Roth Conversions

It's time for another edition of Mr. Stillman's Opus. Walter Storholt guest hosting today with John Stillman, the founder of Rosewood Wealth Management. John, good to see you. What's happening, brother?

Oh, not too much. Excited for our conversation today. How exciting can Roth conversions be?

Well, we'll make it as exciting as they can possibly be right here. We're going to answer some important questions about Roth conversions, what you need to know about them, and so let's start there, John. What is a Roth conversion?

That sounds like Greek to some people, others have maybe been through this before. Yeah, and a lot of people have heard of it as a strategy that is maybe a good thing to do, and yeah, in a lot of cases it can be a good thing to do, but at first... Or you've heard of a Roth but don't know you can convert it. Right. So essentially, let's first lay out the difference between traditional and Roth IRA very quickly. So traditional IRA, you put the money in now, you get a tax deduction this year, all that money grows, and you're going to be taxed on what you take out as ordinary income when you take it out. So all that growth is going to be taxed. With the Roth, you put it in, you get no tax deduction now, but all the growth is tax-free.

So you put in $5,000 now, you still pay taxes on that $5,000, but if it grows to $100,000, well that's $95,000 that you can take out and pay no taxes on. So that's the Roth. So you're paying the tax on the seed or the growth, right?

Or the harvest or the crop, or what's that saying? So Roth would be, you're paying tax on the seed. Traditional IRA, you're paying tax on the harvest. Basically every tax advisor in the world uses that analogy to describe the difference. So let's suppose you wake up one day and you find yourself with $100,000 in a traditional IRA.

And you say, alright, well, I'm only 30. This will probably grow to $500,000 before I actually need it for retirement. Sure would be nice if that $100,000 was growing to $500,000 tax-free instead of me paying taxes on the whole $500,000. So what you would do is convert that to a Roth.

You would do a Roth conversion, converting that $100,000 of traditional IRA money, converting it to Roth. So you're going to pay the taxes on it now. So you're saying I'm paying the taxes now on the account. Does that mean my balance, it comes out of the balance or does that just come from a different pot?

Good question. So let's say you had that $100,000 in a traditional IRA. You want to make it a Roth. Yes, that's going to be, let's say you're in a 15% tax bracket. When you do that, you're incurring about a $15,000 tax bill in order to make that happen. You're going to want that money to come from somewhere else to pay the taxes. You're not going to want to take it out of the account because you're likely going to incur, depending on your age, likely going to incur some kind of penalty to do that. And now your anticipated growth in that account, you're hamstringing that growth by pulling it out too. Right. So if you're converting $100,000 and you're paying $15,000 in taxes to do that, you want to have that $15,000 in a bank or after tax brokerage account somewhere that you can pay the taxes with.

Okay. So let's suppose you do convert that $100,000 and it does grow to $500,000 before you need it. Well, that's great. You paid $15,000 in taxes at the time of conversion, but now it grew $400,000 from that point and that entire $400,000 you could take out tax-free. So that's a pretty big benefit if indeed it grows that much. If you had never converted and you left it in, I guess the difference is then 15% of $500,000, not 15% of $100,000. Right. You know, assuming you're in that same tax bracket at that time, but yeah, exactly.

All right. So it's pretty obvious to see why you might want to do that. Why can it be especially helpful for people who are high income earners?

Cause I know I've heard that before. So there's something called a backdoor Roth and it's really all it is is a Roth conversion. It's just that it's gotten this name backdoor Roth because it's a way for people who can't otherwise have money in a Roth IRA to get money in a Roth IRA. So if you make too much money according to the IRS and it's, you know, married filing jointly right now, it's about $185,000 adjusted gross income. If you have more income than that as a household, you cannot contribute to a Roth IRA. So what that means is you could only contribute to tax deferred investments, 401ks or IRAs or you know, if you make too much, even more than that, you can't even contribute to a traditional IRA and get the deduction.

Wow. There's really no income limit for the 401k so you can always put your money in there. But if you want to have some money growing tax free for the future, the Roth is a very powerful tool to do that.

But you say, all right, what do I do? I'm precluded from doing that because I'm a rich person who has to be punished, so I'm not allowed to put money in a Roth. Well, there is no income limit, at least as tax laws stand now, there is no threshold for converting to Roth. You can convert money to Roth at any time as long as you can pay the taxes on it. So let's suppose you're somebody who made $200,000, you're making too much to put money in a Roth. Well, you could put that money in a traditional IRA, then the next year you convert it to Roth. So let's say you put in your $5,500 that year into a traditional IRA. The next year you convert it to Roth, you're going to pay taxes on that money that you contributed, but now it's growing tax free from this point forward. That's why it's called the backdoor Roth. It's kind of a way around the tax law and perfectly legal and I haven't really even heard any talk about them changing that law. So our assumption is that for the foreseeable future, that'll still be a strategy you can enact. That'll be helpful.

