Ep # 76: Making Lemonade - Time For A Roth Conversion?

Benjamin Haas |
  • What is a Roth conversion? (3:00)
  • Who is it for? (4:49)
  • What's in it for you (8:39)
  • Why now? (13:06)



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Full Transcript:

Benjamin Haas  00:02

Hi everyone and welcome to A/B Conversations, where we will help you CFP your way out of it. A podcast where you get into the minds of a couple of Certified Financial Planners on how we think and feel about everyday financial planning questions and what should really matter most to you. A healthier financial life starts...now! Andddd...we're back. How are you doing, Adam?


Adam Werner  00:30

Great. Happy June. 


Benjamin Haas  00:32

Yeah. Love it. Summertime. I think it's going to be filled with lots of pool time, probably for your kids, my kids. Lots of time outside, maybe a lemonade stand or two. 


Adam Werner  00:45

Yeah, so that's a great jumping off point for the topic today. Trying to make lemonade out of lemons and in our view, it's the stock and bond market to start the year has given us a lot of lemons to work with. So part of it is again, just trying to figure out, we've talked about this in other iterations, trying to think opportunistically when things don't feel great and now you kind of have to take that maybe bad circumstance or bad scenario for us here. We're talking about the stock and the bond market, both being down potentially double digits here in the first five full months of the year and let's try to at least look opportunistically. Are there things that we could be doing to take advantage of some of the negativity to set things up better moving forward? So yes, trying to turn some of these lemons into lemonade.


Benjamin Haas  01:42

And it's not in the sense of like a 50-cent cup or $1 cup on the side of the road? Yeah, I think the financial planners in us, the conversations we have with a group of people, let's focus really on those that have enough, right? They saved, probably at that phase of life where the things that they're worried or they're feeling right now, it's not great about the market. Maybe it's not great about government on one way or the other. There just continues to be these things that kind of give them some Ageda and when I think about your comment making lemonade out of these lemons, they're often things that we want to kind of like point to. How can you take advantage of this, even if it's not something you're going to feel today but big picture, long-term, what really matters most to you? And I think people that have that kind of wealth, say, I really want to limit my taxes. I want to keep what I have, if not for myself and for my heirs. So with that kind of being the backdrop. Roth conversions. 


Adam Werner  02:45

What better way to avoid paying taxes then paying taxes upfront? So somewhat of an oxymoron but there's rationale behind it. Let's just go over that. 


Benjamin Haas  03:00

What is it? What are we talking when we say Roth conversion? What is it? 


Adam Werner  03:05

Yeah, so yes. So essentially, you're converting IRA dollars or essentially pre-tax retirement dollars that you've not paid a single dime in income tax on. So, if you're saving into a 401k or you have a traditional IRA at this point, that is has not been taxed, those distributions are going to be taxed when you pull them out at whatever point in the future. So essentially, what you're doing is you're taking a portion of that pre-tax money and moving it to a Roth IRA to avoid taxation in the future.


Benjamin Haas  03:45

Later, yeah, I think sometimes this gets confused with Roth contributions. As people go through the accumulation phase of life, sometimes we get that question, where should I be saving? We're not talking about that. There are limits, there are rules that. Anyone in the world can convert dollars but it has to be understood that when you choose to do that, it's to pay the taxes now so you don't have to pay it later. 


Adam Werner  04:12

Right. Yeah. So even when you convert, it's essentially going to look and feel like a withdrawal from a tax point. 


Benjamin Haas  04:20



Adam Werner  04:21

It's going to show up on your income tax return as ordinary income for tax purposes but that's where part of the rest of this discussion is going to be, that may then include some short-term discomfort. Again, paying the taxes now but there's definitely some cases to be made for why you would want to do that and why we think the timing now may make some sense.


Benjamin Haas  04:49

Yeah, so then what's in it for going back to my vision here of let's talk to the people that have saved a lot. This isn't to look backwards and say, well, I wish I would have saved after tax before when I wasn't making as much money. It's the long-term growth that you hope to see in the Roth IRA, where all of that growth is never going to be taxed either but you see it being most advantageous. So, what we're really talking about here is somebody that's saved in their 401k, pre-tax set aside, did a great job. Now, they may not need to be taking as much out but what we're looking forward to with them, is a period of time when they're going to be forced to take money out of a traditional IRA. It's called a required minimum distribution. So what's in it for you, in this period of time, however long it is, to think about paying some taxes now. Like you said, doesn't sound like a wonderful thing but let's go through, what are some of the cases to be made for? Yeah, do it now because the long-term reward may be better. 


