Your Roth Conversion Questions Answered – Episode 454

by | Sep 15, 2023 | Podcasts

Your Roth Conversion Questions Answered

Are Roth conversion questions holding you back from actually DOING a Roth conversion? Join us as we untangle the intricate webs of Roth and traditional IRAs, their tax implications, and the key reasons behind considering a strategic switch, and the Roth conversion questions that invariably pop up.

We promise to offer you a clear understanding of many of the potential benefits and drawbacks, and help you navigate your individual financial situation. It’s a journey of discovery that will empower you to make informed decisions about your retirement planning.

In this podcast episode, we dive into the nitty-gritty of Roth IRA withdrawal rules, the not-very well known five-year rule, the misunderstood special purposes, and the tax implications. The trickier the terrain, the more you’ll appreciate why financial advisors are essential in these scenarios. From simulating different scenarios to discussing staged conversions, this episode is packed with practical insights and strategies. Listen in, learn, and get answers to your Roth conversion questions here.

Links for Roth Conversion Questions Episode #454

Morningstar article
Catch all of the Mullooly Asset podcast episodes right here.


Transcript for Roth Conversion Questions – Episode #454

Casey 00:00
Hello and welcome back to the Mullooly Asset Podcast. I’m your , Casey Mullooly, back at the table this week, with Tom . This is episode 454. Didn’t mention that in the beginning last week, so I wanted to get that in there. This week we’re going to talk about Roth conversion questions. It can be a pretty complex topic, but we wanted to start out on a high level. So, Tom , what is a Roth conversion?

Tom 00:26
Well, at the highest level. This is something we talk about ALL the time. We talk about it all the time with clients. And it is worth discussing, because there is no hard and fast rule that says Roth conversions are good. It really kind of depends case to case.

Casey 00:43
So let’s actually take a step back even further from that. What is the difference between a traditional IRA and a Roth IRA?

Tom 00:52
All right. Traditional IRA was created in 1981 that allowed people to put $1,500 into an IRA and deduct it from their taxes. By 1986, they took away the tax deduction for most people, and so people stopped putting money into traditional IRAs. Fast forward 15 years as we got to the end of the 20th century, Roth, who was from Delaware, proposed this new legislation that you could create a Roth IRA.

Depending on your income situation, you could contribute to a Roth IRA. You wouldn’t get a tax break for it, but the money would continue to compound without any taxes, and so out of that sprung the whole idea of Roth conversions.

Casey 01:44
So Roth conversion is basically taking your money from a traditional IRA and converting it into a Roth IRA. I think one of the biggest differences between the traditional IRA and the Roth IRA is what happens when you take the money out of those accounts. Taking money out of a traditional IRA means that you’re going to pay ordinary income tax on it. Taking money out of a Roth IRA, in most cases, means that you’re not going to pay tax on it.

So the benefit of doing Roth conversion is that you’re paying the taxes upfront. Basically is what it boils down to, and the benefit of that is being able to choose when you want to pay taxes and hopefully, paying less taxes as a result of that.

Tom 02:40
One common misunderstanding that happens when people are putting money away into a Roth IRA is they say well, I have to do this for my taxes. Good rule of thumb to remember when you’re talking about Roth IRA accounts the money going into a Roth IRA account always, always, always, will be after tax dollars, Always.

Casey 03:08
Right, so it’s after tax on the way in, but then you don’t have to pay tax on the way out. Correct? With a traditional IRA, you don’t pay tax on the way in, but then you get taxed on the way out.

Tom 03:20

Casey 03:21
So that’s a simplified way, easy way to think about the two different types of IRAs there. So why would someone want to do a Roth conversion? I kind of touched on it before, but why would someone want to convert their traditional IRA into a Roth IRA?

Tom 03:39
I’ll answer a question with a question. So do you think taxes will be higher or lower in the future?

Casey 03:46
Well, that depends. I think taxes will probably in on a tax rates. Tax rates will increase in the future, but on a personal level, it depends where you’re at in your life. For someone like me, my taxes are probably gonna be higher over the next 20 or 30 years, but for someone like you who is towards the end of their career —

Thanks a lot!

-for someone or for someone getting ready to retire, their their tax rate might be decreasing in the future because they’re not gonna have that earned income from from their paychecks.

There might be a gap in their early retirement years where you know they’re not getting that steady paycheck but they haven’t started getting their arm deez, they haven’t been required to take their arm deez from their Retirement accounts. So that window is usually where we see people do Roth conversion.