I always find examples to also be helpful. John, can you maybe give us an example of how you've seen this in your practice at Rosewood Wealth Management, an example of a person who maybe would really benefit from a Roth conversion and you identified that when they came in? So let's think about somebody in their mid-40s. This was Kim. Kim had a situation where she'd basically gotten an inheritance that was a pretty substantial amount of cash. It was the sale of her parents' home. So she had $75,000 that plopped into the bank after it was split between her siblings and everything.

So she's got $75,000 in cash. She had herself an old 401k that had about $200,000 in it. She was also in a situation where she was without a job that year. She was in between jobs and she'd gotten a severance package the year before that it all paid out. This is probably more detailed than you need, but long story short, she wasn't going to have any income this year. She was living off money that she had in the bank from a severance package from a job previously. So in her case, if she was able to take that $200,000 and convert it to Roth, yeah, she's going to pay the taxes on that $200,000 as income, as if it was earned income this year. But because she didn't have any other earned income that year, if there was ever a year for her to do this, it was that particular year. Otherwise the tax bill would have been so huge if she'd done it during a normal working year.

Right. And so in converting that $200,000, she incurred a tax bill of around $40,000. Well, with that $75,000 she'd inherited, she could pay the taxes on that. And now she's essentially cleansed her money, right? That $200,000 is now growing tax free down the road. She's 45. She's not going to need that money for 20 years when she retires. And so hopefully that money will have doubled, tripled or quadrupled by the time she gets around to needing it.

So she took a $40,000 tax hit now, but for the purpose of having a gargantuan tax free account once she retires. The instant gratification versus delayed satisfaction debate that we always have. Yeah. That's a good way to phrase it. Maybe an example would be helpful, John, of a person who is on the other side of the coin who shouldn't do a Roth.

All right. Well, generally speaking, the older you are, the less it's going to make sense. So Mike and Jill were really excited about the idea of a Roth conversion. But when we looked at their situation, it didn't make as much sense.

They were both in their early sixties, and they really were planning to retire in five or six years. So they were looking at converting money to Roth, paying taxes on it now and letting it grow tax free. But they needed the money in a relatively short period of time. So one problem was they didn't have all that long for the money to grow before they needed it. It's not like the 30-year-old who had the $100,000 plan that was going to grow to 500K.

Exactly. And the benefit of the Roth, as you'll remember, is the growth is tax free. So if you don't have that long for the money to grow, there's limited benefit there. The other problem was, as I said, they were both in their early sixties. They were both in their prime earning years. So they're making as much, they're earning as much as they ever have. And now we're going to do a Roth conversion and add even more income on top of that.

Really didn't make any sense in their case. So, you know, if you're under 50, there's a good chance that it makes sense for you. If you're between 50 and 60, you know, it really depends on your situation. If you're over 60, very rarely is it going to make sense to do a Roth conversion.

Those are very general age brackets there, but that's kind of how it breaks down on average. Is this something, if I do kind of hear your explanation, John, and think, okay, this sounds like it would probably be good for me, or at least to explore, investigate, or yeah, gung ho, I feel like I fit right into this good spot here. Is it as easy as just going into my Fidelity account and clicking a button and making it happen? What are some of the pitfalls of trying to execute the strategy? No, it's usually never that simple. And you pretty much always want to have a CPA involved in the process, even if it's a relatively small amount, because there are a lot of things you need to account for exactly right on your tax return. And if there's something in your situation that makes it unwise for you to do this Roth conversion, you're probably not going to find that thing just by reading some articles online or even listening to a podcast.

You want to have some good tax advice along the way. So it is a little bit complex. It's a fairly simple concept, but all the record keeping and the paperwork that goes along with it, you probably do want to have some professional help there. Not to go down a long path here, because this is probably more detailed than anybody wants to get into, but it just, I think, is a good example.

The right answer for somebody might be you've got a half a million dollars in an IRA, and the right answer for you might be half of it stays IRA, half of it converts to Roth, but it's all in the same account and trying to figure out the proper paperwork and tracking for all that kind of stuff. You can see how complicated and ridiculous that might get if you aren't used to dealing with those kinds of procedures. And that door that you opened up right there is one of the complexities that I don't even want to try to get into on here because it is so complex, but yes. Could be the right answer for somebody. If you're trying to convert part of an account, it does become very problematic.

Yeah. So that's just a good example of some of the ways in which you can get some outside help rather than just trying to figure it all out on your own. If you have questions about a Roth conversion, does it indeed make sense for you?

Is it something you should consider? John can help you out, certainly, at Rosewood Wealth Management. You can give them a call at 919-391-3446. Again, 919-391-3446. Or always online at rosewoodwealthmanagement.com.

That's rosewoodwealthmanagement.com. Thanks, John. We appreciate the help. Always a pleasure, my friend. Thanks for Roth Conversions. Hope that helps you out a little bit. For John Stillman, I'm Walter Storholt. We'll talk to you next time on Mr. Stillman's Opus.