Ready For Retirement
Ready For Retirement
Am I Too Old for Roth Conversions? 3 Things to Consider
Gary is a 73-year-old with $8 million in savings. Despite having substantial assets, he’s concerned about missed opportunities for Roth conversions as he faces significant required minimum distributions.
James encourages Gary to reassess his investment strategy, particularly the bond funds in his Roth IRA, and align his tax planning with his broader financial goals. By doing this, Gary could make more informed decisions that support his retirement goals and charitable aspirations.
Questions answered:
How can I give money to friends and family without them incurring a huge tax bill?
What advice do you have for someone who has more than enough but has a hard time switching from saving mode to spending mode?
Timestamps:
0:00 - Gary’s question
2:04 - More wealth = less freedom?
5:16 - The controlling factor
7:22 - An exercise
10:09 - Living life; investment allocation
12:49 - Giving considerations
16:09 - Medical expenses considerations
18:45 - Modeling
20:40 - Summary
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On today's episode of Ready for Retirement, we're taking a look at Gary's financial situation Now. Gary believes he's too old to begin implementing tax strategy in a serious way, but we're going to help him unpack what things he can do, as well as a couple blind spots that Gary might not be recognizing in his plan as a whole. Let's jump into Gary's question. 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. Gary says this. He says my question is about making a series of huge Roth conversions to help reduce some of the error of not starting the conversions when I retired at age 57.
Speaker 1:My wife and I are 73. We have no children and we sold our house and will not be buying another. We have saved very diligently and spend so little, which has resulted in a total of about $8 million in savings. We have $1.3 million in CDs. The balance of our brokerage accounts is $3.2 million in the Vanguard total stock market index. Our combined Roth IRA balance is $400,000 in a Vanguard high yield corporate bond fund. The combined total of our traditional IRAs is three point three million dollars. My pension is seventy five thousand dollars per year in our combined Social Security is twenty five thousand dollars. Our annual expenses do not exceed forty thousand dollars. Our first required minimum distribution this year was one hundred and twenty thousand dollars, leaving us in the 24 percent tax bracket with enough space remaining that tax bracket for a $125,000 Roth conversion. We have no debt and no state income tax.
Speaker 1:I have listened extensively to various tax planners and have recently used Glenn Reeves' tax spreadsheet to look at different scenarios for advantages and disadvantages of making three or more annual $500,000 conversions, and I'm still unclear on what action to take. I know that making three such conversions would reduce my future required minimum distributions to approximately half, which should keep me in a lower tax bracket through the coming years. I've been listening to your podcast for only a few months, but I've come to respect your opinion. You have a wealth of knowledge on the topic and are able to articulate it better than anyone else I've heard. My goal is to see if it is too late for conversions, to even make a small dent in the error that I've made by not learning about the unfortunate impact of the required minimum distribution years ago. I truly appreciate any suggestions you can provide. Thank you, gary. Well, gary, thanks for that question and a lot to unpack there, and this is a tax question.
Speaker 1:But there's three main things that you want to extract from this. As with everything, it's almost never just about the issue at hand, but it's about how does that issue at hand impact the overarching retirement strategy and really, how does that retirement strategy as a whole support our vision or our dream of what life can look like for us? So here's where I want to go. First, the first issue and, at the risk of maybe getting too high level and maybe even too philosophical, the first issue and I say this without knowing Gary or really anyone, and not knowing all the context around this, but the first issue I see is that sometimes more wealth leads to less freedom. So what on earth does that have to do with Gary's question? Gary's asking about tax strategy and conversions. Why are we bringing up freedom? Well, here's why I'm bringing it up.
Speaker 1:When you ask most people what does money mean to you, they may say a few different things, but it ultimately comes back to freedom freedom to do what I want, freedom from having to go to that job that I dislike, freedom of time and the ability to do the things I want to do with the people I want to do them with. So it's freedom. What actually happens is you start getting some money and you start feeling a little bit of freedom, but then sometimes you get a lot of money and you start to almost feel like your freedom is being restricted. Give you an example I live in California. California is beautiful. California also has extremely high tax rates. The top marginal bracket is 13.3%. So what does that mean for a lot of people? Well, you come to California and you realize you need a high income, depending on where you live, to even make ends meet. So you earn a little bit of money and you start feeling really comfortable and you start having that freedom to live where you want to live and you start earning more money and all of a sudden you start looking at your tax bill and realizing the absurdity of how much you're paying in state income taxes. You start looking at that and that causes a lot of other people to move out of state.
