Do You Know The Difference Between Contribution and Conversion?

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This is the Truth Network. Welcome to Finishing Well, brought to you by cardinalguide.com, with certified financial planner, Hans Scheil, best-selling author and financial planner, helping families finish well for over 40 years. On Finishing Well, we'll examine both biblical and practical knowledge to assist families in finishing well, including discussions on managing social security, Medicare, IRAs, long-term care, life insurance, investments, and taxes.

Now, let's get started with Finishing Well. Well, welcome to Finishing Well with certified financial planner, Hans Scheil, and today's show, actually, we have a question. Do you know the difference between a contribution and a conversion, which is a really good question. And we're going to be talking about when it comes to IRAs, do you know the difference between a contribution or a conversion?

But also, since we're on the subject, you know how I am. I got to look at this from a spiritual standpoint. And so, when you think about, do you contribute to church, or are you converted? Are you a churchgoer, or are you born again? That might be a good way to do that when you're looking at this from a standpoint of what's the difference between a churchgoer and born again. And so, if you think that, wow, if I contribute to God through the plate, and if I do, do, do, do, do, like teach Sunday school and help little ladies across the street and all that, if you think that in itself gets you to heaven, then you're a churchgoer. But in order to be born again, the fascinating thing about that word is that one doesn't have to do with do, but it has to do with done, right? Because here's what happened. Jesus did what it was gonna take to get you to heaven.

That's already been done. You don't have to do anything. It's a free gift, salvation. If you believe, it's simply a matter of faith.

If you believe Jesus did what it was gonna take to pay for your sin by dying on the cross, and you believe he did enough, then by entering into a relationship with him, asking him to come live in your heart, rule your life, essentially, and turn from your ways, seek him with your own heart, you know, then born again, that's another thing. And like, how wonderful is that? But now it's no longer do. It's not a matter of contributing so much as it is.

He's done it. And now, you know, how can I obey him with my life in order to, you know, live with him in relationship? So along those lines, right, when it comes to IRAs, Hans, the one is contribution, the other one is conversion. Okay, so we're going to outline the difference between the two. But let's get one thing clear. You can be a church goer and converted.

Oh, yeah, yeah, yeah. Good point. You can be both. And the same is true. A contribution can be a conversion as well. So, but let's get back to the point with this is that we got contributions, and we got conversions. And the reason we're even talking about this in the first place, is, as we're doing financial planning, and we're advising clients, and they're on the way in, and we start talking about Roth conversions, and just discussing the possibility of them, many people will come out and say, well, you're talking about converting $100,000 in a given year, or $50,000 a year, I thought you could only put $10,000 in there, or I thought I make too much money to make any contribution. And therein lies, there's a difference between a contribution and a conversion. And so we're really, we're going to ultimately identify what we're talking about, about Roth conversions.

But before we do that, we're going to talk about what is a contribution. So it's when you put money into an IRA or a 401k, when you're taking money either out of your paycheck, like in a 401k, or out of your savings, or out of the earnings of a business, if you're a self-employed business owner, and maybe you have a simplified employee pension, which is, by the way, nothing more than an IRA that's on steroids. And you're contributing, you're taking before tax money, typically, money you haven't paid taxes on yet. And you're putting it into an IRA, or a 401k, or an SEP, or something that's tax qualified. And you're going to pay taxes later. And you're also not going to pay taxes on the earnings until later. So it's a pre-tax account.

And most people listen to the show know what we're talking about. And there's limits on the contributions that you can make in any given year. So it stops a person from having a big income, and then putting all their money into their 401k. It stops an IRA or 401k from becoming a tax shelter.

Right. So it's kind of like, this is where the question becomes really important. Because of these limits, you know, people get confused, that they think that, wow, you know, how could I have a Roth IRA, for example, because of the limits to income and that kind of thing. And so hopefully, by understanding the difference of what a contribution is, is your monthly giving that in through your paycheck is a lot different than deciding at some point in time, wow, I've got $400,000 in this IRA, I want to convert it over to a Roth IRA, or I have all this money in a 401k, and I want to convert it to a regular IRA. Those are conversions in one great big lump of money, rather than a regular contribution coming by month. Is that a good way to explain it?

