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Roth conversions are one of the most popular tax planning tools among retirees today. And we're going to spend
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this entire episode answering your questions about Roth conversions so you can better understand both the obvious
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and the subtle reasons to either pursue Roth conversions or not. Welcome to Personal Finance for Long-Term
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Investors, where every episode teaches you personal finance and long-term investing in simple terms. Now, here's
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your host, Jesse Kramer. Welcome to Personal Finance for Long-Term Investors, episode 145. I'm Jesse
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Kramer. I'm a financial planner working with retirees and also with busy professionals who are getting ready for
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retirement from all across the USA. You can learn more at planwithjesse.com. Today's review of the week comes from
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username going to retire. Great username who left me very kind words, but only a
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threest star review on Apple Podcasts. It's actually the second time that's happened where I had a a wonderfully
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kind review but only three stars. That's okay. The words mean far more than the stars and I'd be happy to mail you a
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super soft t-shirt. So username going to retire. Reach out to me via email jessy
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at bestinterest.blog and I'll get that t-shirt sent out to you. And as a reminder listeners, you can submit your
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questions to future ask me anything episodes by emailing me at [email protected].
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I'll answer those questions on a future AMA. Now, before we get to the specific questions from you about Roth
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conversions today, I'm going to spend a few minutes kind of priming you listeners with some of the basics of
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Roth conversions in case you're not quite familiar with them. So, we'll talk about the very basic how it works of
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Roth conversions, who might be a good candidate, when are the typical best years to consider Roth conversions, what
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might get in the way of doing them, and then how do you measure if you were successful ultimately in your Roth
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conversions? So, let's just get diving straight into it. The very basics. A Roth conversion occurs when you move
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dollars from a pre-tax, aka traditional retirement account. Usually, it's from a
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traditional IRA directly into a Roth account. Usually, there it's a a Roth IRA. Most of the time, because those
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dollars have never been charged a scent of income tax, this conversion from traditional to Roth counts as a taxable
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event. The amount of dollars that you convert usually counts to you fully as income in the year that you do it. So in
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that way, you are intentionally realizing income with a Roth conversion and you are therefore intentionally
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choosing to pay more taxes this year. So why would anyone ever intentionally pay
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more taxes? Well, that gets us to our next question. Who might be a good candidate? Good candidates for Roth
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conversions are people who look at their financial plan and look years out into the future and they realize that their
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future years might involve much higher tax rates while their current years involve quite low tax rates. And there
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are many reasons why this might happen in your financial plan, but perhaps the most common one could be something like,
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okay, Bill and Linda, Bill and Linda have retired at 58. They have about $4 million total. About 2.5 million of it
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is in their traditional IAS from former workplace 401k accounts. They really don't have much income right now because
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again they're retired. They're 58 years old. They have some dividends. They have
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some interest from their bank accounts, some uh dividends from their taxable investment account, but no social
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security, no outside income. And so their marginal dollar when they file their taxes is only getting taxed at
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about 12%. But as they project how their financial plan will evolve and how their
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accounts might grow over time, they look at the numbers and and their traditional
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IAS might easily be $5 million by the time they're age 75, which is when RMDs would start for them. And they'll be
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collecting social security at that age, too. And that's more income in their life. And when they look at this set of
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facts, they realize their marginal dollars at that age might be getting taxed as high as 32%. So 12% today, 32%
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in the future. So Bill and Linda, they kind of ponder, should they intentionally pay some taxes today at
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12%. In order to move those traditional dollars to Roth dollars, thereby preventing a 32% tax on their
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traditional withdrawals in the future. That's the logic, right? In this simple example, we would call that tax
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arbitrage. And you might hear me say that word a lot today, that term tax arbitrage. you know, Bill and Linda are
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intentionally choosing to pay 12 cents on the dollar today to save 32 cents on the dollar in the future. That's a 20
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cent tax arbitrage. And so that's the kind of thing if that's in your financial plan, it might really pop out
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at you. There's a really good chance that you're a great candidate for a for a Roth conversion. So, we'll move on now
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to the next question. When are typically the best years to consider Roth conversions? And then also, what might
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get in the way of you successfully doing them? So, the best times involve little
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other income in your life. And then what might it get in the way are the consequences of realizing too much
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income. It really is that simple. And we will get into much more detail throughout this episode. But
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specifically here for many retirees, the years after they've stopped working, but
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typically before they've started claiming social security and certainly before RMDs start, those are really good
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years to consider Roth conversions. or at least what I should say is like those are the years where you're most likely
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to be a good candidate for Roth conversions after you've stopped working but before any other retirement income
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has come into your life. Now, just because you've started collecting social security, you still might be a good
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candidate. I'm not saying that it precludes you, but I'm just saying the more income you're collecting, the less
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likely you are to be a good candidate for Roth conversions. However, depending on when you retire, what age you retire,
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you might be relying on something like the Affordable Care Act, ACA, healthcare, Obamacare, and the costs of
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ACA, and and really it's the premium tax credit that you receive to help you pay
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for the costs, that's tied to your income. And so, too much income means higher health care costs. So, if that
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sounds like you, well, then doing Roth conversions might not be good. It might not work because injecting more income
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into your life via Roth conversions could have a negative effect. It's almost like a in in medical terms I
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think they call that contraindication. It's like when when two medicines don't work together or when one medicine and
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one uh symptom are really bad. These things can conflict in some way. So there's a lot of that going on in
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financial planning. And by the way, if I just got that medical term wrong, please
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ignore everything I say. I am not a doctor. The last question in this little preamble that I have is how do you
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measure if Roth conversions will be or were successful? You know, in other words, here you are, maybe you're 57
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years old, you think you're a good candidate for Roth conversions. Like, how do you really know? Or maybe a
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better question is like, at what age in the future will you know for sure if the
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Roth conversion you did at 57 was good? And how are you going to calculate it? So, the challenge with this question is
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that it's based on many, many different assumptions. And a lot of those assumptions, we're just simply not going
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to know whether our assumptions were right or wrong until 10 or 15 or 20 more years play out. Right? You need to
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assume future tax rates. That's a huge one. You need to assume future investment returns. You need to assume
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your future portfolio withdrawal rates. You need to assume a particular time value of money. Time value of money is
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that that recognition that a dollar today is worth more to you than a dollar in the future. So you can think of that
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as maybe an opportunity cost calculation. Asop with his fable, you know, a bird in the hand is worth two in
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the bush. That's all time value of money stuff. And so the more murky or gray your assumptions are where you just
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simply don't know what's going on, there's a good chance that Roth conversions might not be a good fit for
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you. But also, what I'll say is that the more similar your future looks to your present, I'll say that again, the more
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similar your future looks to your present, the more likely Roth conversions might not be a good fit.
