Listen to every episode on demand on our radio show archive page. Please note: Some of the events referenced in our audio archives have already passed.
“The Roth Launcher”
James Lange, CPA/Attorney
Special Guest: Steve Kohman, CPA, CSEP, CSRP
|Click to hear MP3 of this show|
- Introduction of Guest, Steve Kohman, CPA, CSEP, CSRP
- Background and Basic Assumptions of Roth IRA Conversions
- Strategies to Enhance the Benefits of Roth IRA Conversions
- Caller Q&A: Converting 401(k)s and/or IRAs to Roth IRAs
Nicole: Hello, and welcome to the Lange Money Hour, Where Smart Money Talks. I’m Nicole DeMartino, and today, we’re going to be talking with Steve Kohman. I’ll give you a little bit on his background in just a minute, but he’s going to be sharing with us tonight his newest epiphany on Roth IRA conversions, so we’re certainly excited about that. We’re also excited because tonight’s show is live and the phone lines are open as of right now, so feel free to call and ask the experts your questions. The phone number is 412-333-9385. So, before we get started, let me make my introductions for tonight. As always, I’m here with Jim Lange, Pittsburgh-based CPA and Attorney and best-selling author of “Retire Secure! Pay Taxes Later.” Also sitting here with me is another member of the Lange team, Steve Kohman. Steve obtained his Certified Public Accountant designation back in 1984, and that’s hard to believe that’s over 25 years ago, my goodness, and he’s a certified specialist in estate planning, as well. Steve is the leading Roth IRA planner in our office, and was a large contributor to our book, “Retire Secure!” He’s also the co-author of the article “The Roth’s Real Advantage,” which was published in May of 2000 in “Financial Planning” magazine, and that article won the CFP Board 2001 Article Award. So welcome Steve, and I think, Jim, you had some things to add?
Steve: Thanks, Nicole.
Jim: Yeah, Nicole, that’s a very nice introduction for Steve, but it doesn’t really cover the depth of his expertise. Steve is literally one of the top Roth IRA experts in the country. Both books, all the articles that I’ve done, Steve has done the quantitative analysis for that work, and really, is kind of like, in a way, the backbone of that information, because even though I’m, in effect, maybe the public face for a lot of this, Steve has done all the calculations, in fact, all the new calculations that we’re gonna talk about regarding Roth IRA conversions, Steve is the person who did the analysis. And he’s been with us, for how long?
Steve: It’s been over 16 years.
Jim: Oh my God.
Steve: Thanks for all the accolades, Jim. It’s been wonderful, and hopefully tonight, I can share many of the benefits of the Roth conversion with our listeners.
Jim: Alright, well, Steve, your idea, which I loved, is a terrific idea, and I do want to relate that to our listeners, but I think before we do that, I think that we should give them a little background first.
Jim:And particularly, since we’re on at a new time, we have a lot of new listeners who have never heard some of the intricacies of the Roth IRA conversions, or even some of the basic information. What I’d like to start with is for years, you had done projections and I had presented those projections at workshops all over the country. I included those in my peer-reviewed book. But, now we have some new tax laws, that is, we have two tax increases that have already passed. These aren’t theoretical. These are two tax increases that are going to happen, the first one in 2011 and the second one in 2013, and, if you recall, I said, “Hey Steve, now that we have these new tax laws, the Roth IRA conversion is going to be even more favorable because it gives people a chance to pay tax at today’s rates and save taxes in higher future rates.” So, I was wondering if we could go through a little bit of the advantages to, let’s say, a high income tax payer if they were to make, say, a $100,000 Roth IRA conversion in 2010. So, let’s assume that you have somebody at a high tax rate, and they and/or their family will always be at a high tax rate, and they make a $100,000 Roth IRA conversion in 2010, and before we get into any of your fancy strategies, why don’t we just do a straightforward analysis of what will happen, how much better off will that taxpayer be, let’s say, over the next twenty years?
Steve: Yeah, and it’s also important to know that this is the first year that high income taxpayers can do Roth conversions too, so that was another tax law that’s been recently passed that’s impacting 2010.
Jim: That’s actually a huge point to think about, because up to now, there has not been even a possibility for high income taxpayers to make a Roth IRA conversion, and now, this is the first year. So, for a lot of people, it’s now a possibility, when before it was not.
Steve: Right so we’ve done some calculations that show that the Roth IRA owner themselves, over their lifetime from a $100,000 conversion could be better off by over $93,000 using our basic assumptions.
Jim: And how many years? So, they do the conversion now, how long will it take?
