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Roth IRA Conversion Stories
James Lange, CPA/Attorney
Please note: Some of the events referenced in our audio archives have already passed. Please check www.retiresecure.com for an updated event schedule.
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- You’re Never Too Old to Make a Roth IRA Conversion
- Caller Q&A: Converting 401(k) to Roth IRA
- Jim Lange’s Roth Story
- Caller Q&A: Various Questions on Roth IRA Conversions
- Three Pots of Money Story
- Caller Q&A: Clarification of the Five-Year Rule
- A Roth IRA Conversion is Not Always the Answer
Nicole: Hello, and welcome to the Lange Money Hour, Where Smart Money Talks. This is your host, Nicole DeMartino, and, as always, I’m here with James Lange, CPA/Attorney and nationally recognized Roth IRA expert. Jim is the President of Lange Financial Group and has been practicing in Squirrel Hill for almost thirty years. He’s also the best-selling author of the first and second edition of “Retire Secure! Pay Taxes Later,” and he’s just about to bring out his third book, “The Roth Revolution: Pay Taxes Once and Never Again.” Actually, tonight, we’re going to be talking about some stories that you’re going to be able to find in the book. We do have a very fun and educational show planned this evening. Jim, before you start, I just wanted to make sure everybody knows that tonight’s show is live, so this is really a great night to call in. You can add to one of the stories we’re going to tell, or tell your own story, but we’re here to take your call. That number’s 412-333-9385, so give us a buzz. We’re going to be here for the next hour.
Nicole: Alright, Jim? So where are we going to start tonight?
Jim: Well, I thought that we could start with a couple of stories.
Nicole: Sounds good to me!
Jim: One story that, it stays with me because usually when I see clients, they’re usually in fairly good health. In this case, the gentleman was not in good health. In fact, he was literally on his deathbed. He was a smart old engineer, and he had heard about me, and he had done some reading, and I usually don’t make house calls. I usually ask clients, or even prospective clients, to come into my office, but in his case, he obviously couldn’t. He was literally, you know, bound to his house and, even specifically, his bed, and he asked me to come out and review his situation and I did. And one thing that was interesting about the meeting is nobody pretended that he was going to survive very long. So, you had a situation where he knew he was going to die, his children knew he was going to die, his grandchildren knew he was going to die, and the issue was what should he do? Now, if we’re going to simplify the situation, and I’m not going to get into all the details, and speaking of, by the way, not getting into all the details, I will have to tell you that for his story and subsequent stories coming up, I have a terrible conflict between two competing values. One is the value of journalistic accuracy. I am the son of a journalism professor. My mother is a professor emeritus of journalism, and I have grown up with a very high value and respect for the integrity of the details and the accuracy of the details of any story. On the other hand, I have a competing value, which, in this case, I believe, trumps the value of journalistic accuracy, and that is the value of confidentiality, and the fact that somebody has died, at least in my mind, does not destroy that duty that I owe all clients, and even prospective clients. So, in order to protect confidentiality, I am going to take significant liberty of changing facts, changing situations, and I’m trying to make it so even if someone heard their own situation, they would not be able to recognize it, because I never want to hear somebody say, “Oh, you know, I could tell that that was me when you talked on the radio or in your book.” So, I will tell you that I am taking some liberties with the facts, due to the client confidentiality. Anyway, so, again, I’m taking a few liberties here, but I’m also going to, in this case, try to simplify the situation. So, this is back in the days when the exemption amount was a million dollars, and to make a long story short, he had a million dollars of an IRA, and he had about $300,000 of what I would call after-tax dollars, and the question was what should he do? Now, the status quo was he was going to die with $1.3 million. His estate would have a $1 million extension, so he would have to pay estate tax on the additional $300,000, figure, maybe, $100,000 in estate taxes, and then his heirs, in his case, his children and grandchildren, would have a little bit of after-tax dollars after paying all the taxes and expenses, and mainly IRA dollars that they were going to have to pay income taxes on every year for the rest of their lives. And what I proposed is that we actually, well we call it, whether you want to call it financial projections or running the numbers or, actually, calculating what the best scenario is and doing it in an objective, quantitative way, and we came up with the idea of actually making a Roth IRA conversion of his entire IRA. So, we did a one million dollar Roth IRA conversion. We ultimately paid quite a bit of money in income taxes, but the money that we paid in income taxes actually reduced his estate tax. One of the old strategies back in the day before Roth IRA conversions was they would say, “Hey, cash in your IRA before you die, and that way you get the income taxes that you paid on the IRA out of your estate.” Well, this is a little bit of that same strategy, but we end up with after-tax, or even better, Roth IRA dollars. So, we calculated that his family would literally be millions of dollars better off by doing a Roth IRA conversion before he died, and I use that as a story, not only just to tell the story, but I think the moral of the story, if you will, or one of the lessons of it is that you can’t be too old to make a Roth IRA conversion, and I think that that’s a really important concept because I have a lot of seniors who have gone to other advisors and read other, what I would consider, fallacious pieces of information. They say, “Oh, I’m too old to do a Roth IRA conversion.” And if you go through the analysis, and we’re not going to do it here, that we go through in our workshop and in the book, that talks about measuring assets in purchasing power rather than in total dollars, I can prove to you that in most situations you’ll be considerably, and your family, much better off than the status quo. So, the moral of the story is you cannot be too old to make a Roth IRA conversion.