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Meaning, if you're currently 55 and you're going to pay 22% tax rates on your conversion right now at age 55, 22%
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taxes, but then by your analysis, you're only going to save an assumed 24% tax rate when you're 75. That's like kind of
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similar. Your tax arbitrage, going back to that term that we defined a couple minutes ago, is 2%. 22% today versus 24%
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in the future. And that might be too close to actually be a worthwhile Roth conversion. there's too much time.
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There's 20 years of time there where there's a lot of unknowns that are going to happen and the tax rates are very
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very similar. So, it's kind of this thing where you say like what are the odds that all of your assumptions
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actually work in your favor over the next 20 years and would you actually rather pay the tax today waiting 20
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years worth of opportunity costs where you're out the money that you paid today? It's gone. And now in in 20
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years, you're hoping to kind of recoup that money via a 24% savings in the future. That's where Roth conversions
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can get really, really murky. But I'll paint a little bit of a counter picture there. If you're 69 years old today and
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you're going to pay 10% and 12% today on your Roth conversions, knowing that you're going to save 24 or 32% when
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you're 75 years old, I mean, that sounds like a home run. Again, in in that example, there's a 6-year waiting period
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between age 69 and 75 to save something like 20 to 25% even, maybe even more on your taxes. That sounds like it's
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probably a home run. And then the very last thing I'll say before getting into your listener questions, and I think I
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probably addressed this on a previous episode, I do think that Roth conversions are a bit oversold, right?
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They are sometimes pushed too much or just talked about too much. Some people almost speak about Roth conversions the
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same way they speak about getting a driver's license or voting. It's like, of course you're going to do it. Of
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course, you're going to do it. It's just a matter of of reaching the right age, of reaching the right stage in life. You
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have kids, you work your job, you buy the house, you retire, you do your Roth conversions. It's just a matter of
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course. And I think the financial media and the financial services industry, of which I'm a member of both, guilty is
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charged, certainly kind of fan the flames of this conversation. I think instead we need to think of Roth
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conversions as another one of these great examples where we need to let the numbers be our guide. Some of you, many
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of you maybe even will never have a smart opportunity to do Roth conversions. Or perhaps any Roth
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conversion that you do will just be some kind of tiny drop in the bucket of your
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overall portfolio. Or maybe if we approach it from the other angle, from the other side, it's that if you try to
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force Roth conversions into your plan, the numbers would suggest you actually might be worse off for doing so. So
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before getting your questions, I guess just to reiterate that point, Roth conversions are not a universal good.
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They can be great. They have potential to be good, yes, but they also can be neutral or they simply might just not be
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worth your time. They also could be net negative costing you more in taxes and leading to worse after tax outcomes
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leading to worse financial planning outcomes. So they're not as universal certainly not as universal as uh getting
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your driver's license or voting. And that's the preamble. So now let's get to the questions from listeners like you.
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First from Roger. Roger says, "With all the back and forth about Roth conversions, it makes me want to just
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not think about them and not do them. What's the worst that could happen? But seriously, how big of a deal do you
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think it is when a quote unquote good candidate for Roth conversions doesn't do them? So, great question to start us
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off here, Roger. And there's an important reason why I'm starting here. The reason is that, you know, the quote
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unquote best candidates for Roth conversions, the people where the math seems to be an obvious no-brainer, uh,
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are also typically people for whom Roth conversions are simply a cherry on top of their ice cream sundae. A nice extra,
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right? a nice extra tax savings in what is already a sound financial plan. So, let me explain. Let's say a couple is
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married filing jointly. They're 65 years old today. They look at their future social security income, their dividend
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and interest income from their taxable account, their future RMDs when they'll be 75, uh, which is 10 years from now,
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and they realize, wo, we're going to be paying like 35% on our marginal dollars.
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That is so much tax. And this is all federal tax. And to that end, well, they're not wrong. 35% is a pretty high
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tax rate on their marginal dollars. But let's just pause a second because we need to ask, how much income does it
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take to be in the 35% marginal tax bracket? And the answer is for this married filing jointly couple over
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$500,000 in income. Meaning these people have a lot of retirement income cuz remember they're retired. This is all
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retirement income. It's not even W2 income from jobs. So, we also know that a large chunk, probably more than half
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of that amount is coming from their RMD. Social Security, after all, can only be
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so big. And that begs another question. How big do your traditional retirement accounts need to be in order to generate
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some RMD of 300,000 or 350,000 or $400,000? And the answer there is like 8 or 9 or 10 million in size. So, let's
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rewind back to age 65 before this couple has claimed social security before their
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RMD start where the only income they receive is in interest in dividends and they might have lots of space in their
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tax returns for Roth conversions. They are probably a great candidate for Roth conversions, right? Paying a 12% tax
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today in order to prevent a 35% tax in the future. That's wonderful. Or you could even look at through the lens of,
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you know, they're just paying 12% taxes today to lock up those dollars in a Roth
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account forever. You know, you can look at Roth conversions through that lens alone and convince yourself it's a
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pretty smart thing to do. In other words, you could say, "I have no idea what my future tax rate is going to be,
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but I'd happily pay 12% taxes simply to lock dollars in a Roth account forever."