Steve: Let’s say if they did it when they were age 65, and this is by age 85, so 20 years, so that’s almost double the amount you converted as a benefit. And that’s just during the IRA owner’s lifetime. What frequently happens is the benefits inure to the children and the grandchildren of the IRA owner…
Jim: Alright, let’s take that for a second. So, we have somebody who makes a $100,000 Roth IRA conversion. They, themselves, 20 years from now, are $93,000 better off. Since I always, usually, recommend that you spend your after-tax dollars first, your IRA dollars next and your Roth dollars last, then, let’s say they die with the Roth dollars. So, what is the impact on their children of them dying with the Roth dollars versus somebody in an identical situation who doesn’t make the Roth IRA conversion? How much better off will the children be?
Steve: Well, the child has a lot longer timeframe to reap the benefits of tax-free growth, and it turns out, using the same assumptions, that the child ends up being over $890,000 better off over their lifetime, which is another 30 years or so beyond the death of the IRA owner, because of their younger age and longer life expectancy.
Jim: So, we’re getting at least another 50 years of tax-free growth. What if instead of naming an adult child as the beneficiary, what if you named a very young beneficiary? What would the impact of, or even a 25 year old, let’s say, a grandchild, what is the impact of the Roth IRA conversion for a, then you make the conversion…
Jim: …you live 20 years, you die and you leave it to a grandchild, what’s the impact on that grandchild?
Steve: Well, they have even longer life expectancies, so they get many more years of compound tax-free growth, and the amount they’ll be better off than if they hadn’t done the conversion would be over $12,000,000 during the life of the grandchild, and all this from a $100,000 Roth conversion. It’s fair to say that those numbers are in today’s actual dollars, or in future actual dollars, and we need to account for inflation and the effect of inflation, but even when you take inflation into account, the grandchild could be better off by over $1.1 million over their lifetime from a $100,000 conversion today, which is eleven times the conversion amount. So, with that logic, you’ll think, “Oh, well, if that’s from a $100,000 conversion, what would the benefit be for a $200,000 Roth conversion?” It would be twice as much. And so, the benefits for the children and grandchildren can be staggering under the right conditions, where they let the tax-free Roth grow over their entire lifetimes.
Jim: Or, what if some of the high net worth listeners, what if they made a $1,000,000 conversion? Would they literally be ten times better off, and what are some of those numbers?
Steve: Yeah, they would be. The owner themselves would be better off by close to $1,000,000 themselves, and in today’s dollars, that’s over half a million dollars better off over their own twenty year lifespan, the child, over their lifespan, on top of that ends up being better off by almost $9,000,000, which in today’s dollars is over $2.3 million when we account for inflation, and the grandchild, over their lifetime, would be better off by a staggering $122,000,000, which even accounting for inflation ends up being over $11,000,000. And so, it’s really, really a big advantage for high income taxpayers to take advantage of tax-free growth, because of the increase in taxes we’re gonna face during their lifetimes, which are going to actually start hitting the books next year when the tax rates go up.
Jim: Well, I know that you have run these numbers before, or you’ve made these financial projections before, and the benefits were not nearly as powerful as the numbers that you just gave. Is that because of future tax increases that of locking in at today’s rates why 2010 is such an important year to do a Roth IRA conversion?
Steve: Yeah, that and the fact that we haven’t assumed that it’s the top income taxpayers that are doing the conversion. Remember, with the new tax laws, the high income taxpayers are the ones that get hit with higher rates, not the lower or middle income taxpayers. So, for example, the top tax rates’s going to be 39.6% starting in 2011 rather than 35% this year, and then, there’s that surtax that’s going to be added on in 2013, and it really makes for a huge tax increase, and so the advantage of it all being tax-free becomes that much better.
Jim: Right, so, let’s say you’re subject to the surtax too, so then, you are, in effect, locking in at 35% to save tax at what will be 43.4%. Is that right?
Steve: Yeah, actually, that’s right. Good math there, Jim.
Jim: Okay. I’ve actually memorized that one. That’s a pretty easy one. And by the way, we will take calls, but I do want to talk about the new strategy before we do take the calls. Alright, Steve, we have, in our office, often recommended a strategy to even enhance the benefits of Roth IRA conversions that involves separating your IRAs into multiple IRAs. Before we get into your specific epiphany, can we give the listeners, let’s say, a couple of basic ideas on why we would want to bother separating the accounts, and then also a description of recharacterizing, or undoing a Roth IRA conversion?
Steve: Yeah. I suppose our strategy is in realization of the recharacterization rules which allow you to undo your Roth IRA conversion.
Jim: Alright. Why would you want to undo, if this Roth IRA conversion is so wonderful, and, you know, you’re gonna be hundreds of thousands, and your family eventually millions of dollars better off, why would you want to do it and then undo it, and I think the technical word for that is recharacterize?