Tom 04:45
Yeah, if you’re working with with a financial planner, he should, he or she should be able to Spot, isolate a couple of years where you stop working or have lower income. But yet, as Casey said, before you begin taking your required minimum distributions from retirement plans, that window may be a very good time to be talking about doing Roth conversions. As you can probably surmise by how we’re talking about this; there is no “hard and fast rule” that says you really should do this – or should not do this.

Because we are seeing situations, just as an example, just one anecdote where people are working and then retiring and they’re finding out that, hey, my retirement income, my pension and, and now I’m getting social security, I’m not really seeing any drop-off in my income. I’m really gonna have a whopper of a tax bill if I want to convert my retirement funds into Roth accounts. So, again, situation where working with a planner can really bear some good fruit.

Casey 05:58
Yeah, I think you got to think about and plan for what your income is gonna be. Let’s say you’re in the botTom of I don’t know the 22% Tax bracket, but let’s say you’re at the botTom of that bracket. You know the the idea was doing a Roth conversion. There would be to fill up that 22% bucket with a Roth conversion and not push you into the next tax 24% bracket.

Right, right it’s. Those are kind of the situations where it does make sense. I don’t think it. Like you said, a situation where it doesn’t make sense is If your tax bill is just gonna be even higher as a result of it.

Tom 06:39
But again, it boils down to personal preference and like I think it, there’s no hard and fast answer to that, because, yes, you may remain in the same bracket when you’re retired because of different circumstances, but you may want to look at this and say, hey, I kind of like the idea that I don’t have to take a required minimum distribution in the future, right, or I kind of like the idea that, hey, the government’s getting all other tax dollars today and then I don’t have to give them any more.

Casey 07:10
Yeah, what’s the saying the Devil you know is better than the devil you don’t right sure.

It’s kind of what’s happening here. You get to choose and be selective and know and plan for ahead of time when you’re gonna pay those taxes. So that is one of the benefits of doing the Roth conversion. One of the other things to consider is maybe if you’re not gonna touch your IRA, you’re not gonna be drawing it down, except for R&D’s.

But if you are planning on passing it to the next generation, doing a Roth conversion for them could make a lot of sense to sure here’s.

Tom 07:47
I’m just gonna throw out a scenario again. These are all anecdotal, but we’ve got a situation where we’ve got a married couple. They both have over a million dollars in their retirement plans if they want to Take their required minimum distributions. They’re both around the same age. In their first year, when they’re 73, they’re going to be looking at a combined required minimum distribution of about $80,000.

That is certain, in their situation, to push them into a higher bracket they’re gonna be taking about 40 grand each from their retirement accounts. The two of them now are gonna have $80,000 more. Then they had to report the year before.

It really does make you stop and think about what’s going to happen to our income and our income taxes going forward.

Casey 08:38
You know, when we talk about the next generation Inheriting assets, it depends on the type of account that those assets are in. Because if it is a taxable brokerage account, then you don’t want to gift those assets to the next generation before you pass away because then they’re not going to get a step up in cost basis.

Tom 09:04
They’re going to keep the same cost basis that you had.

Casey 09:07
Right, which means that they’re going to have You’re just giving them you’re gifting them a tax bill, exactly.

But with an IRA you don’t get a step up in cost basis, taking care of the taxes and doing a Roth conversion ahead of time. You will be gifting them the assets without the tax bill attached to it, which makes their life a whole lot easier. So something to consider there. Those are some situations where a Roth conversion makes sense. But let’s talk about how money is distributed from Roth’s. There’s three ways or three buckets that it falls into. The first is your contributions.

So how are contributions taxed when distributed from a Roth IRA?

Tom 09:55
Something that I wish everybody understood when we have these conversations, or at least remember when we have these conversations your contributions will come out of your Roth IRA first. The reason why is because you’ve already been taxed on that money. That’s why money going into a Roth is always, always, always, post tax.

And so that money can be taken out at any time without any penalty, even if you haven’t had a Roth account for five years, like the rules say. Very, very important.

Casey 10:33
So let’s say your Roth IRA is worth $20,000. You have contributed $10,000 over the last couple of years and you want to take money out. You can take out $10,000 tax-free because that’s what you put into it. That’s right?

Tom  10:51
And what about if you said, hey, I need all of the money, then what?

Casey   10:55
Then it’s going to depend on how the other money got there.

Tom   11:00
If you, Well, let’s just say we put in $10,000 over the years that’s our contributions and now it has grown to $20,000. Now, for some crazy reason, I need $20,000. I know that the first 10 comes out no tax. It’s basically a return of my own principal. What about the next $10,000?