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Okay, that's fine. But going back to Roger's question, if this family never pursued a Roth conversion in their life,
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are they at risk of not fulfilling their retirement dreams? If a family ends up with $10 million in traditional accounts
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alone by the time they're 75, even if you know, again, it's all traditional, it's all pre-tax, are they at risk of
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ruin? Probably not. So, that's my point. This family is a wonderful candidate for
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Roth conversions, they are also in a wonderful position regardless of whether Roth conversions existed or not. To
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them, the Roth conversion is just a cherry on top. Now, they absolutely would be missing out on something pretty
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smart. And from that perspective, what they would be doing if they skipped Roth conversions, skipping Roth conversions
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would be suboptimal, but it's not going to prevent them from summoning up that mountain. So, a financial plan has
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dozens of little knobs to measure and turn and dial in. And Roth conversions are certainly one of them. But you don't
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need to get every single dial perfect in order to have a good retirement. That's
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for sure. In fact, you can make the argument, as I did on some recent episodes about balancing out different
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type of risks in your retirement. You can make the argument that it's impossible to get every single dial
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perfect because sometimes dialing up one thing over here is naturally going to force you to dial something down over
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there. But the point is, if you're comfortable with the concept of Roth conversions, you're comfortable with the
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math, you've convinced yourself that you're a good candidate, Roth conversions certainly are a dial that
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you can and probably should try to hone in to your advantage. Here's a quick ad and then we'll get back to the show. Hey
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listeners, Jesse here. My team and I are preparing for episode 150 of the podcast, which we'll be recording in a
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couple weeks. And we thought it'd be fun to do an ask me anything episode. Many of you know that my normal ask me
00:15:00
anything episodes focus entirely on retirement and financial planning questions. Well, we want episode 150 to
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be a little different. We're going to open it up to just about anything. Ask me anything you want. And I'm not
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slipping down the slope of becoming a self-absorbed influencer, but we figured, you know, once every 150
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episodes or so, it could be fun to share a little more than tax rates and expense
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ratios. So, if you have a question, ask me anything. Simply send an email to [email protected].
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Thank you. So, thank you for the question, Roger. And next question from Nicole, who says, "My husband and I are
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uh Gen X. When we worked, we didn't have Roth 401k options. As a result, we have
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a very substantial portion of our net worth, our portfolio in traditional IAS and traditional 401ks. Everyone says
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doing Roth conversions look great when you're in your low tax years, but given that the vast majority of our retirement
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income will be withdrawals from pre-tax accounts, we'll end up remaining in the 22% tax bracket throughout most of
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retirement until RMDs kick in. Does it ever make sense, Nicole asks, to do micro Roth conversions? So instead of
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converting $50,000 or $100,000 at a time up to the top of a tax bracket, what if
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we just convert $5,000 or $8,000? Convert just enough that it doesn't hurt too much to pay the additional tax on it
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in a given year. And Nicole says on our $2 million pre-tax portfolio, it doesn't
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really seem like a $5,000 conversion here or there will get you anywhere, but I could be wrong if the money compounds
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for 20 or 30 years. So, thanks for the question, Nicole. I I understand where you're coming from, and I'll start by
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saying this. If you're a good candidate for Roth conversions, then doing something is is certainly better than
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doing nothing. And also, you might not really know until you're 75 or 80 or 85 years old. You won't know until then, as
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you're looking backwards to today what the perfect strategy would have been right now, right? In hindsight, looking
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through the rearview mirror, you're going to see perfectly what you should have done. But as we sit here today,
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looking through the windshield, it's very, very foggy. You don't know exactly what today the perfect strategy is. So
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from that point of view, I have heard some pretty smart financial planners say that they do always heir on the side of
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doing too small of Roth conversion. You want to compare two possible sins. Like that's kind of what we're talking about
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here. Would you rather sin too much or too little in your Roth conversion? And if you keep your Roth conversion too
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small and that means that you pay too much tax out in the future. But if you make your Roth conversion too big, that
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means paying too much tax today. And from a time value of money point of view, I'd rather not pay too much tax
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today. Now, personally, I do think there are a couple slippery slopes that you want to avoid here, Nicole. The first
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one goes back to Roger's original question. You certainly could find yourself with quote unquote micro
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conversions that are so small, or at least so small compared to where the math would lead you, right? Where the
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objective size conversion would be, that you're simply underoptimizing. Now, it's
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not a terrible sin, but it's also not ideal. Now, what do I mean there? If your financial plan, if your software or
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if the expert you're talking to advises you to do a $30,000 Roth conversion, let's say he says, "Hey, this is
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optimal." The software says this is optimal, and you choose instead just to do a a micro conversion of $4,000. I
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mean, yeah, you're airing on the side of being too small, but it also sounds like
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you're just not taking the smart advice. But then the other slippery slope that I'd point out here, and I'll likely
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touch on this later in the episode, occurs when someone is outright not a good candidate for Roth conversions at
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all. Maybe they're still working, for example, and they're just earning lots of income, and yet this person tells
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themselves, "Oh, you know what? I just want to do a small Roth conversion this year just to just to say that I could."
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And again, the problem there, of course, is that if you're in your high earning years and you already have tons of
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income, you're only shooting yourself in the foot to do a Roth conversion. And sometimes people will say, "But it's
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just a small one. It's just a small one." And then that's a case where you say the right number for you right now
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is zero. You should do zero Roth conversions in this particular year. And any number greater than zero is
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absolutely a mistake and you shouldn't do it. So again, that's just that slippery slope where people say, "But
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it's just a small one. It's a behavioral slip up." And and I guess that's what I'm saying here. These are behavioral
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slip-ups because we often conflate this micro idea with, "Well, it must be harmless. I won't even feel it. And so,
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while I agree that the the consequences of a small mistake are by definition going to be small consequences, I also
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think it's important to say let's try to not make this mistake in the first place. So, thank you for that question,
00:19:25
Nicole. And the next one is from Gerald. Gerald says, "Jesse, what about wash or
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neutral Roth conversions? I've seen different opinions in various DIYer forums. What are your thoughts?" So,
00:19:36
great question, Gerald. and listeners, uh, let me explain this idea of a wash or a neutral Roth conversion. It refers
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to the idea that someone knows their tax rate won't really be changing. They're simply choosing to pay taxes today at
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say 22% to get the money into Roth rather than paying 22% on some RMD at some point in the future. They are
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knowingly not saving on taxes, but they value having fewer dollars in their traditional IRA and more dollars in
00:20:03
their Roth IRA. And yes, this is where you say, well, objectively there's no objective mathematical tax reason at
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least to do it. But sure, there are some subjective good reasons to think this way. And what I want to do in this
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answer, Gerald, and listeners, is point out some of those subjective reasons. So, at least you know them because I
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really think this is where we're getting to a little bit of gray area and your mileage may vary. So, the first and most
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obvious subjective reason is simple RMD management, required minimum distribution management. Many people
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don't like the idea of being forced to withdraw money from their traditional IAS via RMDs. And many people would say
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that if you're going to force my hand, I'd rather you force it less than more. I'd rather my RMD be only $100,000
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instead of $110,000. And these neutral or wash conversions give you more control over your future RMDs and
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therefore more control over your future taxes. The next reason that sticks out to me is the so-called widows tax trap.