Steve: Yeah, recharacterize back to a traditional IRA. Well, traditionally, this is done because people did Roth IRA conversions, but there was a limit on their adjusted growth income to be eligible to do that, and they had to have a way out if they did it and then found out they weren’t allowed to have done it. So, they made this law that says, well, you can undo your Roth conversion, and then there was another factor which was the internet stock bubble that occurred after 1998, I guess it was after that that the stock prices went way down, and so people that had done, say, $100,000 conversions ended up having an account only worth $50,000 or even less, and then they had to pay tax on $100,000, and that was actually more than, or close to, what the whole account was worth. So, they really didn’t get much out of it, so they really wanted to undo it if they had done one in the first place.
Jim: Alright, well, don’t we have the equivalent of that now? Let’s say that you made a Roth IRA conversion sometime in 2009, and let’s say the value went way down. Would it be a reasonable thing to want to recharacterize, or undo, that conversion?
Steve: Sure. If you did it and you could pay the same tax rate in 2010 on the conversion, and let’s say it was $100,000 and it went down to $50,000, and your tax rate was 30%, you’d pay $30,000 in tax, but if you undid it and redid it in 2010, you’d only pay $15,000 in tax, so when the stock market’s lower, it’s a better time to do a conversion and you can undo your old ones done when the prices were inflated and redo it later in another year when they’re lower.
Jim: Alright, and what is the deadline for recharacterizing a Roth IRA conversion?
Steve: Well, technically, it’s by the time you file your tax return for the conversion year, but there’s a special rule that allows you to take advantage of doing it as late as October 15th of the year after you do the conversion, which is the extended due date of a tax return.
Jim: Alright, so if somebody makes a Roth IRA conversion in calendar year 2010, let’s say somebody, one of our listeners or, preferably, many of our listeners, say, “Wow, this Roth IRA conversion’s gonna be unbelievable. I’m gonna go hear Jim Lange’s workshop on Roth IRA conversions.” They hear the workshop, they develop a strategy, and they, let’s say, they make a $100,000 Roth IRA conversion in, let’s say, July 2010, and then, unfortunately, the investment that they picked didn’t do so well. So now, it’s October 2011. Is that the time they can, in effect, undo? Is that the latest that they can undo or recharacterize the Roth IRA conversion, because nobody wants to pay tax on $100,000 and only be left with a $50,000 conversion?
Steve: Yeah, I would try to get it done before October, just because I don’t like waiting until the deadlines because of the paperwork sometimes takes longer than you think it does, but yeah, October 15th, you wanna see that money move back. Otherwise, you’re stuck paying the taxes.
Nicole: We do need to take a break. We’ll be back in ninety seconds. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole:We’re back, and we’re certainly talking smart money here this evening with Jim Lange and Steve Kohman from the Lange Financial Group in Squirrel Hill.
Jim: Well, Steve, we were talking about the strategy that we use for some of our particularly high net worth or people who have substantial IRAs of, in effect, taking advantage of the recharacterization where we recommend a division of the IRAs before we make a Roth IRA conversion. Could you tell us a little bit about why you would take, let’s say, one Roth IRA and, let’s pick a nice, even number like $1,000,000, and why you would put that into ten separate IRAs and then make a conversion?
Steve: Yeah, for example, what you might want to do is you might want to end up with a Roth IRA that grows more in the first year than your overall investment portfolio would grow, and you would be able to get more out of the Roth IRA’s tax-free growth during that first year you have hindsight. If you divide the account into multiple Roth IRA accounts, and then invest them differently so that some of them go up in value more than the others, and although, overall, it might be a well diversified portfolio and we stick to that overall philosophy, the individual components of a well diversified portfolio have components that do differently. Some do well, some do less well, and what you want to do is you want to be able to pick the ones that did the best and keep those in the Roth, and turn the other ones back into a traditional IRA. So, the basic strategy is to convert enough that you actually maybe convert more than you really want to so that you can keep the Roth IRA accounts and end up with their proper conversion level, and then the rest of the Roth IRAs, you can recharacterize back and not pay tax on.
Jim: Well, you know what that sounds like a little bit to me? It sounds like going to the horse track, betting on all the horses, every single one, and then, one of them is gonna be a winner and you get to keep that one, but the track will let you take back all the losers. That sounds like a pretty good deal.
Steve: That sounds like a great deal, and I don’t think that the horse track would make much money if you did that, but that’s essentially a good analysis. You get to keep the winning bets.
Jim: Well, in this case, you’re right. The owner of the horse track would have more good sense than to allow that, but perhaps our government does not, because when it really comes down to it, isn’t it true that it is, in effect, a zero sum game. So, if you are up hundreds of thousands or your family is up millions of dollars, isn’t it also true that that’s how much worse off the government is?
