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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today, after countless requests from listeners, I'm finally kicking off a two-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. So if you're ready to master the basics of Roth conversions, today's episode is for you. For the links and resources mentioned, just head over to youstaywealthy.com forward slash 147.
Okay, 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. And 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 these current events lead us to make quick, oftentimes irrational decisions with our money and investments.
Inflation ticked up higher last month. Double digit inflation could be around the corner. We have a war overseas. The Fed just hiked interest rates for the first time in four years. And yet the stock market just had its best weekly performance since November of 2020. So once again, a reminder to stay focused on the things you can control.
The second update, I've been meaning to share this for a while now, but for those who listened to my two-part series on robo-advisors last April, you might remember that one of my primary concerns for going all in with one of these online advisors was them selling to a large Wall Street firm, much like LearnVest got swallowed up by Northwestern Mutual in 2015. Well, it seemed to kind of fly under the radar, but earlier this year in January, the big publicly traded Wall Street firm UBS...
bought the very popular robo-advisor Wealthfront, which if you followed Wealthfront from the very beginning of their journey, this pretty much goes against everything that they ever stood for. So it left a lot of people and investors scratching their head. Betterment is the other big robo-advisor and they're still standing, but my guess is that we'll see them go through something as well. Either they'll go public or follow in Wealthfront's path here at some point.
Okay, 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 because this can get really confusing. 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 really easy to get these things 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. However, as most of you know, 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 really wanted to, but you absolutely can't contribute $3 million to one.
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 per year, let's say, and you could 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? Well, a Roth conversion is the process of transferring money from a pre-tax retirement account into an after-tax Roth IRA.
Some examples of pre-tax traditional retirement accounts include SEP IRAs, simple IRAs, traditional IRAs, and traditional 401ks. Now, technically, inherited IRAs are also pre-tax retirement accounts, but those cannot be converted into Roth IRAs.
Let's go through an example to help illustrate how Roth conversions actually work. Let's use my friend Pete the Pilot here. Let's say Pete the Pilot has been working at Southwest Airlines for 30 years. And fun fact here, that's actually my dad's name, and he was a captain for Southwest Airlines for most of his career. Like my dad, Pete the Pilot, who's totally hypothetical here, Pete was a good saver. And over those 30 years, he accumulated $1 million in his pre-tax 401k retirement account.
And like most of his pilot friends, when Pete retired, he rolled that $1 million 401k balance over to a traditional IRA. Pete was all excited about the $1 million that he accumulated that he had in his traditional IRA, but he was quickly reminded that that $1 million doesn't all belong to him. It's pre-tax money, which means a percentage of it belongs to the IRS.
Well, Pete the pilot, he's used to making quick decisions at 30,000 feet going 500 miles per hour. And he doesn't want to sit around and wait for the IRS to slowly chip away at his money here. He wants to pull the ripcord and pay his taxes and just move on. So without seeking any advice, Pete does a Roth conversion. He transfers or converts $1 million from his traditional IRA to a Roth IRA and
That $1 million is taxed as ordinary income, which means this transaction thrusts Pete into the 37% tax bracket. We're going to keep it simple for this illustration, and we're going to push state taxes aside for now and just estimate that Pete has to cut a check to the IRS for about $300,000 as a result of this Roth conversion. And he has to pay this tax bill come next April when he files his taxes. Now,
Now, thankfully, Pete has the cash in a savings account. He's going to use 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 that 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% tax bracket and created a giant tax bill. Sure, you know, 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're going to get to Roth conversion strategies and how to properly implement them so that they benefit you instead of the IRS. But first, let's just quickly address why Pete and other retirement savers just love getting their money into a Roth IRA.
I broke it down into three main reasons. Number one is Roth IRAs grow tax-free and the money can be withdrawn tax-free. So if Pete's $1 million in his Roth IRA grows to $2 million, he can withdraw that $2 million without paying the IRS a dime.
This gives Pete some extra flexibility in retirement. So if he needs a new roof or wants to buy an airplane or needs some extra income, he can take funds from his Roth IRA 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 also potentially increase Medicare premiums. But because all of Pete's money is in a Roth IRA, he doesn't have to worry about any of that.
The second big reason is that Roth IRAs avoid those pesky RMDs, those required minimum distributions. As most of us 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 pretty big depending on your account balance, and they actually get larger and larger every year as you get older.
In other words, your pre-tax retirement accounts are what we refer to as a growing tax liability. And again, those taxable RMDs on top of other income that you might be receiving can cause social security to become more taxable and potentially spike Medicare premiums.
The third reason why people love Roth IRAs is that they're 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.
So to recap the three reasons why getting money into a Roth IRA is so desirable. Number one, your investments grow tax-free and can be withdrawn tax-free. Number two, you avoid RMDs at age 72 on that money. Number three, your heirs can more easily inherit a Roth IRA.
The benefits of having money in a Roth IRA are powerful. And while anyone with a pre-tax account or pre-tax retirement account can do a Roth conversion, it doesn't necessarily mean that everyone should pursue Roth conversions. In addition to the five reasons that Stephen and I covered in episode 145 earlier this month, which I'll link to in the show notes if you missed it. In addition to those five reasons, here are four more situations where Roth conversions may not be appropriate.
First, if you're under age 59 and a half and you don't have money outside of your IRA to pay the tax bill, you might want to reconsider a Roth conversion. Yes, technically, you can pay the tax bill with the money that's being converted, but there will be a 10% penalty on the amount owed to the IRS. And that's because money withheld from the conversion to pay the tax bill is actually considered a withdrawal.
and not part of the conversion. And since you're under age 59 and a half, it would be considered an early withdrawal, which carries a 10% penalty. So if that's you, you might hold off on Roth conversions right now. The second is 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 you to overpay the IRS like Pete the pilot did.
Number three, 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 just 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 traditional IRA, they're going to have 10 years to withdraw the funds and pay the taxes. So you'll want to take that into consideration here.
Lastly, if you've never opened a Roth IRA and you think that you might need money in five years or less, you might want to think twice here or at least plan ahead. So if you've 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 that you're 65 years old and you convert $100,000 to your very first Roth IRA. You've never had a Roth IRA before. You opened one, you're 65 years old and you converted $100,000 into this Roth IRA. Okay.
Well, that $100,000, let's say, grows to $150,000 in the next three or four years, and you need to withdraw the entire $150,000 balance to, I don't know, pay for a home remodel. Well, because you haven't met the five-year rule, that $50,000 of earnings or growth in your Roth IRA will become taxable. So you miss out on the great benefits of a Roth IRA being tax-free.
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 or at least start to plan ahead. 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 the 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 could potentially save hundreds of thousands of dollars or even millions of dollars in taxes over their lifetime. And we're not talking about anything overly complex or even 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 just 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 the end of your life? And just think about all the things that go into that calculation from dividends, interest and capital gains to periodic IRA withdrawals to supplement your income, RMDs at age 72, social security, other income like real estate or pensions. And it gets even more complex when we're crunching the numbers for a married couple.
But it's a really 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 start to 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 that retirement savers need to know about. For all the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 147. Thank you as always for listening, and I will see you back here next week.
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.