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When one spouse dies, when the first spouse dies, the surviving spouse goes from married filing jointly to a single
00:21:11
filer. Now, if this has happened to you recently or if you know someone this happened to, usually what happens is
00:21:16
that in the year that the first spouse died, the surviving spouse can still file jointly that year. And then the
00:21:23
following year after the first spouse died, that's usually when they're forced to start filing single in case it ever
00:21:29
matters. But what happens, of course, is that it instantly cuts every single tax
00:21:33
bracket in half. And the surviving spouse often maintains approximately the same income. Again, if a lot of this is
00:21:41
RMD income, what'll happen is that now the surviving spouse has all of the IRA income in their name alone, the RMDs
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really haven't changed usually. So a lot of times that same income is kind of thrust or foisted upon the surviving
00:21:54
spouse at higher tax rates and this is the so-called widows tax trap and the logic of doing a neutral or a wash Roth
00:22:03
conversion while both spouses are still alive converting now at the joint tax rate protects the survivor from
00:22:10
converting later at some higher single rates or taking RMDs later at some higher single rates. So again, the
00:22:16
widow's tax trap is one of the reasons why you might want to consider a neutral Roth conversion. The third reason is the
00:22:23
psychological value from certainty. Tax law uncertainty exists. We don't know where future taxes are going to go. So
00:22:30
knowing that your retirement money has already been successfully taxed can remove some anxiety about future tax law
00:22:36
changes. And some people simply uh sleep better at night knowing that they don't
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owe the government any money. they don't own this IRA. That's essentially a deferred liability to the IRS. The next
00:22:48
reason has to do with estate planning. Roth accounts have no RMDs during your lifetime and they don't have any RMDs
00:22:55
even after you pass them on to an heir and that makes them just a cleaner account to pass on. A traditional IRA
00:23:01
left to heirs, it comes with a complex and and sometimes contentious tax liability. Whereas the Roth IRA is just
00:23:08
money that your heirs receive inside of a Roth account, no less. no embedded tax
00:23:12
time bomb, easier to plan around, simpler for executives and heirs to understand what's going on. But to end
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your answer here, Gerald, I do want to push back on something, and that's the idea again that these neutral Roth
00:23:24
conversions, I don't think they're actually neutral. There's certainly not no cost associated with them. Right?
00:23:30
You're thinking to yourself, well, there's no cost. I convert today at 22 instead of paying 22 later. And that is
00:23:35
often how they're discussed. But you are paying an opportunity cost by choosing to pay those taxes today instead of
00:23:42
paying them out in 30 years or 20 years or 10 years. Now obviously 30 years or 20 years or 10 years that timeline makes
00:23:50
a really big difference as far as the time value of money as to how much opportunity cost you're paying. So, if
00:23:55
you are say 50 years old right now and you're thinking about making a neutral Roth conversion, even though you won't
00:24:03
start saving that money until RMD age at 75, those 25 years of opportunity cost,
00:24:08
I think, are really important to consider and might make this neutral Roth conversion pretty bad. But I'll
00:24:15
contrast that and say, you know, if you're 70 years old today and your RMDs are starting in 3 years at age 73 and
00:24:22
you're making a neutral Roth conversion for one of these subjective reasons we just talked about, well, now all of a
00:24:27
sudden you say, well, it's 3 years of opportunity cost. That's not that much. Again, if you throw throw something into
00:24:32
some sort of compound interest calculator, it's also also just not that much uncertainty to deal with. Like you
00:24:37
can feel relatively confident over what the world might look like in 3 years. So, my point is that you can make a much
00:24:43
more clear decision about a neutral Roth conversion in that 70 to 73 example that
00:24:50
you really can't make if you're 50 and you're looking out at age 75. So, just my parting thoughts there, Gerald,
00:24:56
thanks for the question. And we'll go down to the next question from Susan. We've been told that Roth dollars are
00:25:01
better to leave behind for our children as compared to traditional dollars. What
00:25:05
are your thoughts on aggressively pursuing Roth conversions in order to help our children out? Susan, great
00:25:10
question. That's true. Roth dollars are better to leave behind to your children.
00:25:14
Now, why? Well, it's because those dollars won't come out with any tax bill for your kids. Uh when a non-spouse, a
00:25:21
non-spouse inheritor receives your Roth IRA, they do have to empty the account within 10 years, so-called 10-year rule,
00:25:29
but there's no associated tax bill with their future distributions from that inherited Roth IRA. But yet again, we
00:25:36
need to be asking ourselves at what cost? Cuz basically Susan is saying that she is going to prepay the taxes during
00:25:43
her lifetime, thereby preventing any tax bill that her children would otherwise pay because if the kids inherit a
00:25:49
traditional IRA, they must empty it within 10 years as well. But those distributions are taxable to the kids as
00:25:57
income. So that's the way a traditional inherited traditional IRA works. So you do want to be a little bit careful here,
00:26:03
Susan. Anyway, you cut the cake. This is a case of you taking on some pain so that your heirs won't have to. And the
00:26:10
question becomes, I guess, can you afford to take on that pain? Are you putting your retirement at any sort of
00:26:16
risk in order to pay these taxes? And perhaps even before that point, we really want to make sure how much money
00:26:23
are you actually going to be saving your kids? You know, there's a chance that your tax rate as a retiree might be
00:26:30
higher than their tax rate as an heir. So, how much are you actually saving them? It's it's nuanced here. There's a
00:26:36
chance that your tax rate as a retiree might be higher higher than their tax rate as an heir. So, what you might end
00:26:44
up doing here is spending more dollars from your taxable account. Follow me here. You're spending more dollars from
00:26:50
your taxable account to pay the Roth conversion taxes. Right? Roth conversions come with taxes as we know.
00:26:56
How are you going to pay those taxes? With money from your taxable account. That's the smart thing to do. Well, if
00:27:01
you're paying money out of your taxable account to cover a tax bill, that leaves
00:27:05
behind less money in your taxable account. You have fewer taxable dollars to leave to your heirs. So, sure, you've
00:27:11
left them now some Roth dollars instead of some traditional dollars. And and that supposedly is a good thing, but you
00:27:18
would have been better off leaving them a bigger pile of the taxable dollars with which they could have paid taxes on
00:27:25
their inherited IRA distributions at more preferential rates. I do realize as I'm rereading and I just as I was saying
00:27:32
that that out loud, I'm not sure if there's necessarily a better way to explain what I just explained. The point
00:27:38
is it is more complex than simply I'm an heir. Would I rather receive a Roth account or a traditional account? It's
00:27:45
far too simple just to say that inheritors would rather get Roth dollars and therefore that you should convert
00:27:51
more to Roth. There are many realistic scenarios where that strategy would not only make your retirement more difficult
00:27:58
because you're paying you're you're kind of prepaying this tax bill, but it would
00:28:02
also actually leave fewer dollars in your heir's pockets. And you know, you say, well, where does the money go? And
00:28:07
the answer is it goes to the IRS. By prepaying the tax bill here via Roth conversions, you might end up giving
00:28:14
more money to the IRS and fewer less money to your heirs. So, you really want to check your personal tax situation.