Steve: Well, I’m not so sure that it’s the government that loses the money. It’s the accounts that go back in the traditional IRA, but in a way, the government will never collect the tax on the growth because it didn’t grow as much as the Roth did, and the Roth’s growth is tax-free, so the government loses out on their long run amount of tax that they get.
Jim: Alright, so, I think we’ve set the stage that Roth IRA conversions, in general, are good. We have this, let’s say, sophisticated strategy of separating multiple IRAs starting with, let’s say, one large IRA, separating them into different accounts, making a Roth IRA conversion of all those accounts, and keeping the ones that do the best and recharacterizing the ones that do the least. Could you tell me a little bit about the new strategy that you are adding to this general strategy?
Steve: Yeah, our basic Roth conversion analysis that we do for people compares the amount of tax you pay on a conversion to the ultimate tax rate that would be paid on the IRA withdrawals if you hadn’t done the conversion. So this tax rate on the conversion is very important, and for people who aren’t necessarily in the top tax bracket, they might pay a higher tax when they do a Roth conversion than their ultimate tax rate is, because tax rates are graduated and they go up, for example. A common situation is for someone to be in the 25% tax bracket in the long run, but if they do a large conversion this year, they would pay 33% tax on some of the conversion money, because it bumps up their tax rate. The ordinary idea for a lot of people is, “Well, I don’t necessarily want to pay 33% tax when I do a conversion if I’m only gonna be paying 25% tax later in life.” So, this strategy actually overcomes that problem and allows you to realize that you didn’t pay 33% tax on your Roth conversion. You may have only paid, in this calculation, 25.4% tax on the value of the Roth conversion. Let’s take an example where you want to do $100,000 worth of Roth conversion, and you would pay 33% tax on that conversion, but later in life, you’d only be in the 25% tax bracket. Let’s say you use our strategy where you break it into multiple accounts, and some of them go up and some of them go down, so that, overall, your portfolio doesn’t make any money at all, but you picked a couple of funds that actually did well in the one year’s time, and say, those two funds, whether they were, you know, small cap or the international fund, or the bond fund, or whatever they were, they went up, say, 30% in this one year’s time while maybe the other funds went down a little bit and, overall, you didn’t make anything. So what you’re left with at the end of the year is a Roth IRA that’s worth $130,000, but you did a $100,000 Roth conversion. And so, you’re paying, let’s say, $33,000 tax which is 33%, and you’re left with $130,000 Roth IRA after a year. Overall, your portfolio didn’t make any money, so really, you shouldn’t have made anything, but you made $30,000 because you cherry picked and kept the winners in the Roth. So, when you divide $33,000 by $130,000, you get 25.4% tax after a year’s time, and that’s a heck of a lot less than 33%, and it’s approximately what your long term tax rate of 25% is gonna be, so it makes you realize, it was an epiphany for me to realize that, “Oh, these people can actually do more Roth conversions than they think they should. They can convert a lot more, and if they’re able to cherry pick the winners, they can be left with a lot bigger Roth IRA for the same tax dollars.”
Jim: Alright, so, if we were to quantify that for our listeners, that alone was an $8,000 savings. And if you think about how hard people have to work to make $8,000, and here, they just, more or less, did it with a little bit of paperwork. That sounds like a pretty impressive gain for not a lot of extra work on their part.
Steve: Right. You can look at it as an $8,000 gain today, but when you think about the fact that, “Oh, I could convert $200,000 instead of $100,000,” well, in the long run, your grandkid might be better off by $2,000,000 rather than $1,000,000. So, the amount of Roth conversion makes a big difference for your children and grandchildren and the more, the better for them, because their benefits are so much larger than what your benefits might be in your lifetime.
Jim: Alright, now, I have another question about this strategy. So basically, we want to do multiple Roth IRA conversions, keep the ones that do the best, recharacterize the ones that don’t do the best, and then we can actually do better in terms of the tax rate that we pay and we can actually make more Roth IRA conversions. Let me ask you this. I can picture somebody driving their car or listening right now will say, “Boy, they separate into ten different accounts, that’s gonna be a lot of extra paperwork. Why can’t I just do it in one account, and then, in the one account, I’ll recharacterize within that account.” Can you do that?
Steve: No, unfortunately, you can’t. There’s specific rules on recharacterizations in the IRS codes which say that what you have to do, if you have one account, is take the overall growth in that one account, determine the gain from the time you did the conversion to the time you recharacterize it, and recharacterize that dollar amount back to your traditional IRA. So, if overall, your account didn’t grow, but inside of it, a couple of funds went up, you can’t just say “I’m gonna keep those.” They have to be allocated with the ones that lose, so you really didn’t gain anything by keeping it all in one account.
Jim: I see. So, it really does make sense. Now, let’s say that you had a $10,000 IRA. Do you think it’s worth chopping it into ten different $1,000 accounts, or is that just too much paperwork for not enough gain, or is that something that the listeners themselves have to decide?