Well, it is. But, you know, let's just talk about contributions and what they are and what those limits are for 2023. So if you are under 50 years old, and you are not part of an employer retirement plan, you don't have any 401k available at your job, you can put $6,500 in an IRA, as long as you earn $6,500 in the year. So you can't, if you only made 2000 for the year, you can't put 6,500 in. But you can put all of your earnings up to 6,500 bucks into an IRA.

You can also do the same thing for your spouse. If your spouse didn't work, or doesn't have earnings from work, or you can, you can put some of your earnings, so you could each put 6,500 bucks, or you could put 13,000 in your separate accounts. Now, if you're over 50, that number is 7,500 bucks. So they just have a catch up contribution for people 50 and over. So that number for 2023 is $7,500, the IRA contribution limit. Now, in a Roth, excuse me, in a 401k plan, the limits are much higher. So if you participate in your employer's 401k plan, so you got the 401k plan at work, you can put a maximum of $22,500 in there, if you're under 50.

Wow. Yeah, most people don't put near that amount. A lot of people only put in just enough to get the employer match. And that $22,500 figure does not count the employer match.

That's just your contribution. And that's for people under 50. If you're over 50, you can put $30,000 into the 401k in 2023.

Wow. Yeah, you can only do that out of income. So you, you can't earn 20 and put in 30. I mean, you, you can contribute every dollar you make up to those limits. Again, it's $22,500 for people under 50. And it's $30,000 for people over 50.

Now, we have a lot of people that come into us, and they want to hear about Roth conversions, because the real attraction here is tax break. Because most people inherently know, they got a problem with this lump of money they have. And we're talking to people generally in their 60s. And they're anticipating retirement. And they have several multi $100,000 balances, some of them well up into seven figures. And this is usually a good size percentage of their financial wealth. And they're aware of the fact that they got this big hunk of money that they haven't paid taxes on yet. And so a Roth conversion or the idea of turning that into a tax free account is very attractive to people until they learn what they got to do to turn it into a tax free account. And that's where they really need us.

Okay. Now, when people are interested in a conversion, I find it really interesting that many people are not taking advantage of the Roth 401k. So, for all you people listening out there that are participants currently in a 401k, you're still working.

My guess is, is most of you that are contributing are doing it in the traditional way. It's pre-tax money going in. And my guess is you need to check with your employer and check with the 401k plan, but they have a Roth option for contributions. Now, most employers won't let you convert money that's already one kind inside the 401k to the Roth, but they will let you put your new contributions in there. So, one thing that I leave people many times after a first or second meeting is they're going back to their 401k plan. A lot of times they just go online and they're able to start contributing immediately with their paycheck into the Roth portion of their 401k.

And when you start looking at these numbers, and if you're a couple of three years away from retirement, you can get some pretty sizable money into the Roth just by doing a payroll deduction. Yeah. Yeah. And that would save you from having to do a conversion later. Right.

And take advantage of the lower tax rates now. Right. Yeah. But that's only with new money. So, we're still talking contributions, you know, like what they are and, you know, the limits.

And we're going to stay on there for a little bit. Okay. Now, there's also some other limits that come in. Okay. So, if you're, if you even are part of a 401k at work, or your spouse is, and you take advantage of that, you could still put money in an IRA if your income is smaller than certain amounts.

Okay. And I've got to find those certain amounts on the sheet. But it's like in the low over six figures. So, it's like 116,000 to $136,000 if your adjusted gross income is in that range, or lower than that range. You could also put money in an IRA, you can contribute to an IRA. Now, most people don't take advantage of that, if they have less than $100,000 a year of income, because they're already contributing to their 401k, there isn't that much money to go around.

But it still is an option. And a lot of times people are referring to these limits thinking they're going to stop them from doing Roth conversions. So, then there's another set of limits is if you want to open up a Roth IRA, or you want to do a conversion, but you want to just open a Roth IRA, I mean, you just, you want to open one, you can't put money in a Roth IRA, if your income is higher as a couple between 218,000 to 228,000, or as a single 138,253.

So, if you make more than that, you can't open a Roth IRA with contributions. That's a good point, right? At this point, we could talk about that, but yeah, the show is brought to you by cardinalguide.com. And, you know, of course, we always want to point you there to get the show notes or even see the YouTube video on the exact same subject of, you know, contribution versus conversion is there under the IRA tab, under the seven worries there. And it's also, if you just go to YouTube and watch the video, there's a link right inside the video. And that's Cardinal Advisors on YouTube.