Speaker 1:Now, I'm not making a judgment on whether that's good or bad. I'm simply stating the fact that sometimes, when you have a little bit of money, you feel like there's more freedom and the more money you have, you start feeling like, oh my gosh, I'm paying so much money in state income taxes. I have to move away. And maybe you end up moving away to a place that you don't enjoy as much. It's not as beautiful, it's not as close to family or friends. Obviously, I'm making up this scenario here, but it's not too dissimilar from what a lot of people experience.
Speaker 1:And what you do, or what you start to realize, is people move out of state to save on taxes and then their quality of life diminishes and they're not around the people that they want to be around and they're not in as beautiful as a place as they once were. I'm not making a judgment call here. Again, I know there's plenty of good reasons to move out of state outside of just this, but what I am saying is sometimes a little bit of wealth gives you that freedom and you get a lot more wealth and that wealth starts to control you. You start making decisions not based upon what you want to do, but what's going to save you the most money on taxes, what's going to allow your wealth to continue compounding or at least preserve it as much as possible. So this is one of the great ironies of wealth, of, yes, wealth can provide freedom, but at a certain point, if we're not careful about it, we can start being controlled by that wealth. So I know I'm getting off on a tangent here and, like I said, this is going to start off more philosophical and then we're going to go back into the actual practical of what we can do.
Speaker 1:But this directly applies to today's question. The question I would ask Gary, and the question I'd ask many of you who are in similar situations as Gary, is is the money the controlling factor here, or is your quality of life or your purpose of life the controlling factor here? So, even as you're listening, whether you have $8 million or $800,000 or $80,000 really does not matter. It's the principle here that I want to start with is to what degree is that money enabling your ability to pursue what you want to do in life, versus to what degree is that money controlling what you do in life? Because now all of your decisions are filtered through what's going to minimize the tax burden here, or what's going to maximize how much my money can continue growing.
Speaker 1:And, by the way, even as I'm saying this, I'm not saying this because Gary has $8 million in his portfolio. I'm saying this because Gary has $8 million in his portfolio and he and his wife have a combined $100,000 in income between social security and pension, and this is the real thing. They're spending $40,000 per year. That's what their expenses are. So when I look at this and yes, we're going to get to the tax question that he asked directly, but I want to start with this first when I look at this here's where my mind goes I say, okay, gary and his wife have $100,000 coming in with income from pension and Social Security. That $8 million, conservatively, could generate another $300,000 per year in income for them. So let's say that they could be spending $400,000 in income if they wanted to, but their expenses which I read as that's what they're actually spending is only $40,000. So they're truly spending one-tenth of what they possibly could be. And now it could be that Gary and his wife spending $40,000 per year. They have the absolute dream life, better than anything I could possibly imagine, and I hope that's the case. But if that's not the case, if they do feel like they're not doing all the things that they could be doing, or if they don't feel like they're getting the most out of life with their money, then it's probably because they have a challenge switching from a savings mindset that clearly got them to this position to have accumulated several million dollars. They're having trouble shifting from that savings mindset into a spending mindset. That's the case.
Speaker 1:I might ask Gary and his wife this question. I'd say there's a presidential election coming up. I'm recording this in July of 2024. Not sure exactly when you're listening, but there's a presidential election coming up here in the US and my guess is, for all of you listening, you're not totally, completely in love with both of the candidates that we have. You probably like one a whole lot less than you like the other. So I'm going to use Gary as an example here.
Speaker 1:Gary, let's assume that you could be generating $400,000 total from your portfolio and income sources this year, but you're only spending $40,000. What that means is there's a Delta or a gap of $360,000 of money you could be spending. That's not being spent, at least as I read the question that he provided. That's the way I'm interpreting this. That $360,000. Let's go through an exercise of Gary, you and your wife and for all of you listening, go through the same exercise. You have $360,000 this year that you have to spend on something. If you don't spend that on something that could be travel, that could be giving, that could be home improvements, that could be a new car, it could be anything you want but if you don't spend that $360,000, it is going to be donated directly to your least favorite of the two political candidates that we have running for office. So anything that's not spent, anything that's not donated, anything that you are not using, of that $360,000 directly goes to your least favorite political candidate.