Steve: Well, they have to decide for themselves if they want to do that. I mean, it wouldn’t make sense to pay somebody to do it, because that’s a lot of paperwork, but I mean, even if you’re a do-it-yourselfer on a small scale, I mean, it might make sense to do that, but I prefer to work with the larger ones that have potential for larger conversion amounts. So, it might make sense, but most clients, they wouldn’t really want to follow the ten different accounts, fill out all the paperwork, fill out all the beneficiary designation forms for real small amounts. I don’t know where to draw the line for everybody. You have to decide for it yourselves. But, you do have to fill out new account applications, get statements for the ten different accounts if you want to use that many. There’s no set limit. So, there’s more paperwork to fill out, but when you think about the potential benefits and how much you can save in the long run, and how much better off your children and grandchildren could be, it would be worth it or maybe only putting up with it for a year’s time.
Nicole: Jim, before you go on, I just want to remind our listeners out there that the lines are open. If you have a question for Jim or Steve or both of them, feel free to give us a call. The studio line is 412-333-9385.
Jim: Okay, Steve, that sounds like a tremendous strategy, because you’re getting, in effect, a lot more Roth IRA conversion or a lot more value for your money. Can we talk about some of the other sophisticated strategies that we have used in our office? And one of the things that we sometimes do is we help the clients make a Roth IRA conversion with non-deductible, or after-tax, dollars. So, for example, we have a lot of Westinghouse employees and a lot of people who have been in the workforce for quite a long time, and they have a combination of two different types of money that I would say, conceptually, are pretty much the same thing. One is that they have non-deductible IRAs, that is, when they were putting in $2,000 contributions, but their income was too high, they weren’t allowed to make those deductible IRAs, so they made non-deductible IRAs. And by the way, that’s still happening right now, and for people whose income is too high to make a Roth IRA conversion, I routinely recommend non-deductible IRAs, and that’s money that grows income tax deferred. You don’t get a tax deduction, and then, when you eventually withdraw the money, part of it is taxable, which is the growth part, and the return of capital is not. But, people have after-tax dollars inside their IRAs and retirement plans, and non-deductible IRAs. Can you tell us a little bit about some of the strategies that we are employing to help people make Roth IRA conversions without having to pay the tax?
Steve: Sure. It actually follows the same logic that we look at with all our clients when we do a Roth IRA conversion analysis, which gets down to, well, one of the main factors is comparing the tax rate on the conversion to the ultimate tax rate that would be paid if you didn’t do a conversion. And what having basis in your IRA does, which is what the non-deductible contributions are, it’s basis in your IRA, is it makes the tax lower on the amount you convert to a Roth IRA. And so, if your tax rate is 33%, but 10% of your Roth is tax-free, then your tax rate’s gonna be 29.7% instead of 33%. So, it lowers the actual tax you pay on the conversion, and therefore, it might make you more comfortable doing a larger Roth conversion. The idea of contributing to a traditional IRA when you’re not allowed to deduct, it is a good idea, like you mentioned, that traditional IRAs, a lot of people can’t deduct traditional IRA contributions because their income’s too high and they’re covered by a retirement plan at work, so it makes a lot of sense to continue those contributions and then use that for Roth IRA conversions later.
Jim: The idea of paying less taxes is terrific, but what if you have some after-tax dollars inside an IRA or retirement plan, but you don’t want to pay anything in taxes. Is that ever a possibility?
Steve: A sophisticated strategy could be used in many cases. It involves rolling over all your IRAs into a retirement plan. A retirement plan being a qualified plan, like a 401(k) at work or a 403(b) at work, although it’s important to know it’s not allowed to be done with an SEP because that’s considered to be an IRA. So, when you roll over your IRA money into a retirement plan, there’s a filter that the IRS has created for us. This allows you from putting your after-tax contributions into the retirement plan. So, what you’re left with in the IRA after you do that is an IRA made up of entirely basis, and if that’s all that’s in your IRA, and you do a Roth conversion, you don’t have to pay any tax on it at all.
Jim: Well, that sounds like a pretty cool thing. So, you’re talking about the possibility of making a Roth IRA conversion without paying the tax. You’ve also talked about a pretty sophisticated technique of doing a series of conversions and recharacterizations. Could you tell the listeners a little bit about what you might typically do with a client that comes to our office and is interested in coming up with a master plan, if you will, or a series of long-term projections, and whether you only think about Roth IRA conversions or whether you incorporate other issues when you do this type of analysis?