Casey   11:21
So those would be classified as earnings. So that’s where the five-year rule kicks in. You have to have held. The five-year rule means that you have to have had the account open for five years, and if you haven’t, then you need a special purpose in order to not pay tax or penalty on taking that money out.

Tom   11:47
So the special purposes I think they’re pretty similar to the.

Casey   11:51
IRAs. They are If you’re over 59 and a half. That is one of the special purposes. The other ones include death. So if someone passes away they’re not going to that kind of.

Tom   12:06
They won’t need the money right, but someone else in their family might.

Casey   12:09
Yeah, so death, disability, first home purchase up to $10,000.

Tom   12:14
That is something a lot of people overlook.

Casey   12:16
Yep First home purchase, though Not principal home purchase.

Tom   12:20
Yes, and it’s not the whole account Right up to $10,000 right. So some of the other examples are medical expenses, medical insurance premiums while unemployed, that is, could make a big difference for someone these are things that people overlook all the time and, unfortunately, when they’re sitting down with us, we hear that last year they did this or that and we’re like Could have taken that money from your Roth. Yeah so let’s talk about educational costs.

Casey    12:54
Yeah, educational expenses are higher educational expenses. So that’s you know, secondary or college Education costs also fall into this special purpose rule for withdrawing earnings from your Roth IRA and the other. The other two are substantially equal periodic payments. That one is a little confusing, yeah.

And then the last one is birth or adoption costs. If you’re in that situation when you’re looking to adopt a child, then you know you can use money for that from your Roth and that’s a good thing because it can be more expensive than some people think. So those are earnings.

Again, you gotta. There’s the five-year holding period that you gotta. You gotta check that box. If you have had the account open for five years, then you know you should. You shouldn’t have to pay tax or penalty on that. If you haven’t had it for five years, then you’re gonna need to qualify for one of these special purposes.

If you don’t qualify for one of the special purposes, then you’re gonna have to pay Tax and I believe a 10% early withdrawal penalty on that’s correct. So, again, this is for earnings. We talked about contributions before. Contributions always come out tax-free. But for earnings, you’re gonna want to do your homework ahead of time and make sure just clarify the tax ramifications Before you do that.

Tom 14:23
Casey, let’s go back, half a step and just talk about this five-year item, because this is something that a lot of people do not understand. People say, “hey, I opened my Roth IRA years ago and I put $2,000 in” or “$4,000 in five years ago, but then I added $3,000, $4,000, $5,000 each year after that.”

“Do I have to wait five more years for the rest of that money to be able to come out, or is it just from the date the account started?”

Casey 14:58
It’s from the date the account started. So that’s gonna. That’s your kind of. The clock starts, then just has to be open for five years and then that checks checks that box.

Tom 15:10
That’s an important clarifier and we spend a lot of time helping people understand that.

Casey 15:17
So then the the last way that money can even get into an IRA is through conversion. So a lot of the same rules apply for Taking converted dollars out from a Roth IRA that they do for earnings. So the same same rules apply, seeing special purposes apply.

Usually the order goes at least from my understanding it goes contributions, then converted dollars and then earnings come out last.

That’s my understanding too, right.

One of the benefits of doing the Roth IRA is it can play that role of like a like a flex spot in a portfolio when, if you’re unsure about you, don’t think you’re going to need the money, but then you’re not really sure you want to have access. You don’t want to contribute it to a 401K or some other tax-afford account and have that money tied up with a penalty to take it back out. The Roth IRA can kind of play that role of long-term – but also has that short-term accessibility.

And again, that’s because contributions come out tax-free.

Tom 16:27
I do want to just touch on when people do a Roth conversion. I think they need to know that they don’t have to convert 100% of their 401K or their IRA into a Roth. They don’t have to do it all, and they don’t have to do it all in one year either. They can do this in stages.

It’s important because you have to pay tax on this money. That’s a big amount of cash you’ve got to come up with. A lot of people don’t really understand wow, how am I going to convert a million-dollar IRA into a Roth? I don’t have $389,000 to pay federal taxes with. It’s got to come out of that account, or I don’t really think I should do it.

Casey 17:17
Like we mentioned before, you want to be smart about this and fill up your tax brackets as high as they can go without pushing you into the next tax bracket. Maybe that means spreading out the Roth conversion over five years, five or 10 years.