Speaker 1:Sit with that thought for a minute. What would you do with that $360,000? Would it be hiring a housekeeper? Would it be going on vacation? Would it be doing some of the home improvements you've been putting off? Would it be a new vehicle? Would it be helping friends or family? Would it be donating to charity? Whatever it is is fine.
Speaker 1:Just ask yourself what is it? And I say that because so often we become consumed with these questions of how can I save more money on taxes, how can I get my portfolio to grow more, how can we run one more Monte Carlo simulation to make sure we're fully on track, and those become somewhat complex distractions from what actually matters. And what actually matters is very simple, which is who am I and what do I want to do? And the follow-up question is how can I use my money and my resources to enrich that sense of who I am and what I want to do here on this earth? So I know, so far this has absolutely nothing to do with Gary's question about tax savings, but here's why I'm starting here. So, gary, let's assume that I have a magic wand and I'm going to wave this magic wand and now you never owe a. Probably yeah. At the beginning, for the first several days or weeks, that's pretty cool. You're probably jumping up and down and feeling pretty cool.
Speaker 1:But long-term, does that make you happy? Does it actually contribute to your quality of life? Does it actually in any meaningful way enrich your life, apart from the upfront joy of knowing, or excitement of knowing, that you're not going to have to pay anything in taxes? Long-term, does it actually change anything? I kind of have my doubt, simply because there's already this sense of Gary could be spending all this money but is only spending a fraction of what he could be spending. So even if he saved all this money in taxes, does that actually change what he is doing. Does that actually change what he's able to do to live a more fulfilling life? And again, I don't want to make this sound judgmental towards Gary's life. Gary may be living an incredible life and I hope he is. All I'm doing is judging the fact that what he is spending versus what he could be spending.
Speaker 1:There's a significant gap there and sometimes, if our focus goes too much towards, like I said, tax savings, investment performance, monte Carlo analysis, rerun projection, rerun projection, rerun projection it just becomes this giant distraction that prevents us from actually looking at what's most important, which is are we doing what we want to do and how can we use our money to help us do so? So I'll wrap up this first point before moving on to the second two points that I make. But I want to go back to something that Gary said. Gary specifically said there was an error and not learning more. He looks back now, 15 years after retiring, 16 years after retiring, wishing I wish I'd done that tax strategy earlier, I wish I'd implemented Roth conversions earlier. I'm saying this so that 15 years from now, gary doesn't look back and say, gosh, my 8 million turned to 10 million, 15 million, 20 million, but what was all, for what did I actually do that led to a more meaningful, purposeful, enjoyable life? I wish, at 73, I'd thought more about this so that I could have lived then, because now it's getting a little bit too late for me to do so in my 80s and 90s. So I think that's a lesson that all of us can keep in mind is what are we actually doing with our wealth to ensure that we're living the lives that we want to live, whether we're already retired or still working? The question remains and is something that we should always be considering. So that's the first issue that I wanted to look at Is more wealth leading to less freedom? We want to make sure the answer is no. We want to make sure that more wealth is ideally leading to more freedom and that our wealth does not become the controlling factor of our lives.
Speaker 1:The second thing that I want to look at here is the investment component, and this is just a real quick thing before we go to the tax side. Gary said that his Roth IRA is all invested in a bond fund. Now, usually, for most people, you'd like to see a Roth IRA invested more aggressively. I think Gary's is in a high yield bond fund. He said there may be a specific reason for that. I don't know anything about Gary other than the question that he provided, which is just a few sentences, so maybe there's a good reason for that. Maybe that's money he's planning on pulling out for something fairly soon and so he doesn't want to invest it too aggressively. However, that's not the case, I would just reconsider the asset allocation there to say, is it maybe more advisable to have any of the bond funds in a traditional IRA and the growth funds in something like the Roth IRA? So real quick.