Steve: Yeah, I’ll tell you a little bit about the way it works when I meet with a client to do a Roth conversion plan. The first thing I do is I try to get an understanding of how much the client knows about the benefits and costs of doing a Roth IRA conversion, and spend a little bit of time showing them, maybe, some charts and some analysis in the book “Retire Secure!,” finding out and telling them what the benefits are if they don’t know, and so, maybe a little education session at first, and then I spend some time gathering information about the client. I find out about their financial accounts, how much they have, find out about their family situation, how much their children have, what they earn, where they live, state income tax often plays a big role in the Roth IRA conversion analysis. For example, in a state like California, they pay a really high income tax rate on Roth conversions, whereas in Pennsylvania, you don’t. And so, I spend some time gathering information about the client, what their income level is, what their spending needs are over the rest of their lifetimes, whether they have any major financial plans of income or expense they are planning on having, and then the next part is to actually get into the details and determine how much tax they would pay when they did a Roth conversion in 2010. And I use our tax software and I use a specific Roth conversion analysis worksheet that we’ve developed that shows how much tax they pay on a Roth conversion in total and on different levels of Roth conversion, and then I break it into increments as to how much tax they pay on different increments of the Roth conversion. So, I get pretty into the numbers when I do that, but it’s very important to know how much to convert to a Roth and when to do it. So, then the meeting leads into a detailed and inclusive analysis to draw a conclusion on how much to convert and when, and whether it makes sense to do conversions in future years, so that it’s determined for 2010 and possibly future years.
Jim: I want to keep going, but I think we have to take another break.
Nicole: We do have to take a short break. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back to the Lange Money Hour. We are here with Jim Lange and Steve Kohman, and I don’t know, Jim, I do see a caller here. Do you want to take the call?
Jim: Let’s take the call in one minute, because I wanted Steve to finish a point. By the way, the radio archive is a treasure chest.
Nicole: It is.
Jim: We have the top Roth IRA experts in the country giving their best opinions, and we have a little description of each show, and that is a wonderful resource for listeners. Steve, before we take the call, I want to ask one more question about when you see people. You gave a pretty good description of what you do regarding Roth IRA conversions. In the real world, people have a lot more concerns than just their Roth IRA conversions. For example, it might be appropriate to get life insurance. It might be appropriate to buy a house or not buy a house or buy a car or not buy a car. Could you tell our listeners what else you do besides Roth IRA conversions when you have these types of meetings?
Steve: Sure. We also offer a service that involves long-term lifetime financial projections that deal with all those issues you mentioned, and shows clients how much money they have left at the end of each year going out over the rest of their lifetime. We can incorporate assumptions on spending levels and gifting levels, charitable contributions, insurance, life insurance and unusual purchases like you mentioned.
Jim: Yeah, and by the way, I’ll mention something for our listeners, because I go all over the country training financial advisors and talking to them, and I would say of all the thousands of advisors that I have addressed, and I’ve talked to many of them afterwards, I don’t really think there’s a really comparable service, because what you’re really talking about is a 25-year veteran who really knows his stuff at a very, very high level, taking a very in-depth look at somebody’s personal finances and what’s going on in their lives, and making some recommendations. So, I really applaud you for being able to do it.
Steve: Yeah, there are different needs clients have. Some clients, maybe I’ll say on the low-end, although they’re quite wealthy people, maybe they’re concerned about how much money they can actually spend the rest of their lifetime. Can they afford to go on multiple vacations around the world every year? How much money can they really comfortably spend and not worry about running out of money? Other clients, maybe they’re interested in how much can they gift to their grandkids ever year. Maybe they have a lot of grandkids. It could be a huge number. Maybe some clients are worried about being able to provide the most they can for their children and grandchildren when they’re gone. And so, there’s different needs that different clients have, and when you get into learning about their situation, you’ll find that each client’s different and has different needs that we can address in the projection process.
Nicole: Alright, well, it looks like we do have someone, we have a caller here, and let’s take Bob from Bethel Park. Bob, are you on the line?
Bob: Yes, I am.
Nicole: How are you this evening?
Bob: Very good, thank you.
Bob: The weather’s a little dicey, but I think I’ll get home safe.
Nicole: That’s what we hear. What is your question?
Bob: My question is this. I’m in my mid-fifties right now, and there was actually a topic that I think Steve touched on, 401(k) conversions to the Roth. I’ll be honest with you, gentlemen, I’ve listened to the show here and I really made my first priority each year now to make my contribution to the Roth before I go to the 401(k). I’m not independently wealthy, by any stretch, but as I get closer to that retirement age, hopefully, I was curious as to what would be the strategy once you decide to retire, and you have this lump sum in the 401(k), would it be to make a massive conversion at that point, or, I mean, what would you suggest to avert, obviously, the biggest tax consequences, you know what I’m saying?
