The Roth Conversion Sweet Spot: Maximize Retirement Savings (And Avoid Costly Mistakes)

Listener Nael opens up a discussion about Roth conversions. There are benefits to doing Roth conversions, but can you do too many? Are there any downsides to Roth conversions?

Reaping the tax benefits from Roth conversions requires hitting a specific sweet spot. If you convert too little or too much, you’ll be leaving money on the table. 

So, how do you find Roth-conversion the sweet spot? James lays out five things you should consider as you plan when and how much to convert:

1. Macro and micro tax environment
2. Required minimum distributions
3. State tax brackets
4. Charitable giving
5. Legacy planning

Questions answered:
How might a future out-of-state move impact Roth conversion decisions?
What impact might Roth conversions have on charitable giving or legacy gifts?

Timestamps:
0:00 - Question from Nael
2:20 - The wrong
4:27 - The right way
7:21 - The reality
9:12 - Macro/micro tax environment
11:19 - RMDs and state taxes
15:36 - Charitable giving
17:12 - Legacy and life expectancy
21:22 - Wrap-up

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Transcript

Speaker 1: 0:00

Although they have the potential to save you lots and lots of money in taxes over time, roth conversions can also be overdone. And when Roth conversions are overdone, they can be potentially devastating, costing you tens or hundreds of thousands of dollars over the course of your retirement. So on today's episode of Ready for Retirement, we're going to discuss at what point Roth conversions become excessive and what you should be focusing on to understand the right number for you. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's podcast comes from a question from Nael. Nael says the following James, I love your podcasts and YouTube videos. I listen to several podcasts on my daily walks and yours is by far the best Easy to follow, easy to understand and always relevant.

Speaker 1: 0:48

You frequently talk about Roth conversions during retirement years, especially if one can leverage an after-tax bucket to manage their tax bracket. While Roth conversions will reduce lifetime taxes substantially, is there a point at which the tax savings will be offset by limited growth of the portfolio due to the tax payments? In other words, is there such thing as too much Roth conversions. Can you please elaborate on this topic and discuss the framework for considering the impact of Roth conversions on portfolio growth? From Nayel Well? Nayel, thank you very much for that question and for the kind words about the podcast and YouTube videos. To answer your question directly yes, there's absolutely a point at which Roth conversions can be overdone. And when Roth conversions are overdone, it's not just a oh well, we overdid it, it's you potentially paid a lot more in taxes than you otherwise would have had you just sat around and done nothing. So it's incredibly important to, yes, understand the benefits of Roth conversions and why they should be done and to what extent they should be done, but it's also important to understand the potential downsides and the costs of making those mistakes if you overdo it.

Speaker 1: 1:49

So here's the hypothetical example I'm going to give. I'm going to give an example of how to think about this and then I'm going to give you a framework of what are the things you should be thinking about in your own personal situation to understand at what point you should be doing this. Here is a hypothetical you have $10,000 and you're trying to determine whether or not to convert that, so that $10,000 is currently in a traditional IRA. You know with certainty that that $10,000 is going to double within the next 10 years. You also know that you're in the 20% tax bracket today I'm going to assume combined federal and state and you know the certainty you will be in the 20% tax bracket 10 years from now when it comes time to take that money.

Speaker 1: 2:28

So, with that hypothetical in mind, should you do a Roth conversion? Well, to illustrate the correct way to look at this, I'm first going to illustrate or show the wrong way. That, unfortunately, is a very common way of looking at this that leads people astray. So you have $10,000 in an IRA. You want to know should you convert that to a Roth? A lot of people will look at it like this and keep in mind this is the wrong way. They'll say, okay, I have $10,000 in my IRA today. I could convert that to my Roth IRA and pay $2,000 in taxes. So I'm going to do that, $10,000 entirely converted to my Roth IRA. So now the 10,000 is my Roth and I have $2,000 in cash, say on the side in my bank account that I'm going to use to pay that tax bill. Separate issues with that in a second, but I'll get back to those that $10,000 then grows inside of your Roth IRA and it doubles over the next 10 years, like we talked about Now. If, 10 years from now, you wanted to take that 20,000 out of your Roth IRA, that would cost you nothing. You've already paid taxes on that, so you'd have $20,000 tax-free.