Adam Werner  05:50

Yeah, the perfect circumstance and you kind of touched on it, those 401ks and the IRAs, those pretax accounts, that you're going to be forced to take withdrawals from at age 72. At least that's the rules right now. It used to be 70 and a half. Now, at age 72. There's more legislation currently bumping around I think it's at the house or maybe it's at the Senate level. Doesn't matter that they may extend that, again, who knows. But the point being, if you do nothing, as if you have money within a pre-tax retirement account, you're going to be forced to take withdrawals at age 72, based off of a formula that the IRS puts out. But at that point, your flexibility is pretty much, maybe not completely gone, but you're going to be forced to take out whatever that dollar amount is and whatever tax bracket that may put you in, you're kind of stuck. 


Benjamin Haas  06:46

Yep, that's it, it is what it is. The argument has to be if you've done a really good job saving and now you're not really relying on that savings as much, let's say early in retirement. Maybe Social Security's fulfilling a purpose, maybe you're got a pension, maybe you're working part time. Maybe you just had bank assets. You're a good saver there, too. Now, you're not taking money out of this account. If you're going to be forced to later, the question is going to be, I sometimes use the analogy, do you want to pay taxes on the seed or on the harvest? Is it better to maybe pay taxes on a known dollar amount today and control what taxes you're going to pay by controlling how much you convert? Versus just seeing where things go in the future? Who knows where tax brackets are? Who knows how much the money grows to and how much you'll have to take out? There are a lot muddier variables potentially in the future.


Adam Werner  07:39

Yeah, definitely. Yeah, so let me just build on that but I think there's definitely a sweet spot in terms of situation. There's that window of time and maybe I'm just reiterating some of what you said. That between retirement and that age 72, depending on what that age of retirement is, that could be a fairly short window to be able to execute these Roth conversions without the compounding impact of RMDs or maybe any other future income. Depending on the situation, we certainly have clients now that are delaying Social Security. That also could be added income in the future. So again, there's different timelines for different situations but I think you hit on the key point is that you're in this scenario. Ideally, it would be somebody who's not relying on their retirement funds to meet their income need for at least a period of time.


Benjamin Haas  08:39

Yeah, so I think the other point that we wanted to make, what's in it for them. It is, like you said to think longer term, too. It's not just the known of the taxes now and that timeline that is defined, but there are no required minimum distributions on Roth IRAs. Once it goes into that bucket, not only you hopefully letting it grow tax free for as long as you can, where you do have the flexibility to tap into that and not pay taxes, if it's for you. But some of this is estate planning is not?  Now, nobody else that ever is going to inherit that account has to pay taxes on that either. 


Adam Werner  09:13

Yeah, and thinking back to just more recent legislation. That is another change that occurred within the last, I guess, two years now. Where if one of your heirs inherited the IRA or a 401k, the pre-tax side, they have a 10-year window to exhaust that account. It used to be you could stretch that out over your lifetime. Now, the IRS or government says, well, now we're going to give you a 10-year window because we want to get our tax revenue sooner than later. Understandable. With the Roth IRA to your point, not having RMDs, that's one benefit. But for your heirs, if they inherit the Roth IRA, they're still forced to take withdrawals over that 10-year period but they are also not taxable to your heirs. So again, it's just a great way to really have that Roth IRA potentially grow for a very long period of time and all of that growth is tax deferred and tax free. 


Benjamin Haas  10:17

Right. Not only for you, like you said, but your heirs. It's a wonderful estate planning mechanism. So, I'm going back to like, who is this best for and I'm thinking of, I don't want to say like slam dunk recommendation. But I feel like this has been a no and, in some ways, a no brainer for us. For those that maybe earned a really good income, they did a really good job setting that aside, maybe it was at the end of their career, they had bank assets. And we love the fact that once they retire, we can make them look poor. From an income standpoint, right, because even if they're on Social Security, they may be living off of their savings and there is no qualified money coming to them. So this is a prime opportunity to take some money out, show it as income but move it into that Roth IRA where it will never be taxed again. You're controlling your taxation now but getting it into what we feel is a much more advantageous spot for later. 