Speaker 1:The second issue. There is investments, and then, finally, the third issue, and the issue that Gary actually asked about is tax planning. Well, before I can answer, what should you do with tax planning? It really does come back to again what do you want that money to do for you? Do you want that money ultimately to go to a charity? Well, if you want the money to go to a charity, then maybe you're not doing a whole bunch of Roth conversions. Maybe instead, you're simply gifting to charities right from your traditional IRAs. This is called a qualified charitable distribution Gift money right from your IRA. Therefore, you're not paying income taxes on any of that money that's coming out. Nor does the charity, of course, pay income taxes on that money coming out. For 2024, there's a limit of $105,000, and that's the most that an individual can gift as a QCD a Qualified Charitable Distribution from their IRA. Gary and his wife both did it. That's $210,000 max that they could do, but that's a great way to gift to charity and then you can even name the charity as a beneficiary of your IRA. That's another great way to pass money onto the charity. The charity won't pay any income taxes on that money because they are a charity and all that pre-tax money as long as it stays in your IRA while you're living, you're not paying taxes on it either. So if you want to go to a charity, that's one option.
Speaker 1:Do you want to pass assets to your children? Now, I know that Gary and his wife don't have children, so this is more of a broad thing, not necessarily specific to them. But if you want to pass assets to your children and you're asking yourself about Roth conversions, then don't just look at your income tax bracket today versus your income tax bracket in the future, but also keep your children's projected tax brackets in mind, and not their tax brackets today, but their projected tax bracket at the time of your passing. Now, even as I say that aloud, I recognize how absurd that sounds, but that's just the reality of it. It's absurd or it's difficult because you have no idea when you're going to pass away. You have no idea what tax rates will be at that time. You have no idea what your children are going to be doing for work at that time. You have no idea what their income is going to be at that time. So you combine all these unknowns and it becomes very difficult to understand what will their actual tax bracket be at that time.
Speaker 1:However, to the best of your ability, try to ballpark it, because if you know that you have children that are going to have high incomes and they're going to be working and you're going to pass a lot of money in your IRA, well, all that money in your IRA, they're going to be forced to distribute it over the next 10 years after they inherit it. If they have to distribute a significant IRA balance over 10 years while they themselves are in high income tax brackets, that's going to push them into an even higher income tax bracket. So part of your Roth conversion strategy today isn't just looking at your tax bracket now and in the future. It's also taking into account the fact that, okay, we want to take that into account that being your children's projected future income tax brackets, versus maybe you have a child that's in a very low income paying job, or maybe they don't have a job or likely won't, or maybe they'll be retired when you pass away and you know their financial situation is such that they're not going to be in a very high tax bracket. That's the case that maybe you do less in conversions. Does it make much sense for you to convert these assets at 24%, 28%, 32%, 35%, so on and so forth, if maybe your children could inherit those assets and pay taxes at 12% or 22% or whatever rates might be at that time? So again, I know the difficulty of actually trying to project that because there are so many unknowns, but that's certainly something that should be kept in mind. So that's another thing you can look at is, if you're doing these conversions for your children, keep them in mind. And then, another thing that people think about is okay, I want to do conversions because maybe I have a major medical expense in the future and if I have to pull out a bunch of money for that medical expense. I don't want it all to be taxable. I want it to be in a Roth IRA. There's a ton of logic to that, and that can be a great reason to do a conversion. Keep in mind, though if you have medical expenses, long-term care expenses, other expenses like that, at least today you can deduct unreimbursed medical and dental expenses that exceed seven and a half percent of your adjusted gross income. Now for long-term care, only the long-term care expenses attributable to medical care can be included in that.
Speaker 1:So let's take a look at an example. This example is not going to be specific to Gary, but I'm just going to ballpark some numbers. Let's assume that you have an adjusted gross income of $200,000. That's from your required minimum distribution, it's from social security, it's from pension. All those combined in your adjusted gross income, or your AGI, is $200,000. So that's going to push you into a relatively high tax bracket, potentially.
Speaker 1:Now let's assume in that year you also have major medical expenses. Let's assume those medical expenses are $150,000. Well, if you have to pull more money out of your IRA because of that, you're going to do so. But keep this in mind If $150,000 are your medical expenses and your adjusted gross income is $200,000, 7.5% of your adjusted gross income is $15,000, which means you can deduct any medical expenses in excess of $15,000, or you can deduct any medical expenses in excess of 7.5% of your adjusted gross income. So if $150,000 is your medical expense and again that's what you're trying to prepare against is geez, what if I have this big medical expense, I've got to pull money out. Isn't that going to push me into a much higher tax bracket? Yes, it can, but keep this in mind $150,000 medical expenses that exceeds $15,000 by $135,000, which means $135,000 is now a deduction that you have on your tax bill.