00:28:21
And because this is an estate planning question, it actually involves your heirs tax situation, too. You really
00:28:26
want to check this before you go off and execute it. I think the best case scenario here would be where you know
00:28:32
that Roth conversions are really going to help you during your living years, but then incidentally that the Roth
00:28:38
conversions would also be a better way for your heirs to receive assets from you. So, the best case scenario would be
00:28:44
it's that win-win situation. So, thank you for the interesting question there, Susan. Next from Charles. Jesse, is
00:28:50
there a dollar cost average versus lump sum equivalent for Roth conversion? What's your opinion on the strategy
00:28:56
here? Interesting question, Charles. I think the underlying question here has to do with the timing of Roth
00:29:02
conversions. So, first, let me lay down a few fundamentals. First things first, each tax year presents its own unique
00:29:08
opportunity to execute Roth conversions or do any other type of tax planning. The deadline for doing Roth conversions
00:29:13
is December 31st. Now, are there good times or bad times in the year to make Roth conversions? I say so. Yes. Some
00:29:21
people prefer to wait for negative market performance before making a Roth conversion. The core idea is that when
00:29:27
you convert, you pay tax on the current dollar value of the shares, not on what they'll eventually be worth. So, if your
00:29:34
IRA holds, say, $100,000 worth of stock that was actually worth $150,000 6 months ago, you convert that money at
00:29:42
the depressed value, paying tax on $100,000, and then the market recovery happens inside of the Roth account, and
00:29:49
then occurs completely tax-free. You're essentially locking in a lower tax bill on the same number of shares, and the
00:29:56
IRS never gets to participate in the rebound, so to speak, in the market. But we'll come back to this because I'm not
00:30:03
a really big fan of that kind of timing the market, waiting for negative performance strategy because the next
00:30:08
argument is to convert as early in the year as possible. As early in the year as possible. The argument here is that
00:30:16
as you get more dollars into Roth accounts earlier, it'll certainly lead to a better compounded return in the
00:30:21
Roth accounts over time. More Roth dollars, fewer traditional dollars, a better tax situation. So, you just want
00:30:27
to get more money into the market earlier, right? You want to invest early and often as early as possible. So why
00:30:32
wouldn't you want to Roth convert as early as possible. That's the logic there. But having gone through these
00:30:38
conversations many a time, I have serious hesitations about both of those strategies that I just outlined. I have
00:30:44
serious hesitations about waiting for negative market performance. I have serious hesitations about converting as
00:30:50
early in the year as possible. Or at the very least, I think you want to be cautious about using either one of those
00:30:55
strategies. The rationale is that sometimes it can be very hard to predict how the rest of your tax year will
00:31:02
unfold. So let's say you make a big Roth conversion in January early in the year
00:31:07
or maybe there's a big market dip in March and you react to that market dip with a Roth conversion. The problem is
00:31:13
if you get some surprise income in October, you may now be subject to higher taxes than you originally
00:31:20
thought. Or put another way, that Roth conversion that you thought would be a smart tax move ends up being not smart
00:31:26
due to surprise income that you didn't think was coming. You never knew it could have been coming. So, what do I
00:31:32
recommend instead? I recommend you basically wait until the fourth quarter of the year to run your personal Roth
00:31:38
conversion math. Do it in October or November. Figure out all your numbers, how they all look for the year, because
00:31:45
you'll be about 90% of the way through the tax year at that point. And then you say to yourself, well, what are the odds
00:31:51
I get a surprise? Because you still might get a income surprise in some way, but what are the odds I get a surprise
00:31:56
at this point in my year? The risk is that some surprise income kind of comes up in December or something like that.
00:32:03
So, I would just make sure you give yourself at least a couple weeks of wiggle room in December because the
00:32:07
major custodians, the Schwabs, the Fidelities, Vanguard, they do get really busy at the end of the year and you
00:32:13
don't want some logistical hassle to keep you awake at night unsure if your Roth conversion actually went through in
00:32:19
the correct tax year. And now if you follow the strategy that I just outlined, you know that there will be
00:32:25
some times when you look back on the past year and you do wish that you had pulled the trigger in January or in
00:32:30
April or in August or whatever. You you know that there will be times where you have that regret. But you also know that
00:32:37
you're going to be avoiding a pretty big trap. You're going to be avoiding the trap of a regretted conversion where you
00:32:43
converted money early in the year only to realize later that it was not the right move in hindsight. So personally,
00:32:49
I think that avoiding that trap and avoiding that regret from messing up is the better thing to do. And that's why I
00:32:55
recommend waiting toward the fourth quarter of the year to do your Roth conversions. So thank you, Charles, for
00:33:00
that question. And the next question is from Jason. Jesse, I'm reading that you used to be able to undo Roth conversions
00:33:06
in some way. Is that true? Because if I'm thinking about it right, if I do a Roth conversion and then the market
00:33:11
drops, I'll likely be regretting it and want to undo that conversion. Correct, Jason? Thanks for the question. And yes,
00:33:17
you used to be able to undo a Roth conversion. They changed the law with the Tax Cuts and Jobs Act in 2018.