Speaker 1: 3:33

People wrongly look at this and say well, look, if you hadn't done that conversion, that 10,000 would have grown to $20,000. And that $20,000 in the future, if it was still in your IRA, if you took that all out, you would have paid $4,000 in taxes on that. So by doing this Roth conversion, you effectively saved $2,000 in taxes. You paid $2,000 in taxes today as opposed to paying $4,000 in taxes in the future. So people look at that and they justify the Roth conversion which, by the way, I'm a big fan of when done correctly. But they're missing a critical part of that, and what they're missing here is they're missing a critical part of that, and what they're missing here is they're missing well, you have to factor in the opportunity cost of that $2,000. You used to pay your tax bill upfront. What could that have grown to? Well, that 2,000 hypothetically could have been invested into the same thing and also doubled in value, so that 2,000 could have turned into 4,000. So there is a $2,000 opportunity cost there, which exactly cancels out or negates the initial $2,000 of savings most people think they have when they look at this example. So that is the wrong way because you did not look at the opportunity cost of the cash that you use to pay the tax bill. Here's the correct way to look at it, and this correct way is just going to illustrate the fact that if you know for certain you're in the same tax bracket today as you will be in the future, a Roth conversion is going to be a tax neutral event. So here's the correct way to look at this.

Speaker 1: 4:49

There's two different ways of looking at it. First, let's assume you have that $10,000 in the IRA, you convert it to a Roth IRA and you simply have taxes withheld from the conversion. So 10,000 IRA turns into an $8,000 Roth IRA. Taxes are withheld from that conversion, into an $8,000 Roth IRA. Taxes are withheld from that conversion and those go to pay taxes. Well, in that case, that $8,000, it doubles over the next 10 years. I'm still using the same assumptions and it is now $16,000. And that is $16,000. If you took it all out. At that point it is worth exactly $16,000. The after tax value 10 years from today is 16,000. Now let's compare that to the alternative. What if you had kept that $10,000 in the IRA and it doubled in value over the next 10 years? Well, it doubled from $10,000 to $20,000, but then you take it all out and you want to say what's the after-tax value of this 10 years from now? Well, if we apply that 20% tax rate, 20% of $20,000 is $4,000. So that $20,000 IRA balance turns to $16,000 after tax. So in both cases it's the same exact after tax value to you you as the investor. So that's the first way to look at it.

Speaker 1: 5:55

Now a lot of you are probably saying well, why on earth would you withhold taxes from the conversion? Go back to that first example. You used James. We would use cash that we already have in the bank or in a brokerage account and we would let the whole amount grow in a Roth IRA. Well, you could do that. So let's see what that looks like. You have $10,000 in an IRA that converts entirely to the Roth IRA. So now you have $10,000 in a Roth IRA, you'll use $2,000 of cash in another account a brokerage account or cash account to pay the tax bill. So you do that and then for the next 10 years that doubles and that $10,000 in your Roth IRA grows to $20,000. The after-tax value is 20,000.

Speaker 1: 6:32

Now what you have to keep in mind here is 10,000 did not turn to 20,000. 12,000 turned into 20,000. So that 12,000 was the money in your Roth plus the $2,000 of cash, and that's what people miss typically when they do this analysis. Now let's look at the alternative. If you hadn't done that conversion, the $10,000 would have stayed in your IRA and the $2,000 that was in cash could have been invested in the same thing, and both of those would have doubled.

Speaker 1: 6:59

$10,000 IRA grows to a $20,000 IRA. $2,000 in cash grows to $4,000, invested outside of an IRA or outside of a retirement account. Well, go through the same exercise the $20,000 in your IRA, pull it out to pay 20% taxes, you have $16,000 after taxes. So it seems like that's $4,000 less than you otherwise would have had in the conversion amount. Until you keep in mind or factor in the fact that the $2,000 you had in cash initially was invested, it doubled and it is now $4,000. So that's where you're making up the difference.

Speaker 1: 7:33

Now the reality is here that doubling the $2,000 to $4,000 on the cash, the growth on that is going to be taxable. Now, depending upon your tax bracket, it's taxable most likely at long-term capital gains rates, which are going to be more beneficial, but there is still a tax hit on it. So one of the benefits of using cash is more of your assets are now growing tax-free in the Roth as opposed to growing outside. But, as you can start to see, if you are in the exact same tax bracket today, as you know with certainty you'll be in the future a Roth conversion is going to turn out to be a wash, at least at surface level. There's some other considerations we're going to talk about, but I want to illustrate that point first.

Speaker 1: 8:12

Here's the thing it does not only come down to today's federal tax brackets versus where we expect federal tax brackets to be in the future. Number one this is somewhat of a guessing game. No one knows exactly where they will be in five years, 10 years, 15 years, 20 years, especially considering the fact that Roth conversions aren't a short-term strategy. You're not doing it to get ahead tomorrow or next year or three years from now. You're typically doing it to get ahead 20 years from now, 30 years from now, even for legacy and estate planning, many decades away from now.