Tom 17:35
You’re converting 20% of your IRA every year, converting that to a Roth. It’s going to take a few years for this money to be fully converted.

Casey 17:47
That’s a smart strategy. Like you said, you don’t have to do it all in one year. In fact, it could be a big mistake to do it all in one year.

Tom 17:55
One of the common misconceptions that we have is that point where people say, hey, you shouldn’t do a Roth conversion if I don’t have the cash to pay the tax on that. I’ll be the first to admit that 20 years ago, when people started talking about Roth conversions, I talked to people out of doing it because I told them hey, if you want to convert, say, $100,000 IRA and roll it into a Roth, you’re going to have a problem.

If you take this money and you have to pay the tax out of the distribution, it’s going to be a problem. That’s not necessarily true.

Casey 18:40
Yeah, you’re just going to have less in your Roth account. In that situation, maybe they’ll have $70,000 instead of $100,000 if they pay it out of their account. The other option is to have $30,000 in cash on hand to pay the tax bill. I don’t know if people are necessarily in that spot. I think that’s the best case scenario, but I think paying the tax bill from the conversion is still better than not doing the conversion.

Because 70% in a Roth account is better than zero in a Roth account, because then that’s 70%. You’re not going to have to pay tax on it. We’re referencing an article from Morningstar about misconceptions about Roth conversions. The first one was you shouldn’t do one if you don’t have the cash to pay the tax. The next one is a client in the highest tax bracket should not do a Roth conversion.

Tom 19:41
It’s a case-by-case basis. It’s hard to have a rule that says, yes, you should consider this, or no, you shouldn’t do this when a client is in one of the higher tax brackets. It’s a discussion, it’s something that we really need to talk about.

Casey 20:02
This is when it boils down to personal preference and having that optionality of when you want to pay the taxes. I think that’s the benefit of it.

Tom 20:10
We have situations where clients are now approaching their required minimum distribution ages and they’ve got $1 million, $2 million, $4 million dollars. Four million dollars in an IRA retirement account. You do your first year’s required minimum distribution. You’re taking something north of $160,000 and declaring that as income. It’s big.

Casey 20:40
It all boils down to personal preference. I think the author of the article was mentioning how tax the overall tax rates are set to increase in 2025 under the tax, the tax law that’s In tax cuts and jobs act right TCJA.

So the rates are set to go up in 2025. I think planning for you know, planning your tax strategy, your personal tax strategy, based on what you I guess it’s not what you think tax rates are gonna do, but the tax law changes all the time. Right, if someone different gets elected to and Is in in power, then they can kind of change the tax code to to whatever they want, not whatever they want. You know there’s rules around this stuff, but it could be not what we think it’s gonna be.

Tom 21:31
It’s important to know the sunset dates on some of these tax cuts. But you also have to be realistic and say these tax cuts may become permanent as well. Many do, mm-hmm, you know everybody’s running for reelection at some point, right?

Casey 21:47
The point being there is you have to have your own Personal. It depends more on your personal circumstances than what the tax rates are set to do in a couple years. So that was the second misconception. The third misconception is if the client is not in the highest tax bracket and has the cash to pay the taxes, a Roth conversion is always a good idea, and I know this from taking and passing the CFP test. If you see the word always, it’s probably not true.

Tom 22:18
Those absolutes are always and never, always and never. Except when I say money going into a Roth account, always, always, always, aftertax right.

Casey 22:30
So the author of the Morningstar article mentions how, if you plan on doing a qualified charitable distribution from your IRA, so you’re planning to donate money from your IRA —

We could do a whole podcast on that —

–to a charity, it probably doesn’t make sense to do a Roth conversion. So that was his exception to the rule of not being in the highest tax bracket and paying cash. That was his example of why it still might not be a good idea.

Tom 23:02
I think the point behind these misconceptions and this article will link to it in the show notes is that there are no hard and fast rules. Where you say I’m in the 24% tax bracket, I should not be considering a Roth conversion, not so fast. It needs to be examined on a case-by-case basis.

Casey 23:23
Yeah, and it can be pretty complex. If you’re doing it yourself, you definitely want to. If you have an advisor, get them involved. If you have a tax preparer, cpa, you definitely want to get them involved and get their feedback on it as well. It can be pretty risky and easy to make a mistake on trying to do this stuff yourself. So if you’ve got questions, I know a couple of CFPs here in the office that would certainly be able to help.

I think that’s gonna do it for Episode 454 for the Mullooly Asset podcast.
Thanks so much for listening. We’ll be back with you next week.

Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.

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