Adam Werner  11:12

Yeah, right now and we kind of talked about it from the tax brackets, essentially, 12 jumps up to 22%. And that 22% bracket is pretty big, I think it goes from like $180,000 to, I'm not even positive.  I should have looked this up but it's somewhere in like the low four hundreds, the really, really wide gap there to cover that 22% bracket. But the point being, it's the marginal or the effective tax rate that we kind of focus on as part of this process because again, as bad as it feels jumping from 12 to 22%. It's really just because it's the progressive system. So even though you're you may be in the 22% bracket, your effective tax rate could still be in the teens or even closer to that 12% depending how much income you have over and above that. So there still is the potential benefit or I guess the case to be made that paying, I don't know, throw 15% the effective rate. depending on, again, your situation, what income you have coming in the future, what RMDs are going to look like, that may easily push you over and above that in the future where it can be potentially as simple as if I know what I convert now and I'm going to be roughly at this marginal rate and I have an idea of what I'm going to do in the future. It can be that simple. But to your point, I think it is it's a much longer-term plan. Yeah, strategy or the breakeven is somewhat intangible that it really is that future growth and being able to pass that way more efficiently to the next generation that's a little bit harder to quantify.


Benjamin Haas  13:06

I agree with that. I do think when we go back to like the theme here of trying to make lemons, I'm sorry, lemonade out of lemons, though. There may be psychologically, some short-term reward to the idea, well, then why do this now. It may not be just be your timeline, your RMDs, your retirement. Some of this and the reason we're bringing it up today can be market driven. There's your softball.


Adam Werner  13:35

Thanks. Yeah, so if you were a diversified investor and for anybody that works with us, they probably are. With stocks being down anywhere from 10 to 20%, depending on the sector of the market, bonds being down close to 10% here to start the year, there really hasn't been any safe place to hide. We talked about that another podcast but the benefit or why you would do it now is because you're now converting at a at a lower value potentially than where your investment started the year. We know, at some point, this market is going to rebound. We're going to reach all-time highs at some point in the future. It's anybody's guess as to how quickly that's going to happen. But going back to your analogy on would I rather pay the tax on the seed or on the harvest? If we think the market is going to rebound and we are strong believers that over time it will, would you rather have that rebound or that growth occur. On the pre-tax side where you know you're going to get taxed on it or on the tax-free side within a Roth IRA? That now you're actually somewhat taking advantage of market values being down, convert at a potentially lower amount and now that growth can now happen on the tax-free side where again, you're not going to have to be forced to take it out and it's going to pass tax free to your heirs.


Benjamin Haas  14:54

Yeah, I love that. I think you said that so well and I liked that we made that point after talking about like the mathematics of this. There are certainly ways that we have to try to crunch the numbers that we're going to be able to mathematically show look, if we make these assumptions and that's going to be key here. There's a lot of different moving variables that we think this is a beneficial thing. Really, this comes all the way back to, you need to be able to kind of look at, psychologically, this feels like a good time to do it from what matters most to you to kind of keep your money either for yourself or your heirs. That's going to feel good, too and if there's one thing that gives people anxiety, I think, even people that have enough or they're in a good place with their wealth, it's those unknowns, the future. If you can lock it in a tax rate right now that you know, not knowing where this country is going to go, what debt's going to look like, what are tax brackets going to look like? What's government going to be? All of that stuff? Lock in the tax rate today and that can feel good, too. So it's not just in mathematics. This may feel like it's the right time to do something like this. 


Adam Werner  15:59

Yep, definitely. Anything else you want to add? 


Benjamin Haas  16:07

No, no, I was going to ask you the same so I think we're good. Making lemonade out of lemons. Maybe the Roth conversion is your way.


Adam Werner  16:11

Yeah, definitely. So if anybody has questions, they think this may apply to them, or want us to maybe think it through. Again, I think when we talk about planning, everybody always hates the answer of well, it depends or maybe. But this is definitely one of those situations that the individual scenario has to fit for it to make sense but it's definitely we think worth exploring, to at least see if it's a fit, when we think the timing may be right. 


Benjamin Haas  16:41

Agreed. Thanks for wrapping it up. Hope you have a wonderful rest of the day.


Adam Werner  16:47

You too. See you next time.


Benjamin Haas  16:49

 Bye. Hey everyone, Adam and I really appreciate you tuning in. Please note that the opinions we voiced in the show are for general information only, and are not intended to provide specific recommendations for any individual. To determine which strategies or investments may be most appropriate for you. Consult with your attorney, your accountant and financial advisor or tax advisor prior to making any decisions or investing. Thanks for listening!  Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor.


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