Speaker 1: 8:43

So, to answer Nail's question, how can you overdo it? Well, you can absolutely overdo it right off the bat If you are converting today at a higher rate than you otherwise would be in the future. To go back to my examples, if it wasn't a 20% tax bracket today and a 20% tax bracket in the future but maybe it's 20% today and 15% in the future any conversions would likely be costing me money. Now, that's a very simplistic example. The reality is, for most of us, this is a multi-year, multi-decade, all different types of variables factored in. But you can start to see that if I'm converting today at a higher tax bracket, then I'm going to pull money out and in the future this has really backfired and it's actually cost me things.

Speaker 1: 9:24

So what are the five things that you should be looking at as you go through this analysis? Number one is both the macro and micro tax environment. What do I mean by macro versus micro? Well, macro is kind of the thing that you have no control over. What do I mean by macro versus micro? Well, macro is kind of the thing that you have no control over the tax environment in which we all live. This is federal tax brackets today versus federal tax brackets in the future. State tax brackets today and state tax brackets in the future. That's the macro environment. That's going to be the same for all of us, regardless of our actual tax situation. Now, our income that's subject to those different tax rates. That's going to be unique to us. But that's kind of the micro piece.

Speaker 1: 10:00

So if macro is the actual tax brackets, micro is your specific taxable income. This is going to be determined by the makeup of your income. How much is social security? How much is pension? How much is money coming from a brokerage account? How much is money coming from an IRA, a Roth IRA? That is unique to you, based upon your unique withdrawal strategy? That is something that you have complete control over.

Speaker 1: 10:21

So I say that because, as you're looking at this, if all you're looking at is the macro, oh, I think tax brackets in the future will be higher than they are today. They might be, but that's only one part of the equation. If your actual taxable income is lower in the future than it is today, you have to combine the two both what do things look like at the macro level, but also what do things look like for you at the micro level? And the combination of those two is your actual tax situation. So when you look at both of those, you want to understand, based upon both macro environment in my micro situation today versus the expected, which in many cases is just somewhat of an educated guess I'd say in all situations is almost an educated guess In the future, what will the macro tax bracket, macro tax situation be plus or combined with your micro tax situation? So start there and obviously, as we talked about before, if you're guessing or if you're thinking you're going to be in a higher tax bracket in the future than you are today, roth conversions make sense. If you think you're going to be in a much lower tax bracket in the future overall tax situation in the future than you are today, roth conversions probably don't make sense. Why would we pay taxes at a higher rate today when we could simply hold off and pay taxes at a lower rate in the future?

Speaker 1: 11:31

The second thing that you need to look at is required minimum distributions. Now, this is really a part of what we just talked about, but I'm separating this because some people say, okay, if I'm looking at my micro situation, my own income. Well, I've heard about these retirement go-go years and the slow go years and no-go years, where I'm probably spending a whole lot more in the first years of retirement and therefore it stands to follow, or stands to reason, that I'm probably in a higher tax bracket those first few years of retirement because I am spending more, I'm taking more from my accounts, and more or less this might be true. Well, they just assume that because spending is going to start to decline in the future, their income will decline in the future, their taxable income will decline in the future, and that very well could be the case, or it might not be. And one of the main things that would make it not be is required minimum distributions. So the amounts that you are going to be required to pull from your 401ks, your IRAs, your pre-tax 403bs, deferred comp plans, anything that has not been taxed yet, that you're going to be required to take out, that's something that, even though you personally might not be spending more money in the future, in your 70s, 80s, 90s, your income may actually be going up because of those required distributions. So don't look at the micro tax situation of step one just from the standpoint of what do you want to be spending, but also look at it from the standpoint of what might you be required to pull from your pre-tax retirement accounts and what will that do to your tax situation. So take into account RMDs.

