perhaps invest it a little differently given that it has a different goal than their other retirement savings, and just compartmentalize exactly what those dollars are for. In some cases, a client's nest egg may be mostly made up of pre-tax IRA dollars, or they need the after-tax money that they have to fund other near-term expenses.
In these cases, we'll simply open up another pre-tax IRA for the client and transfer the amount that we've decided to earmark for long-term care from their primary IRA to this newly opened IRA. It's a lateral transfer from one pre-tax IRA to another, so there's no tax consequences here. We're just creating a bucket, if you will, that's specifically setting aside and earmarking dollars for a potential long-term care event in the future,
inside of a pre-tax IRA. By keeping these funds in their own account, we prevent everything from getting commingled and we can sleep at night knowing that there's a plan for a potential long-term care event in the future. We're not just saying that we will self-fund and hoping nothing happens, we're taking action and earmarking dollars for that potential event.
planning for the worst and hoping for the best. So if money earmarked for long-term care expenses is in a traditional IRA and a long-term care event occurs in retirement, the client can take money out of that pre-tax account to pay for the medical expenses.
Taking money out of the IRA is a taxable event, as we know. However, the client can immediately turn around and deduct the qualified long-term care medical expenses on Schedule A of their Form 1040 on their tax return. One important thing to take note of here is that the IRS only allows you to deduct the amount of your total medical expenses that exceeds 7.5% of your adjusted gross income, or AGI.
So if your AGI is $100,000, you can only deduct expenses above $7,500. If your AGI is near $0 because you don't have any taxable income sources, keep in mind that that IRA withdrawal in this example will cause your AGI to spike. For example, let's say you have $100,000 of long-term care expenses in one year. All you have is pre-tax IRA dollars to pay these expenses. So you withdraw $100,000 from your IRA.
That $100,000 will now be added to your gross income. And again, you'll only be eligible to deduct expenses above $7,500 or 7.5% of your AGI. While you weren't able to deduct the full $100,000, you were still able to get funds out of your pre-tax IRA at a very favorable rate, perhaps a rate that's lower if you had converted every last dollar to a Roth IRA earlier on.
As always, there are a number of nuances to take into consideration here, and it likely isn't wise to intentionally skip Roth conversions just so you can potentially use pre-tax IRA dollars in the future to tax efficiently pay for a long-term care event.
A long-term care event may never occur or may not be a significant cost. So this isn't exactly something that you can plan for. But if you have pre-tax IRA dollars left over when your Roth conversion opportunity window ends, just know that those dollars could be earmarked for a future medical event.
Also, as discussed in the episode that we did on this topic last year, any excess dollars left in a pre-tax IRA that aren't needed to fund retirement or a long-term care event can also be used to give to charity, either at the end of life or through annual qualified charitable contributions, also known as QCDs.
In other words, not converting every last dollar allows you to maintain some tax diversity through retirement and potentially meet other future goals tax efficiently. Lastly, you might have caught me saying earlier that the IRS also allows you to deduct medical expenses, including eligible long-term care expenses for your dependents, which presents another interesting use case here.
You may not have a long-term care event, but it's possible that you end up caring for an aging parent who has one or needs nursing care. If they meet the criteria to be claimed as a dependent and you determine that claiming them as a dependent is best for your situation, you can deduct those eligible medical expenses that are incurred on your tax return and apply the same concepts that I've discussed here today. Okay, the second reason not to do a Roth conversion is your state of residence in retirement.
There are 13 states, previously 12, but Iowa was added to the list this year. So there are now 13 states that either don't have income tax at all and or don't tax retirement income distributions from pre-tax accounts like 401ks and IRAs. So if you currently live in a high tax state or a state that taxes retirement account withdrawals,
and you plan to relocate to one of these 13 states in retirement, you may not benefit from doing Roth conversions right now. It may be wiser to skip Roth conversions and instead withdraw money in retirement from your pre-tax accounts as needed once you're settled in your new retirement and income tax-friendly state.
There are still some unique situations that would justify Roth conversions before relocating, such as prolonged unemployment and or a significant difference in current federal tax rates versus future. But more often than not, paying state income taxes on Roth conversions when you plan to relocate to a more tax-friendly state in the future when retirement distributions kick in likely doesn't make much sense.