00:33:25
Before that point, before 2018, you could do a tax reccharacterization to retroactively reverse a Roth
00:33:34
conversion. To be totally honest with you, I don't even know how the underlying mechanics works, like if
00:33:38
there was a certain time period. Maybe it was like within the same tax year you were able to convert and then and then
00:33:44
unconvert or something like that. All I know is that you cannot do it anymore. At this point, all Roth conversions are
00:33:50
final and irreversible. And so, going back to Jason's question, I mean, what happens if your portfolio drops 20% the
00:33:57
very day after you execute a Roth conversion? Yeah. What happens is you got hit with some pretty bad luck, plain
00:34:04
and simple, because it means you'll be paying income taxes on the 20% of the conversion that once the market drops is
00:34:11
no longer actually there in your portfolio. you'll pay taxes on a $10,000 conversion even though you're looking at
00:34:17
your account and there's only $8,000 in the account. It's just bad luck. There's
00:34:21
no other way to put it. But similarly, if the market goes up 20% the day after your conversion, you won't be paying
00:34:28
taxes on that big chunk of investment growth. You pay taxes on 10,000 even though the account says 12,000. That's a
00:34:34
stroke of luck. And yeah, this is now definitely an extension of the last question from Charles about the timing
00:34:40
of your Roth conversions. So again, I'll reiterate that logic and explain it a different way. And the different way is
00:34:46
we do not want to attempt to time the market. Now, that's just broad and helpful investment philosophy in
00:34:51
general, but we can certainly apply it here to Roth conversions specifically by admitting to ourselves that sometimes
00:34:57
the market will go up after we convert and sometimes it'll go down after we convert. And that is just the nature of
00:35:03
the beast. Over the long run, it'll average out in our favor. Therefore, the only true timing for Roth conversions
00:35:11
ought to do with the tax aspect of it. Namely, if you do a Roth conversion early in the year, you're facing the
00:35:16
fact that something could occur tax-wise over the next 9, 10, or 11 months, and that'll make you regret the Roth
00:35:22
conversion you did back in January. Whereas, if you delay your conversion until October or November or December,
00:35:28
you're dealing with a lot less uncertainty. Now, at the end of the day, we do not do Roth conversions for
00:35:34
anything having to do with better market performance. It's not that we're trying
00:35:38
to time the market or achieve better returns from our index funds or anything like that. That's not why we do Roth
00:35:44
conversions. Instead, all we're trying to do with Roth conversions is achieve a better after tax result. Therefore, to
00:35:51
do something in your Roth conversions that might jeopardize your tax efficiency or even outright sabotage,
00:35:57
right? And create a net negative damage to your taxes, that is something that we
00:36:02
want to avoid. Here's a quick ad and then we'll get back to the show. Did you know my written blog, The Best Interest,
00:36:09
was nominated for 2022 Personal Finance Blog of the Year, and it's been highlighted in the Wall Street Journal,
00:36:14
Yahoo Finance, and on CNBC. I love writing, especially when that writing is to share financial education. And I
00:36:21
usually write one or two articles per week. You can read them all at bestinterest.blog.
00:36:28
Again, the web address is bestinterest.blog. Check it out. So, thank you for that
00:36:34
great question, Jason. I appreciate it. And next one comes from Diana. And Diana
00:36:39
says, "Hi, Jesse. We're likely going to move in retirement from Minnesota to South Carolina. We're not exactly sure
00:36:44
when we'll make the move, but should I wait on Roth conversions until we figure out where we move?" Thank you, Diana. An
00:36:50
amazing question, and it gives me an excuse to talk about state taxes. Everything I've referred to so far in
00:36:55
this episode has to do with federal taxes, but state taxes really matter, too. listeners, the thought process here
00:37:01
from Diana is that yeah, many states count Roth conversions and other IRA distributions as taxable state income.
00:37:09
Not all do, and that's where you really want to be careful on the state tax side
00:37:13
because many states treat some, if not all, retirement income with special tax rules. Usually, it's lower tax rules
00:37:22
where either some portion of your social security or maybe all of your social security won't be taxable by the state.
00:37:28
some portion of a pension or maybe all of your pension won't be taxable by the state. And same goes with some portion
00:37:34
of your IRA distributions or some portion of a Roth conversion might be taxable or might not be taxable. You
00:37:41
really want to be just prudent and and pay attention when it comes to state taxes and retirement. And Diana here,
00:37:47
the logic makes sense that South Carolina in general does have a lower tax regime than her current state of
00:37:54
Minnesota. So again, her question kind of the logic is, do I want to overpay for my Roth conversion in Minnesota even
00:38:01
knowing in the future I could just wait and kind of underpay or just pay less in
00:38:05
South Carolina? First, what I'm actually going to say, Diana, I crunched the numbers in your actual situation. I
00:38:11
think you'll probably find that the two states are extremely similar. You know, I used what I consider to be a very
00:38:15
typical average American retiree as far as some of the numbers go. And I found that the South Carolina tax is probably
00:38:22
going to save you less than 1% of the total conversion amount. So specifically in my example on a $100,000 Roth
00:38:29
conversion with a couple other minimal retirement income sources, Minnesota charged $6,400 in tax and South Carolina
00:38:37
charges about $6,000 in tax. So just they're very similar is my point, Diana. But let's put a pin in that. Let's put a
00:38:44
pin in Minnesota and South Carolina and instead pivot to maybe a a bigger broader example. Let's compare
00:38:49
California or New York, two notoriously high tax states, versus Florida, a very well-known retirement state for many
00:38:56
reasons, including its 0% income tax. Now, the tax rate difference in this scenario, depending on again how much
00:39:03
income we're actually looking at, the tax rate scenario is going to be somewhere between a 6% tax delta all the
00:39:10
way up to maybe like a 12 or 13% tax delta. And that is the kind of difference, I should say, tax arbitrage,
00:39:16
I guess, here, right? That's the term I've been using all day. So that's just the state tax alone and that's the kind
00:39:21
of difference that really matters because I mean let's think about the federal tax brackets for a minute. The
00:39:26
federal tax brackets here 10% 12% 22 24 32 35 37 now that we know those tax rates a rough rule of thumb and again
00:39:36
just a rule of thumb that gives you direction here is that if you're not getting at least a 10% tax arbitrage in
00:39:42
the federal tax brackets you might want to pause and and really dig into the numbers. If you're getting more than a
00:39:47
10% tax arbitrage, you're probably a pretty good candidate. But if you're getting less, you might want to think
00:39:52
about some of the gray area and some of the subjective stuff we've talked about here. So, if you're converting at 12%
00:39:58
today instead of paying a future rate of 22%, great. You're getting a 10% tax arbitrage likely means you should be
00:40:05
pretty serious and and a good candidate for Roth conversions. And now I explain that because it gives us a good
00:40:10
reference for the possibility that Diana points out here, which is a negative state tax arbitrage. If you believe that
00:40:18
you'll have a federal tax arbitrage of 10% to the good, but then a state tax arbitrage of 6% to the bad, well, boy,
00:40:26
that state tax just took a huge bite out of your potential gain. State taxes can
00:40:31
really, really matter. So again, here I am. I live in New York State, right? I'm
00:40:35
in upstate New York. And if I were doing Roth conversions right now, contemplating the fact that I might move
00:40:40
to a Tennessee or a Florida in retirement, it's really going to matter. The difference between a New York state
00:40:46
income tax and those states income taxes is pretty meaningful. Now, if you're never going to move states, you can
00:40:52
reasonably ignore this idea. Or at the very least, all you need to do really is a much simpler comparison. It's your
00:40:58
personal state tax rate today versus your personal state tax rate in the future. you're paying the same taxes,
00:41:05
the same brackets exist. Your income level might shift and your income level shifting might change your tax rate. But
00:41:11
still, it's pretty easy. But if you are going to move states, especially to a state with a low income tax or with zero
00:41:17
income tax, it's vital you account for that change when you're approaching any sort of tax planning, including Roth
00:41:24
conversion planning. So, thank you for that question, Diana. And that brings us to the final question of the day from
00:41:29
George. George says, "Jesse, I feel like I'm tiptoeing through the proverbial minefield when it comes to Roth
00:41:34
conversions and how they interact with my social security taxes and my Irma taxes." And well, I don't even know
00:41:41
where all the mines are, says George. So, do you have a checklist or something I ought to go through when planning my
00:41:47
Roth conversions? Cool question, George. I intentionally saved it for last. And hopefully listeners, this leaves you off
00:41:53
today with an interesting reminder, a list of interactions that Roth conversions can have in your retirement
00:41:58
plan. And what I think I'm going to do in fact is turn this answer, this checklist that I put together into a
00:42:04
document that you can use. So if that would interest you, just send me an email to jesssee atbinterest.blog.