Steve: Yeah, well, it’s gonna be a lot of tax to pay if you convert the whole thing to a Roth all at once. I think we need to have a sit down and learn all about the financial situation you find yourself in now and maybe what financial situation you’ll be in during the rest of your life. Remember, it’s a long-term proposition, and certainly, rolling the money over out of the 401(k) might be appropriate. I don’t know if it’s appropriate to throw it all into the Roth immediately. I wouldn’t just arbitrarily say, “Yeah, that’s a good idea.” So, it’s something that there’s a lot of considerations and facts and circumstances need to be addressed to really figure out when to do a Roth conversion, maybe it should be a multi-year plan, and how much to convert every year.
Bob: And does it pay to do it before retirement at all, or would you say just keep it in the 401(k)?
Steve: Yeah, what I’ve found is that people who do it before they retire are generally in a higher tax situation because they’re working, they have wage income, and then, when you retire, what you find is a lot of people might be in a lower tax situation, especially if you haven’t started Social Security yet, which you haven’t, being age 55, probably, or in your fifties, and your income might be lower, and you might have a window of lower
income years where you could do lower cost Roth conversions.
Jim: And I would agree with everything that Steve said. I think the idea of doing a massive conversion with the idea of keeping the entire amount in the Roth is going to spike your income tax bracket. Now, if you’re already at the highest bracket, then that might actually be more appropriate, but if you’re in the middle bracket, probably the right answer, of course, is to truly have the numbers analyzed, but, as a general rule, probably a series of conversions over time. Now, the other possibility is actually using Steve’s idea of doing multiple conversions and seeing how the investments do and then picking the winners, and recharacterizing a bunch of the other ones. Now, I did want to say one other thing, because you said that you were still working, and you have access to a 401(k) plan. Hopefully, your boss will also provide you with a Roth 401(k) plan that will give you the option of contributing not just $22,000 to a traditional 401(k), but $22,000 to a Roth 401(k).
Bob: Well, if I may, Jim, I do have presently a Roth in mine and my wife’s names, but you’re saying I could also take advantage of that within my 401(k), even with my own personal Roth accounts?
Jim: You can actually have, and this is only if your employer has a Roth 401(k) option. So, a Roth 401(k) is really taxed, more or less, just like a Roth IRA. That is, you don’t get an income tax deduction, but it grows income tax free, and then, when you do retire, you can roll it into a Roth IRA without any tax, and it’s usually a very good thing or a lot of employees to have a Roth 401(k). So, for example, in our company, each employee has a choice of whether their share goes into a traditional 401(k) or a Roth 401(k), and each employee, on whatever’s best for them, can do whatever they want. The portion that I contribute goes into a traditional 401(k). So, what you might want to do, depending on how much power you have in the organization, by the way, I would say this for anybody, is you might want to ask the boss or ask the benefits person, “Can you please add a Roth 401(k) component to the 401(k) plan?”
Bob: Excellent. I think we actually have one of those, and I think I’m gonna go into them tomorrow and find out when I can start making some contributions on the Roth 401(k). I appreciate your time tonight, gentlemen. Have a good evening.
Jim: Okay, and the only other thing that I would say is, the issue of whether you want to contribute to a Roth 401(k) or a traditional 401(k) is kind of similar conceptually to whether you want to do a Roth IRA conversion, and there, your tax bracket is very important.
Steve: And I’d add one more thing for our listeners that relates to his question, and that is what you want to try to avoid is over converting to a Roth. He said he might think about throwing all of his 401(k) into a Roth, well, if you do that and that’s all your money, you might be left with no income in retirement other than Social Security income that would be taxable. I don’t know what his situation is, but our listeners have to realize that if you do that, you’ll end up with no income taxes for the rest of your life, and therefore, you shouldn’t have paid so much tax when you did a Roth conversion. You could use some taxable income when you retire. So, there’s a fine balance between over converting and converting enough. A general concept to consider is that you want to have some income in retirement to use up your 0% and maybe your 15% tax bracket after you retire, and more conversion than that might leave you with not enough income in retirement.
Jim: I think that’s such a good point, and a lot of people that have sometimes heard us, or perhaps read my book, have gone out and converted more money than I would have recommended, and what happens if they convert, let’s say, their entire IRA, and they don’t have a lot of income outside their IRA, they end up in a very low bracket and they’ve paid a lot of money to make that Roth IRA conversion, so they over-converted. And I think that’s a good point. Why don’t we talk about one other thing that I think sometimes happens, is the relationship of Roth IRA conversions and estate planning. Let’s assume, for discussion’s sake, that you’re married, and let’s say that you have some kids and some grandkids, and maybe you have some different interests. Maybe you want to leave some money to charity. So, let’s say that you have different types of beneficiaries. You might have charity as a portion, you want to leave some money to charity, maybe you have one child who’s doing very well and is in a very high tax bracket, and you have another child who isn’t doing so well and they’re in a very low tax bracket. Do you generally recommend just a straight percentage across the board, or do you sometimes, when you do some of these financial projections, come up with a more sophisticated recommendation for estate planning?