Speaker 1: 12:58

The third thing to look at is potential state tax brackets changing if you plan to move. So, for example, let's assume that you are in California today and you're going to be moving to Texas in five years. Well, any Roth conversion that you do today, you're paying taxes, yes, at the federal level, but also at the California level. So that might be an additional 6, 8, 10%, depending on your income, but you're paying in taxes. So it's not enough to say, oh, today I expect to be in the 12% federal bracket or 22% federal bracket, but in the future I expect to be in the 24% federal bracket or 28% or whatever it is. That might cause you to think at first glance, I should do conversions because my federal tax bracket is going to increase. Well, that's a good starting point, but you also have to factor in your state taxes. What if you're in a higher state income tax bracket and that's going to go away, not because your income goes away, but because you move from a state like California to a Texas or a Florida or Nevada. Now, alternatively, what if you are in a state like Texas or Florida or Nevada and you're moving to a higher income tax state in retirement? Now, that's not as common, certainly not even near as common, but let's assume it is you want to be closer to family or for whatever reason you're moving from, let's just say, texas to California? Well, in that case, you're going to go from a lower overall tax bracket, all else being equal, to a higher overall tax bracket. Even if your federal tax brackets stay the same, you also have to factor in any state tax consequences.

Speaker 1: 14:26

I remember talking to a client this was a few years ago now, but they were in California and they were doing just this. They were going to move to Texas when they retired and this wasn't quite Roth conversions, but they were in the final couple years of their working career, high income, and they were doing Roth 401k contributions. And I talked to them. I said look, I love Roth 401k contributions. These are great, but can I show you an alternative? What if, in these higher income years where you're both in a higher federal state tax bracket and a higher state income tax bracket. What if we shifted this to pre-tax 401k contributions, literally just for a year, because they were going to retire the very following year and move to Texas? And what if any amount that we contribute to pre-tax accounts today which, by the way, at your tax rate, might save us 35 to 40 cents on the dollar? What if we then convert it next year when you're in Texas? And when we do that, you then pay 15 to 20 cents on the dollar. Well, it's effectively tax arbitrage there, because it's looking at getting a tax deduction today and then paying taxes later at a lower tax rate. So the same concept applies, and part of that was yes, this client was in a higher income tax bracket in their working years than they would have been overall in their retired years. But it is also a result of moving from a very high income tax state to a zero income tax state. So keep that in mind as well of where might you possibly be in retirement and to what extent do state tax brackets inform any part of this decision?

Speaker 1: 15:48

The fourth thing to keep in mind is any potential charitable giving that you do. So a qualified charitable distribution can be a very powerful planning tool for any of you who are charitably inclined and by charitably inclined I don't mean, hey, you give a hundred bucks here, a couple hundred bucks there, but I mean more material amounts. That could actually be a big part of your tax strategy. So when your required minimum distributions kick in either age 73 or age 75, depending upon when you were born you are going to have to take a certain amount out of your IRAs, out of your 401ks, out of your pre-tax retirement savings. That entire amount is taxed at your ordinary income rate. Well, with a qualified charitable distribution and you can begin doing this as soon as age 70 and a half any amounts that you distribute right from your IRA to the charity itself, those don't have to come out of your IRA and be taxable to you.

Speaker 1: 16:39

So if your required distribution is $40,000 and you want to give $10,000 to a charity, well, don't take the $40,000, pay taxes on it and then give the $10,000, some of which may or may not be deductible, depending on whether or not you itemize or take the standard deduction but instead just get that $10,000 right from your IRA to the charity. When you do that, that $10,000, it counts against the amount that you're required to take out. So now, instead of having to take $40,000, well, you still are required to take $40,000, but the $10,000 counts against that there's only $30,000 remaining that you have to take. So this can be a great way if you're charitably inclined to make those gifts, but do it directly from your IRA, so you're not paying taxes. The charity, of course, isn't paying taxes and it's counting against your required distribution, so this can be a pretty powerful tool as well.

Speaker 1: 17:24

And then, finally, the fifth thing that you should be thinking about is legacy. Now, this isn't going to apply to everyone, but many people, when they're doing Roth conversions, is not just for them, but they're also looking at the fact that, look, if I have enough to last for the rest of my lifetime, my children or my heirs, or whoever it is, is ultimately going to inherit these IRAs. Now, if my kids inherit these and let's assume they inherit these accounts when they're maybe in their peak earning years well, their rules for required distributions are a lot different than your own rules. For any account that you have, that's a pre-tax retirement account that you have to start taking required distributions on when you turn 73 or 75. The rules for an heir, unless there's a qualified exemption here is you have to fully distribute that account within 10 years. So if you have a million dollars, for example, in your traditional IRA, the first year that you have to start taking a required distribution, it comes out to about 3.8% of that give or take. So a million dollars leads to a $38,000 required distribution that first year and that will start to increase over time.