By the way, I did an entire episode on state income taxes and shared several myths around high tax states like California. So be careful not to accept the headlines you've seen about state taxes at face value and be sure to dig into the details to see exactly how different states impact your tax rates.
You might be surprised to learn that some states that have earned a bad reputation aren't actually all that bad for your personal situation, especially in retirement. I'll link to that episode in the show notes if you're interested in listening to it, which again can be found by going to youstaywealthy.com forward slash 190. Okay, so the second reason why you might not rush to do Roth conversions right now is your state of residence in retirement.
The third and final reason not to do a Roth conversion is if you plan to leave money to your heirs and you anticipate that they will be in a lower tax bracket than you. Perhaps they reside in a more tax-friendly state or simply maintain a lower taxable income for any number of reasons.
If your pre-tax IRA dollars or a good chunk of those dollars are destined for your heirs, who will likely be in a lower marginal tax bracket, then it likely doesn't make sense to intentionally hand over more money to the IRS while you're alive.
If your goal is to maximize wealth for future generations and you don't want to overpay the IRS, it would make sense to let those with the lowest tax rates pay the tax bill. Keep in mind, if IRA dollars are left to someone other than an eligible beneficiary, like a spouse, who is exempt from the new 10-year rule, they will be forced to withdraw the entire IRA balance and pay all of the associated taxes within a 10-year time period.
They could withdraw everything in year one, everything in year 10, or take a little out each year as they see fit. But everything, the entire account has to be withdrawn and exhausted within 10 years. Given that, it would be important to factor in this 10-year time period that your heirs have to spread out the tax consequence to determine if they will truly be able to get money out at a lower tax rate than you.
It's also worth noting here that maybe you plan to leave a healthy percentage of your retirement savings to your kids or your grandkids, but you aren't really concerned with what their tax rate might be at the time of inheritance and if it'll be lower than yours. Heck, they may not care either. As my friend Matt often says when someone complains about a tax bill, give me your income, or in this case, give me your IRA and I'll pay the taxes. It
It may not be important to you to do Roth conversions just so your heirs aren't burdened with a tax bill on their inheritance. And it may not be important to you to go through the hassle of determining who will be in a lower tax bracket and how much, if any, pre-tax dollars should you try and convert while you're alive.
But if maximizing generational wealth is important to you and you want to ensure that your family as a single unit is paying the least amount of taxes possible, it would be wise to determine if it makes more sense to leave money in the pre-tax IRA and let your heirs who might be in more tax friendly situations pay the taxes when the funds are inherited.
Okay, so to recap, the three reasons why you may skip Roth conversions or simply just be okay with leaving a balance in your pre-tax retirement accounts are number one, to tax efficiently pay for long-term care expenses later on in retirement. Number two, you'll be in a more tax-friendly state when retirement withdrawals begin. And number three, you plan to leave money to your heirs and anticipate that they'll be in a lower tax bracket than you.
As with most things, the decision to convert or not depends on dozens of different factors. Age, life expectancy, current and future income, geographical location, charitable giving goals, Medicare premiums, changes in tax laws, the list goes on.
The goal of considering Roth conversions year over year is to ensure that we don't overpay the IRS. We want to pay our fair share of taxes, of course, but I think it's safe to say that most of us don't want to pay more than we have to. We don't want to leave the IRS a tip just because we were lazy with our tax planning and we weren't proactive.
And that's exactly what we're doing when we're evaluating Roth conversions and other tax planning strategies. We are being proactive. We're looking at our current situation, projecting where we will likely be in the future, and then making an educated decision to determine if taking action right now makes sense.
What we want to avoid is retiring from decades of work, celebrating our ultra-low tax bracket during our gap years when income shuts off, and then waking up at age 73 or 75 when RMDs kick in, only to find ourselves in a similar or even higher tax bracket than when we were working.
Not only can this surprise cause cash flow issues and potentially cause someone to overpay the IRS over their lifetime, but it can also cause Medicare premiums to increase as a result of IRMA surcharges and cause Social Security income to become more taxable. So while Roth conversions are not for everyone, and there are plenty of reasons to skip this popular strategy, being proactive with our tax planning to evaluate all opportunities is an absolute no-brainer for every retirement saver.
Once again, to grab the links and resources for today's episode, just head over to youstaywealthy.com forward slash 190. Thank you as always for listening, and I will see you back here next week.