00:42:10
Maybe you can reference the the Roth conversion checklist from episode 145. And as long as a few of you are
00:42:16
interested, I'll make this thing nice and neat. I'll try to polish it up and then I'll I'll probably just send it out
00:42:21
for free to my full email list, which I suppose actually is a shameless and easy
00:42:25
way for me to plug it right now. Make sure you sign up for my weekly email. You can choose so from the homepage at
00:42:30
bestinterest.blog. And that email list, by the way, is the one and only way that
00:42:34
I get to kind of contact you all on a regular basis. So again, if you want to get the copy of this Roth conversion
00:42:40
checklist, drop me an email and let me know. So let's do the list. I'll go through it. I intentionally kind of made
00:42:45
it choppier. I didn't go into too much detail as I usually do cuz otherwise we might be here for another hour. Instead,
00:42:51
I think this will take us another like 5 minutes. So here's the list, the Roth conversion checklist. First, we have to
00:42:57
do tax rate analysis. And this is very much a core exercise. One, we need to look at our current rate versus our
00:43:03
future marginal rate. You need to estimate your tax bracket now versus when you're in retirement or later in
00:43:08
retirement. The conversion makes sense when today's rate is considerably lower than expected future rates. Two, you
00:43:14
need to look at your tax arbitrage window. You need to identify years where income will be unusually low, which
00:43:20
could be early retirement. It could be from an investment or a business loss. It could be because of a year of really
00:43:25
heavy deductions. and that might be a prime Roth conversion opportunity. Three, the bracket filling strategy. You
00:43:32
need to calculate how much room remains in your current tax bracket and consider
00:43:37
converting only up to the top of your bracket to avoid pushing into a higher bracket. That's not a hard and fast
00:43:44
rule. I will say for just a little bit of more clarity there, you know, if you push to the top of the 10% bracket,
00:43:49
you're probably going to be fine continuing on into the 12% bracket. But the thing you might not want to do is
00:43:55
push beyond the 12% bracket because that uh you end up paying in the 22% bracket.
00:44:00
And that's where you'd say, well, maybe the the conversion no longer makes sense
00:44:03
if you're paying 22%. Anyway, on to number four, state income tax. You want to factor in state tax on the
00:44:09
conversion. As I mentioned earlier, some states offer deductions for retirement income, and that makes today's effective
00:44:16
rate quite a bit higher than the federal rate alone. Is it retirement income? Is
00:44:21
it conversion income? Does the state treat it differently? That can really matter. On to the next core set of
00:44:26
ideas, what I call break even analysis and time horizon. This has to be one of your core parts of your analysis. So
00:44:33
number five on this list, break even analysis. Calculate how many years it takes for the tax-free Roth growth to
00:44:39
offset the upfront tax cost. A shorter remaining investment horizon could mean it's harder to justify. The money that
00:44:46
you use to pay taxes today exits your taxable account permanently and you need to compare the long-term compounding
00:44:53
value of keeping it invested versus the Roth benefit. Number six is future tax law uncertainty. Again, we don't know
00:45:00
how tax rates are going to change in the future. The possibility of a a rate increase strengthens the case for
00:45:06
converting right now. Number seven, state of residence changes. This goes back to Diana's question. If you plan to
00:45:12
move to a no income tax state in retirement, converting now from a high tax state reduces the value of your
00:45:19
conversion. So that gets us through the break even and time horizon tasks. And now maybe this part of the checklist,
00:45:25
we're starting to get into really some of the questions that George, thank you, was asking. So the next section I call
00:45:31
competing uses competing uses of the same tax space. So number eight on our list gets us to tax gain harvesting.
00:45:40
Long-term capital gains and qualified dividends occupy the same bracket space as Roth conversions. Harvesting gains at
00:45:47
0% might be more valuable than a Roth conversion in the same year and you ought to consider it. Number nine, this
00:45:53
one goes out for the business owners. Uh the QBI deduction, the qualified business income deduction, especially I
00:45:59
think it's for self-employed business owners here. So, if you add conversion income into your tax space, it could
00:46:05
reduce your QBI deduction by pushing your income past a phase out threshold, and you want to avoid that. That gets us
00:46:12
to number 10 here, I think, which is just other deduction phase outs in general. Roth conversion income can
00:46:19
phase out deductions like student loan interest deductions, rental real estate loss allowances, and some others. So,
00:46:25
that's where it's good to consult with a professional on that case. The next main
00:46:28
section here I call social security and Medicare. Brings us to number 11 on the list. Social Security taxation bump
00:46:35
zone. Right? Social Security benefits go from not taxable at all to half of them
00:46:41
being taxable up to as much as 85% of them being taxable as income. And Roth conversion income can push you across
00:46:48
these thresholds. And that creates a a effective marginal tax rate much higher than the underlying income tax rate.