Speaker 1: 18:26

If your child instead inherits this million dollars, they don't take out $38,000 that first year. They have to distribute that entire million dollars. They don't take out 38,000 that first year. They have to distribute that entire million dollars over the next 10 years. Now a million dollars if it didn't grow at all over 10 years means taking out $100,000 per year. But if it's growing, even at moderate growth rates 5%, 6%, 7% they're really having to take out 150, 160, $170,000 per year to be on track to fully distribute that over those 10 years. Now this is a good problem to have, I'll acknowledge it. But if they are inheriting these assets and they are in their peak earning years meaning they're already in some of the top marginal tax brackets they might be left with a fraction of what they're actually inheriting. So keep that in mind. Sometimes people are doing Roth conversions for themselves, as they should, but the secondary, or maybe even the primary consideration is doing these conversions for the sake of their heirs, kind of as part of a tax planning or an estate planning strategy. So keep that in mind.

Speaker 1: 19:22

Another thing you can loosely group under legacy and looking at this is your own life expectancy. What I mean by that is if you're planning to live to 100, well, your required minimum distribution by that point is going to be much higher. I talked about the fact that at age 75, your starting required distribution amount might be around 3.8%, somewhere in that ballpark. But as you get older, every year the required percentage that you take out grows. Now you could make the argument that maybe you're spending down your IRA, so it's a higher percentage that you have to take out, but it's over a lesser balance. But that doesn't tend to be the case for the first 10 to 15 years, I would say on average. So by the time that you're in your 80s and 90s and beyond, it might be 6%, 7%, 8%, 10% that you're forced to take from your IRA. And so what you can start to see is those distributions get larger and larger and larger, which push you into potentially higher and higher tax situations.

Speaker 1: 20:15

Now, if you knew for certain your life expectancy was 76, well, you would have that one year required distribution. Potentially two years depending on your actual birth date, but that's at a 3.8% withdrawal rate or 3.9, 4% somewhere in that neighborhood, depending on how long you actually live there and what the percentage is that tends to be. Unless you have a really significant IRA, those distributions don't tend to be the things that are too terribly challenging. It tends to be the distributions that are later, in your 70s and 80s and 90s. So if you have a short life expectancy, maybe you don't prioritize Roth conversions too much.

Speaker 1: 20:54

But this also goes back to that legacy piece. If you have a short life expectancy but you want your children to inherit these accounts and they're going to be in a really high tax bracket, maybe you're not doing Roth conversions for you, but maybe you're doing it for them. Alternatively, if you don't have heirs or you're saying you know what, I have heirs, but I'm going to leave this all to charity, well, maybe don't do any Roth conversions if you have a short life expectancy, because that charity is going to inherit these assets tax-free, so no need to pay all these taxes along the way, because, whether it's a Roth IRA, the charity inherits, or traditional IRA, the charity inherits or just any regular cash or investments, they're not paying taxes anyway, so you don't need to incorporate that into your tax planning. So, as you can see, lots of little variables that you need to talk about here, this is by no means is a comprehensive list of everything, but it's some of the big things to take a look at.

Speaker 1: 21:42

And just to go back to the beginning of the intention of this episode, to answer Nail's question directly, it absolutely is possible to convert too much from an IRA into a Roth IRA. I get lots of questions coming in for this podcast of hey. Can you address this question? Too many of those, I see people saying, hey, I'm planning to convert up to this tax bracket, and I don't know their entire situation. But it strikes me at first of hey that might be way too high of a tax bracket to convert to. There's this delicate balance with Roth conversions of yes, they have the power to save you lots and lots and lots of money in taxes over the course of your retirement, but they also have the power to do the opposite to lose you lots and lots and lots of money over the course of your retirement if you're either underdoing it or overdoing it. So finding that sweet spot is really important in your overall tax planning. That is it for today's episode. Nael, I really appreciate that question.

Speaker 1: 22:29

Thank you for all of you who submit questions, who leave reviews, by the way, if you've not done so already, really appreciate it when you do. If you are listening on Spotify or Apple Podcasts, every single review you leave allows more people to find the show, and if you think this is helpful and would like other people to find helpful content, please leave a review there. If you're watching on YouTube and you're not already subscribed, I welcome you to do so. Every Tuesday, we release these podcast episodes, and every Saturday, we released a purely YouTube focused episode as well. And just a little teaser for the future For those of you who aren't already subscribed one reason to subscribe is we're working internally to change this into kind of like a call-in show of actually having people on the show real people, real financial questions going over their data together to provide feedback. So you can see this not just in the context of a hypothetical or a list of things to consider, but actually applying this to a real person's specific situation. So, if that'd be of interest, make sure that you subscribe to the YouTube channel, which is where that information will be released.

Speaker 1: 23:27

That is it for today's episode. Have a great week and I'll see you all next time. Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.