Nicole: Alrighty. You know what, Jim, we do have a call.
Nicole: Let’s take that call. John, are you there?
John: Yes, ma’am.
Nicole: Calling from Greentree?
John: Yes, ma’am.
Nicole: Alrighty. Thanks for calling in. You’re on with Jim and Nicole. I see you have a question about transferring assets or retirement funds?
John: Yeah, exactly. Hi, Jim, good evening.
Jim: Hi there.
John: Hi there, Jim. I got a question like, recently, I had around $10,000 in a 401(k) plan, and I sued the company, and I would like to convert that $10,000 to a Roth IRA, and what exactly do I need to do if I want to do that?
Jim: Alright, now let me understand this. Is the $10,000 still in your 401(k) plan?
John: Yes, sir.
Jim: Are you still working there?
John: No, actually, I sued the company, so I’m not working at that company anymore.
Jim: Oh, okay. Wait, you sued them? Or you left?
John: I just left.
Jim: Okay. Alright, very good. Alright, so let’s talk about that, and I will also broaden the question because it doesn’t necessarily have to be $10,000. Let’s assume, for discussion’s sake, alright, thank you, John, I think I’ll take it from here. Let’s assume, for discussion’s sake, that you have left the company, and that there is currently money in your 401(k) plan. One of your choices is to just leave it where it is. There’s probably a much wider choice of investments outside of your company’s 401(k) plan, so even forgetting a Roth IRA conversion, it might be advantageous to make a, usually people call it a rollover, but I’m going to call it a trustee-to-trustee transfer of the 401(k) into your IRA, and then what happens is you have the, basically, the whole world is your investment choices. No, in terms of should you make a Roth IRA conversion once that money is in an IRA, or now you’re allowed to do it directly. Of course, that’s going to depend on your situation, and that’s what the book is about and that’s what the workshop is about, but assuming that you do want to do that, what you would do is you would pick the appropriate investment vehicle, whether it’s in Vanguard, or whether you’re going to pick particular stocks or bonds or mutual funds or whatever it might be, and then contact that company, get the appropriate paperwork, and then make the Roth IRA conversion. Now, before I end this, I should mention that there are times when you want to keep the money in the 401(k) plan because most financial advisors will tell you the minute you retire, get every nickel out of the 401(k) plan, and I might disagree with that on a couple of situations, and here’s where they would be. Let’s assume, for discussion’s sake, that you are a long-time employee. I assume that you’re not if the balance is only $10,000, but let’s say you’re a long-time employee of, for example, Westinghouse, or perhaps one of the universities, and maybe you have money in TIAA, which technically is a 403(b) or a 401(a). Sometimes, those investments, which are ultimately bond funds or fixed income funds, actually are performing very well right now, and the reason is if you think about a bond fund for a minute, any bond fund is going to buy and sell bonds. So five and ten years ago, when bonds were paying a higher interest rate than they are today, these retirement plans that had bonds in them were buying and selling bonds. And anyway, they still have some of those bonds. So, for example, the interest rates on the existing money in the TIAA or the Westinghouse Fixed Income Fund or similar funds might very well be higher than interest rates outside that you can get on your own, and particularly if you’re going to be paying a management fee. Now, on the other hand, I think you can do better on the equity side outside of the 401(k). By the way, a great time to make a conversion is, I don’t know if you got a job again, John, but if you didn’t get another job and your income is low, that’s a wonderful time to do a Roth IRA conversion. So anyway, I hope that helps, and I wish you the best of luck. Alright? And by the way, we are happy to take more questions, and even do little mini-case studies.
Nicole: Let me give the number one more time: 412-333-9385.
Jim: Okay, should we go on to the next Roth story?
Nicole: Yeah, are we going to go on to your Roth story?
Jim: My Roth story?
Nicole: Let’s go on to your Roth story.
Jim: Alright. Now this one, by the way, is accurate.
Nicole: This is all true.
Jim: Right, because I’m allowed to talk about myself.
Nicole: You’re not protecting the innocent.