So, all right. Well, don't forget Hans' book, The Complete Cardinal Guide to Planning for and Living in Retirement. We'll be right back with a lot more of contributions versus conversions. Well, welcome back to Finishing Well with our very own certified financial planner, Hans Scheil and today's show. Do you know what a contribution is versus a conversion when it comes to IRAs? And so, we've spent the first half of the show going over the whole contribution idea.

And to wrap that up, Hans? Well, what's nice about doing financial planning is we don't generally have to teach people everything about conversions and contributions. We just need to get an assessment of what they're doing, what we think they ought to do, and just explain that to them. So, when we're doing this format of a show, it's like I'm trying to teach you the whole picture. And I'm sure in the last session, I threw you a bunch of numbers. So, let's try to simplify this.

So, let's try to simplify this. As contribution, we're talking about putting money in to the IRA or the 401K. And there's limits of that. Most people don't test the limits. In fact, my advice for most people is up the contribution level. And you say, oh, I can't afford to do that.

Sure, you can. I mean, you know, you just up your contribution limits even if it's a small amount over time. People don't think about retirement until it's too late. So, there are limits.

And again, most people don't test the limits. For the 401K, you can put in 2023, you can put $22,500 in there, just your portion. If you're over 50, you can put $30,000 in there. So, if you're in a person who's nearing retirement, you've got a bunch of money in a 401K or an IRA, and you're thinking, you're coming to me and you're thinking about starting a conversion plan because you're worried about the taxes, I'm going to send you to the easiest place you can go. Is if your 401K allows it, and most of these days do, they have a Roth option in your 401K. And you can go on the computer and you can contribute up to $30,000 of just your money out of your paycheck into the tax-free side of the equation, the Roth side. And, you know, after two, three years, if you're even close to retirement, that's 60 grand in two years. Now, you can say, well, I can't put all my money in there.

Well, sure you can. If you were thinking about converting some of your IRA, I mean, it means you've got some leverage here. You've got some other savings. It's just a very easy way to get to the Roth balance through a contribution.

Okay. One question based on what you said is when you say test the limits, you're not talking about go over the limits. What you're saying is try to get as close to the limit as you possibly can, because obviously that benefits you in the long term. Well, yeah, your 401K isn't going to let you put in more than you're allowed anyhow. I mean, if you're set up to put in more than the 30,000 or the 22,500, when you get to the $1 short, they're just not going to take it. When it comes to the IRA, the limit is 7,500 bucks for people 50 and over, $6,500 for people under 50.

But many times if you're married, you can do this for both of you. And if you're a few years away from retirement, and you don't have much in retirement savings, and you're not part of a retirement plan, by all means, you need to do that. And you do need to watch the limits on that because that would be your financial advisor, the guy like me is only going to take in a contribution an amount that's appropriate. Okay. Now, so we talked about contributions. So what's a conversion? And a conversion is we're going to take money that's in a regular IRA, a traditional IRA, you haven't paid taxes on it yet. And we're going to convert it, or we're going to turn it into money that's already had the tax paid on. So you know how you do that are one of the critical steps. I'm guessing you have to pay the taxes. That's right. People say, Oh, I'm not doing that.

Okay, well, what should we talk about next? And it's counterintuitive, especially to people that have built up a big balance, and they've gotten there. And they've just told themselves, well, this has a tax benefit, I've just been doing it.

And it's just doing it forever. And this is, and maybe they've looked at Ross, they heard a lot of the press that came out and said, Oh, well, if your tax rates higher when now and they come up, people come out with all these slogans, this is good, that's bad. You know, and I don't want to try to win you over in one radio show. But I can tell you that having the availability of tax free income in retirement is pretty attractive. And it also, if most of your money is in an IRA, I mean, it's a good problem to have is have a big bloated IRA, I always point, wonderful way to go.

Here's your problem. If you all of a sudden needed a hunk of money, a lot of people look upon this as their savings, it's going to kill you in taxes the year you draw 100 grand, or 200 grand or 150. And just remember, every time you pull $1 out to spend, you really need to pull out another 50 cents just to pay the taxes, okay, maybe even 60 or 70 cents.