Speaker 1:Now, I know the reality is that if you do actually have that medical expense, you might be forced to pull even more out of your IRA, which could push your AGI higher, which limits the amount that you can deduct. But just keep that in mind, that sometimes those medical expenses themselves can be pretty significant deductions. So, yes, do conversions to the mindset of do we have some money tax-free that we can pull in the event of major medical emergency or just any type of major expense that you have? Yes, that's a good idea, but also keep in mind that you might potentially be able to deduct a lot of those medical expenses just by nature of standard deductions. And then, finally, another thing that you might be looking at when doing conversion, or another goal for the conversion itself, is just you want to live on that money and you're trying to be smart about do we pay taxes on this money today or do we pay taxes on this money in the future?
Speaker 1:This is one that really needs to be modeled out in much more detail. Really, what you want to do is understand what tax bracket will you likely be in in the future, based, gary, upon your rising required minimum distributions each year, your social security, your pension, your interest, your dividends from other income sources. What will that look like in the future? And there's no perfect way of predicting that, but it can at least be modeled out so you have a general sense of will you be in a higher tax bracket in the future or a lower tax bracket in the future? That, too, it depends upon what do tax brackets as a whole do between now and then. But modeling out is a great place to start, and it doesn't matter if you're 73, like Gary, or if you're 53 and trying to figure this out.
Speaker 1:The logic is always going to be the same when should you pay taxes on your pre-tax assets? Well, ideally, you're paying taxes in a year that you're in a lower overall tax bracket, whether that's this year or a future year. That's always the question we want to be answering. When should we be paying our taxes? Pay today at a lower rate or, potentially, pay in the future at a lower rate? That's always the question, and it's really something that must be modeled out in much more detail to get an answer on. But I will say that there's not a time limit for doing that. Ideally, you're doing a lot of conversions before your required distributions kick in, and that's simply because your required distributions are going to push you into a higher tax bracket, just as a starting point, whereas in previous years you can stay in a lower tax bracket because you don't have those larger required distributions and because you're in a lower tax bracket, you can do some actual conversions without being pushed into even higher brackets. But even once you've hit RMD age, you can continue to make conversions if you could do those conversions at a lower tax rate than you could in the future.
Speaker 1:So I'm going to start to wrap up and I'm going to do a quick summary, my wife and I, we had our second child three weeks ago, so a little less rested than usual, and my mind's maybe not quite as with it as usual. So if this got somewhat rambly at certain points or you struggle to understand, it's probably not you, it's me. So I'm just going to do a quick summary here as we start to wrap up. The first thing that I would think about here is make sure that more wealth does not lead to less freedom. Don't start with tax strategy, as the goal of your retirement.
Speaker 1:Tax strategy should support your goal, and your goal ideally is to see how can you get the most out of life with your money, not how do you focus entirely on the money and start to sacrifice quality of life as you do so. That's the first thing I would look at, gary. Second thing is just your investment mix. I would question why you have bond funds in your Roth IRA. Again, I don't know anything about Gary or his risk tolerance or his goals or objectives, but that stuck out to me as something that I might want to reconsider.
Speaker 1:And then the third thing, even with tax planning, of should you do a conversion or not do a conversion. Even then, it depends on. What do you want that money to do for you? Is that money that's going to go to charity? Is that money you want to pass to your children? Is that money that you want to use as insurance against catastrophic medical expenses? Is that money you just want to live on and you want to minimize your lifetime tax liability? Start with the end in mind. Once you know the goal of that, then you can work into what the most effective tax strategy is, and not just with taxes, but really what the most effective strategy is high level, so that your money can support what you want to get out of life.
Speaker 1:So that is it for today. Thank you, gary, for that question. Thank you for all of you who've listened. Make sure, if you're enjoying this podcast, you hit like on Apple Podcasts or Spotify, leave a review, and if you are watching on YouTube, please leave a comment and like and subscribe if you're enjoying this as well. That's it for this week and I'll see you all next time. Hey, well, that's it for this week. And 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.