Jim: I’m not protecting the innocent, that’s right. Alright, so I’m going to take us back to 1998. Actually, I’ll go back even further than that. It was in 1997 when the Roth IRA conversions were first proposed, and usually, as a tax practitioner, I ignore proposed regulations, and the reason I ignore proposed regulations is because I get it mixed up with what actually becomes law. So I usually say, “Alright, I’m not going to bother learning anything until it actually becomes law.” But this was going to be big, and I knew it was going to be big, and just intuitively, I just kind of got it that this Roth IRA conversion was going to present tremendous opportunity to many of my clients, and one of the things that’s a little bit unique about my firm is that most of my clients have significant IRAs or retirement plans. In fact, I’d say the majority of my clients have more money inside their retirement plans than money outside their retirement plans, and I knew that this was going to be a very big thing for IRA and retirement plan owners. Anyway, I went to the American Institute of Certified Public Accountants, and the reason I went to them is because I knew I wanted to analyze this, but I also knew that everybody these days is a skeptic, and now, it’s probably even worse than it was twelve years ago, where nobody believes anybody, and particularly, nobody believes an attorney or a financial advisor. So, I had this challenge. How am I going to convince people that the analysis that I did on Roth IRA conversions was accurate and it was a good thing? So, I went to the American Institute of Certified Public Accountants, and they’re actually a pretty credible group, and they have a journal called “The Tax Advisor,” which is peer-reviewed, which means anything that goes in “The Tax Advisor” has to get through a board of reviewers, and just picture these nitpicking CPAs that love to find mistakes and tell you how wrong you are. But anyway, I said, “Hey, can I do the article?” They said yes. I submitted the article with all the analysis, and it actually went through with flying colors and was published, and it was actually the first major magazine article on Roth IRA conversions, and it proved the value of Roth IRA conversions for many people, and at the time that I did it, it was really done for clients and prospective clients, you know, I didn’t think about my situation, and the reason was because at the time, in 1997, I didn’t qualify for a Roth IRA conversion because my income was more than $100,000. Today, you don’t have that limitation. There is an unlimited income amount, so anybody, regardless of income, can make a Roth IRA conversion as long as they have an IRA. So I was not thinking about this for me. Then, on February 16, 1998, and I know I have a lot of clients listening, and some of you remember this, I was above a pizza shop and there was a devastating fire that basically wiped out the office, and again, the moral of the story is please never put your office above a pizza shop. Just a terrible, terrible idea. But I did, and I was basically wiped out, and I was well insured, but I didn’t get the insurance check until the following year. So in 1998, I probably had my lowest year that I’ve had probably since more or less I started practicing, well maybe in the early years it was a little lower, but anyway, I had a really rough year, and my income was less than $100,000, which meant I qualified for a Roth IRA conversion. And that was good. So, I’m married and I was married back then, to the same woman by the way, it’s been seventeen years now, we had between us $250,000 in our combined IRAs, and I said “Cindy, I think we ought to make a Roth IRA conversion of the entire amount.” So, we had to pay income taxes on $250,000, and the original plan was then we would get a bunch of tax-free income when we were older, and that was good. Well, partly because of a lot of business generated by Roth IRA conversions and other things, it is possible, even likely, that we will never need that money at $250,000, plus all the growth on that money, in our Roth, and it is possible that if neither of us ever needs it, it will end up going to our daughter, who was three years old at the time we made the conversion. Through second to die life insurance, other monies that we will leave our daughter, and money that our daughter will earn herself, it is very possible, even likely, that she will not need all that money, in which case it might end up going to her children. So, we might get 80-90-100 years of tax-free growth and our family will be millions and millions of dollars better off. And even if my wife and I need it and it doesn’t go to the next generation, we will still be hundreds of thousands of dollars better off, and it will have been a very good thing. So, that’s my own personal Roth IRA conversion.
Nicole: Putting your money where your mouth is, certainly.
Nicole: Right? Well, you know what, I see the calls stacking up. How about we take a call, we’ll take a quick break, and then we’ll come back to the callers. What do you think about that?
Jim: Okay, very good.
Nicole: Jack? We’re going to take Jack from out there in Dormont. Jack, are you on the line?
Nicole: Well, thanks for joining us tonight. What’s your question for Jim?
Jack: Jim, I didn’t understand something. In your last case scenario, okay, you take the money out and you pay the income tax on it, and so now, your daughter doesn’t have to pay the tax on it. But wouldn’t you be further ahead if you just kept putting money in it and when it goes to her, she only has to pay, I think the tax rate for kids is 15%, versus income tax which could be much higher that 15% and with this current president, it’s going to be higher than I would like anyway, but you would have to pay some tax anyway. So, why not just wait until the end and pay the 15%? I’m in a slow math group. I’m not sure how that would work out.
Jim: Well, that’s okay. By the way, since I’m an attorney, I’m allowed to rephrase questions a little bit.
Jack: I’m an attorney, but I don’t deal with any numbers.