00:46:56
That's a weird concept. it probably deserves like 30 seconds of explanation. So, the idea is that you can run into
00:47:02
these situations where you do a Roth conversion and you know, oh, of course, the Roth conversion is at 12%, so I'm
00:47:08
just paying a 12% tax. Well, sure, the $1 you just converted, you pay 12% tax on that. But what you don't realize is
00:47:15
that the $1 you just converted also means that one of your social security dollars that was previously untacked is
00:47:22
now going to be taxed. So yeah, you pay 12 cents of tax on the dollar you converted and now maybe you also owe 12
00:47:30
cents of tax on the previously untaxed social security dollar. So they call that the the social security bump zone
00:47:36
and it's certainly something you want to be aware of when you're doing any kind of tax planning. Next on our list, and
00:47:41
I'm kind of forgetting the numbers, so I'm just going to start skipping the numbers. What is this? Number 12, maybe
00:47:45
Irma searchcharges. So Medicare parts B and D, those premiums can jump up due to
00:47:51
the Irma searchcharge at particular income thresholds based on your tax return from two years prior, which is
00:47:58
why Irma planning, it's a small thing, but it's also an annoying thing. It kind of sticks in people's sides in a
00:48:04
frustrating way. A large Roth conversion could trigger Irma search charges that cost hundreds of dollars per month per
00:48:11
person in your relationship. So you want to be aware of Irma. Next on the list is
00:48:15
the net investment income tax, NIIT. Roth conversion income itself is not subject to the NIIT, but Roth
00:48:23
conversions raise your modified adjusted gross income, which pushes investment income or can push investment income
00:48:30
above the NIIT threshold, triggering a new 3.8% tax for you to think about. The next section on this list is the payment
00:48:38
of taxes itself. Because again, Roth conversions cause taxes and you want to try to pay those taxes from outside
00:48:45
money. If you're using the IRA money itself to pay for the conversion tax, it often negates much of the benefit of the
00:48:54
conversion in the first place. The conversion is most powerful when the taxes are paid from an outside taxable
00:49:00
account. The next item on the checklist is withholding, tax withholding, and estimated payments. Conversion income
00:49:07
typically is not subject to automatic withholding. Again, you don't really want to withhold taxes. You you just
00:49:13
want to convert the whole amount. You want the whole dollar amount to end up in your Roth account. You don't want to
00:49:18
withhold taxes from it. But that means you might have to make estimated tax payments or adjust your W4 withholding
00:49:24
to avoid an underpayment penalty when you do your taxes. You also want to be aware of the timing and the rules around
00:49:31
Roth conversions. You have to think about the age of the account, the five-year rules. You know, Roth
00:49:35
conversions each start their own unique 5-year clock for penalty-free access of the converted principal. You also want
00:49:41
to be aware of the 5-year rule. The first Roth account you ever open has to be at least 5 years old before you start
00:49:46
taking money out. And then, of course, you have to think about age 59 and a half, like all IRA accounts. Next, you
00:49:52
want to think about your RMD years. Once RMDs begin, age 73, age 75, well, you have to take the RMD. You cannot convert
00:50:00
the RMD. The RMD has to be distributed first. If you're doing conversions in RMD years, which not many people are,
00:50:08
you certainly want to plan carefully there. Next, you want to think about the year of death and estate timing. If your
00:50:14
spouse or if an heir will inherit a traditional IRA and they face their own high tax bracket, well, in that case,
00:50:21
pre-death conversions might be more efficient for the overall estate. And that actually brings us to more estate
00:50:27
and beneficiary planning topics. You want to think about the 10-year rule for non-spouse heirs. Non-spouse
00:50:32
beneficiaries must empty inherited IAS within 10 years. As we already talked about here, if the heirs will be in high
00:50:38
brackets during that window, converting during your life will reduce their tax burden. You also want to think about
00:50:44
charitable giving plans. If you plan to donate IRA assets via qualified charitable distributions, QCDs, those
00:50:51
dollars pass taxfree anyway, and converting them just kind of wastes some money on taxes that you might not
00:50:58
otherwise need to do. You also want to think about estate tax exposure. Uh, and this, you know, goes out to a minimal
00:51:04
number of you, but if you have a very, very large estate above federal or state exemption thresholds, you might benefit
00:51:12
from simply reducing IRA balances via conversions to just shrink the size of your taxable estate. So again, that's a
00:51:20
a niche corner case that you probably want to talk to a trust and estate attorney and a and a CFP or some sort of
00:51:27
expert uh uh financial planner before you make a move like that. Uh and then last we have healthc care and financial
00:51:34
aid. The last things to think about before doing a Roth conversion uh cuz these can be pretty big. You certainly
00:51:40
want to think about ACA premium tax credits. If you are premedicare, if you're under age 65, if you're buying
00:51:46
healthcare coverage on the ACA exchange, your Roth conversion raises your modified adjusted gross income and can
00:51:53
reduce or eliminate your premium tax credit, which is not something that you want to have happen. If you have kids,
00:51:58
you want to think about college financial aid cuz conversion income appears as parental income on student
00:52:05
aid applications and can reduce your student age eligibility. Uh, and then last, you want to think about Medicaid
00:52:11
and long-term care planning. In some states, IRA balances are counted differently for Medicaid eligibility,
00:52:18
and converting can affect kind of your your Medicaid eligibility and your long-term care planning. So, that's the
00:52:25
list. Like I said, if I miss something on that list, please let me know. If you want a copy of this list or simply if
00:52:31
you want me to polish it up and get it in a ready-made document, just drop me an email to [email protected].
00:52:36
And that is a wrap for this episode. I'm sure there are some great Roth conversion questions that I didn't
00:52:42
address today, but the goal here was to expose you all to just some different good thoughts on the trade-offs around
00:52:48
Roth conversions. Ideally, building up your kind of personal repertoire for how you approach the question and giving you
00:52:54
some more things to chew on in terms of both the benefits and also the costs or the hidden traps of Roth conversions.
00:53:00
Thank you as always for listening to Personal Finance for long-term investors. Thanks for tuning in to this
00:53:06
episode of Personal Finance for Long-Term Investors. If you have a question for Jesse to answer on a future
00:53:12
episode, send him an email over at his blog, The Bestin Interest. His email address is [email protected].
00:53:19
Again, that's jessevestinterest.blog. Did you enjoy the show? Subscribe, rate, and review the podcast wherever you
00:53:27
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00:53:34
on the next episode of Personal Finance for Long-Term Investors. Personal Finance for Long-Term Investors is a
00:53:40
personal podcast meant for education and entertainment. It should not be taken as
00:53:45
financial advice and it's not prescriptive of your financial situation.