Steve: That could be something more sophisticated, because a high-income child might benefit more from a Roth IRA than a traditional IRA. Whereas, a child who has low income, and would pay little tax on traditional IRA withdrawals, would benefit more with a traditional IRA. So, sometimes, we recommend that more of the Roth go to the wealthier child, and even more, dollar-wise, to the child whose lower income, because they’ll have to pay tax, but the taxes won’t be as much as a higher-income child would be. Your point about the estate taxes is very good. We haven’t really touched much today about the estate tax situation in Roth conversions, but I will say that doing a Roth conversion for someone with estate tax problems will save you even more money in the long run, because it’ll essentially lower your estate tax by doing Roth conversions.
Jim: Well, I remember back in the old days, some of the advisors used to say before you die, cash in your IRA, pay the tax on it, and that way, you reduce your estate by the amount of tax that you paid. Is this kind of a similar situation, except instead of being left with plain old after-tax dollars, you’re actually left with Roth IRA conversion dollars?
Steve: Right, and they’re more powerful. You can spend a lot more out of a Roth than you can a traditional IRA, because there’s no taxes to pay with it, and if you’re able to have your heirs keep it over their lifetimes or a number of years, they can enjoy tax-free growth and make it worth more than just regular old after-tax money.
Jim: Alright, and is it sometimes beneficial in the planning process to allow flexibility as to who the beneficiary might be? So, for example, let’s assume that we are leaving some money to children, and one of the children is very wealthy and maybe doesn’t need all of their money that is left to them. Do we often have you recommend that the people disclaim a potion of their money to the next generation?
Steve: Right, disclaimers are a big part of our strategy at our office, and when you do that, you might be able to leave the benefits for your grandchild who grows the money over a longer period. The problem is, you don’t know what tax rate the grandchild’s gonna be in because they’re often so young. You don’t know what the rest of their life’s gonna hold. So, sometimes, you sort of have to keep the grandchildren on equal footing, even though they’re children of wealthier and less wealthy children.
Nicole: I think we have a little bit more time, a few minutes left for one caller, here. Jim from Michigan? Are you on the line?
Jim from Michigan: I am.
Nicole: Thanks for joining us tonight. What’s your question?
Jim from Michigan: Well, the gentlemen were both just stating how it’s generally not recommended to convert all of your IRA assets to Roths, generally.
Jim from Michigan: And I know I’ve heard Jim in the past state on the air that he did happen to do that personally, years ago.
Jim: That’s right.
Jim from Michigan: And I was wondering if there are certain circumstances that would make another person to consider doing that also?
Jim: Well, I don’t think it’s fair for me to ask you on the air what your tax rate is, but let’s take two different possibilities, and we end up with two different conclusions. Let’s say, for discussion’s sake, that you’re in the 25% tax bracket, and you have $1,000,000 in an IRA. If you were to make a Roth IRA conversion of that entire $1,000,000, that would throw your tax bracket into the 35% bracket. So, you would pay 35% to end up saving money at 25%, and as Steve just pointed out, that that will reduce your minimum required distribution even further, so you might end up in the 15% bracket, and when you do the sophisticated financial projections, I think that you’ll find if you pay a very high rate, say 35%, to save money at 25% or 15%, that you’re either not better off or you might have a very, very long break-even point. Now, the other possibility, let’s say that you are in the top tax bracket, so you’re in the 35% bracket and, if you make a Roth IRA conversion, and we’ve done this for quite a few people who are in the top tax brackets, we have recommended that they convert everything, perhaps using our multiple account strategy to recharacterize the losers, but in that situation, if you’re already in the 35% bracket, then adding additional income, you still stay at the same bracket.
Steve: And let me interject too that this is part of our lifetime projection process and, in some cases, what happens is you might want to convert all your IRA, but in the future, you’ll actually be making more money and rebuilding the taxable retirement accounts, and perhaps some people might even have expectancies from their parents or grandparents, and things might happen in the future to change your situation, so we really need to look at all the facts and circumstances of the people in their current situation, as well as what will happen for the rest of their lives.
Jim from Michigan: Well, thanks very much.
Nicole: Alright, thanks. Thanks for calling. Well, I think we are at the end of our hour. Steve, thank you very much for joining us.
Steve: Thank you.
Nicole: Jim, as always, it’s a pleasure.
Jim: And you did a great job. Thank you, Nicole.
Nicole: Oh, no problem. We will see you in a few weeks, two more weeks when we’re talking more smart money. Good night, stay safe with that weather out there, Pittsburgh, and thank you for joining us. You’re on the Lange Money Hour, Where Smart Money Talks.
James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.