So, if you all of a sudden needed something that was $50,000 to help out one of your kids out of a crisis or something or just some reason, something came up that you all of a sudden needed a hunk of money, and the only place you have to go is your IRA, and it all happens in one year, that's not a good thing. So, right off the bat, I like people to begin thinking about getting some of this money out of the IRA or the 401k, and either just pulling it out, paying the tax, and sticking it in a savings account so they've got a place they can go for money in emergencies and things when, you know, they don't have to pay taxes on it. Preferably, if they don't need to spend the money right away, is we're going to do a Roth conversion. So, and then we need to be real smart about how much do we convert, that's the magic answer.

So, the first thing we got to do is get you clear on whether you want to do this or not, okay, and whether you're bought into the fact of taking a little pain now, strategically over a number of years, and paying the taxes so that you'll have a tax-free account either to live off of or to go ahead and pass on to your children. And it also doesn't have minimum distributions against it. So, there's a whole bunch of pluses to a Roth conversion. But in order to do a conversion, you got to have the money in there in the first place. And none of those limits apply. I mean, a Roth conversion is limited by how much money you have either in a 401k or an IRA.

If that's $400,000, $800,000, $2,000,000, $120,000. I mean, your limit of conversion is just limited by the amount you have in a pre-tax IRA or 401k. Now, we can't convert money inside a 401k.

So, a lot of people think this is going to be real easy. I just, I want to convert. Now, if your employer lets you do it, and I haven't seen many that allow conversions, but I've seen a few. So, it is possible to do a conversion if your employer allows it, but most don't. So, most of the time, what we need to do is we need to do an in-service distribution without paying the taxes from the 401k, rolling it over into a self-directed IRA, okay?

We can handle that for you. And then, you know, you may want to do several years' worth so you don't have to be doing this every year. You may only want to do one year's worth. And so, all you're going to do is take a pre-tax account that's in a 401k or an amount of money and move it into a traditional IRA of a certain amount.

No taxes due yet. Then when we do the conversion, we could convert that whole account or we could just open a separate Roth IRA account and take so much of it and just convert it. And then it becomes a Roth, the new account, and then you've got to come up with the taxes. And so, then the issue is, do you want to pay the taxes out of the converted money, okay, or out of the money in the so you end up with less in the Roth because a bunch of it went to taxes.

Not a bunch of it, but a bit of a chosen amount. Then, or do you have money on the sidelines that you can pay this tax out of other money? And if you have that, that can make the Roth conversion even that much more attractive.

Which, you know, just pretty much tells me why you don't try this at home. Because I'm sitting there going, okay, so I can't convert from a 401k to a Roth IRA so I've got to convert my 401k to a regular IRA before I can convert it to a Roth IRA, you know. Let us worry about all that. That's what I was saying.

Yeah, let us worry about all that stuff. Just in principle, if you've got a big bucket of money and it's like it has a mortgage on it, you know, it's just you're in partnership with the IRS and they own some percentage of your IRA and then of every dollar of growth. And a lot of people just can squeeze by and wait till 72 before they take anything out of there. And they're just making the problem. And again, it's a good problem to have a bunch of money in a pre-tax account.

I'm not saying this is bad. I'm just saying it's going to become bad and frustrating to you if down the road you're forced to make withdrawals or you pass away all of a sudden and this goes to your kids. And then your kids have a huge tax bill on this because they want to get it all the money all at once. I mean, so this is a problem you need to look at and a Roth conversion, well thought out, is just one strategy we can utilize to deal with this.

We got several other ones. But the key point that I'm getting is that a lot of folks thought because their income was above $138,000 that I can't start a Roth. I can't do that conversion because I don't qualify for Roth.

They had, they had the, they didn't understand the differences was not a contribution. This is a conversion. And so you can in fact do that if you're, what you're doing is conversion of money that like we talked about is done. That money's already in the account. So you're just taking that and converting it over to the Roth and paying taxes in the, in the, in that tax year based on that and doing that in a by strategizing, you know, taking a certain amount each year rather than, you know, just whopping it all together. Right.

Right. And so this is, this is a way to get ahead of a problem, right? So we've got lots of shows along those ways where if you go to cardinal guide.com, you'll see the IRA tab there and you're going to see, we've got several shows along the ideas of how to figure out these brackets, but hopefully today we understood the difference between, you know, contributions and conversions. And if you need more information, of course, you've got Hans's book, the complete Cardinal guide to planning for and living retirement, and then the YouTube channel, call it Cardinal advisors. But of course we'd always point you to Cardinal guide where you can get up with Hans and again, great show today, Hans.

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