Jim: Oh well, I’m sorry to hear that you’re an attorney. But anyway, Jack, what I’m really hoping is that my daughter will not be in the 15% bracket, and remember, she doesn’t get this money until I die and most likely my wife dies.
Jack: No, when she gets your estate, that would be 15%, wouldn’t it?
Jim: Well, no. There are two taxes that we have to worry about for after death.
Jack: Oh okay, I see what you’re saying. The federal estate…
Jim: One is federal estate, and federal estate tax or, I like to call it a transfer tax, because it’s a tax on the transfer of money at death, and two, income tax. Yes, the money in an IRA or a Roth IRA is going to be subject to federal estate tax if the exemption is low enough and the assets are high enough. But by the way, even then, we are helping with a Roth IRA. If you remember my first example, the gentleman had a million dollars in his retirement plan and $300,000 afterwards. So, his estate at his death was $1.3 million. If he makes a Roth IRA conversion of a million dollars the day before he dies, he pays the $300,000 tax, then he only has estate tax or a taxable estate of a million, meaning that he saved taxable estate on $300,000, which in this case, saved him about $120,000. So, I’m hoping a. I reduced my estate, or transfer, tax, although hopefully there won’t be any, because a lot of times, with good planning there is no estate tax, and I don’t know if my planning is going to be as good as George Steinbrenner’s, who picked the right year to die and leave his $1.5 billion interest to the Yankees estate tax free, I don’t know if I’ll be that good, but anyway, if my daughter is in the same income tax bracket or higher, it will be enormously beneficial, but even if she’s in a low bracket, let’s even say that she’s in the 15% bracket, and let’s assume that I’m in a higher bracket, and at the time, I was 42 years old. There’s going to be so many years of income tax-free growth that even if it’s taxed at a lower rate, it will still be tremendously beneficial.
Jack: Well, okay, but let me ask you this though, okay? Let’s say, you get up to you take out, you convert $250,000 and it gets up to $2,000,000, which to say that’s the time when the estate tax kicks in.
Jack: So then, you’d only have to pay, or your estate would only have to pay the estate inheritance. I mean, your daughter would only have to pay the state inheritance tax, which would be, maybe, I forget what it is…
Jim: It’s four-and-a-half percent for any heirs.
Jack: But you only have to pay four-and-a-half percent? That’s like peanuts. So, she’d only have to pay $90,000 on $2,000,000. So, I would say that, you know, you have benefited because you have done well and all that, but if you converted it from $250,000 and it goes up to $2,000,000, and then, you know, she gets the $2,000,000, assuming you give it to her, she’ll only have to pay $90,000, or four-and-a-half percent, what is that, that’s $90,000, you can’t beat that, can you?
Jim: No, and that’s what I’m saying, that this is good for income taxes and estate taxes. I believe we have a commercial coming up.
Nicole: We do have a commercial coming up.
Jim: But thank you very much. I really appreciate it.
Jack: What is your name, sir? What is your name?
Jim: My name’s James Lange.
Jack: And you’re in Pittsburgh?
Jim: Yes, I’m a CPA, and the name of the firm is Lange Financial Group.
Jim: Alright, thank you.
Nicole: Thanks, Jack.
Jack: Thank you.
Nicole: We’ll be right back. We have a call from Ed. Oh, they’re stacking up. You can call us at 412-333-9385. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back to the Lange Money Hour. I’m your host Nicole DeMartino, and I’m here with Jim Lange, and we’re taking calls tonight and we’re going to get right back into it. We have a gentleman on the line, Ed. Ed’s calling from Murrysville. Ed, are you there?
Ed: Yes I am.
Nicole: Alright. Thanks for calling tonight. What’s your question for Jim?
Ed: My question is, if you make a conversion and pay the taxes on it and you have to withdraw that money for illness or any other reason, are there so many numbers of years that you have to leave the money in there before you can get back into it?
Jim: The answer to that is, and it’s confusing, because a lot of people will tell you about the five year rule, and they say, “Oh, you can’t get the money for five years,” and that’s not true. You can get the money the next day, and you can get it for any purpose you want. What the five year rule says is that the growth on the money is not subject to income tax if the investment is in there for five years. So, I’ll give you an example. Let’s say you make a $100,000 conversion in 2010, and you wait four years and 364 days, and at that point, your investment is up to $125,000. You pull the money out, you have to pay income taxes on the growth, which in this case would be $25,000. If you wait that extra day so that the money is in there for a full five years, now the Roth IRA is $125,000, and if you want, you can take out the entire $125,000 income tax free.
Ed: I understand. Thank you very much.
Jim: Okay, thank you for calling, Ed.
Nicole: Thanks for calling, Ed. Alrighty, Jim, we’re going to take one more, okay?
Nicole: Andrew, thank you for waiting. Andrew, are you on the phone?
Andrew: Yes, I am.
Nicole: Alrighty. What’s your question for Jim?
Andrew: Okay. I’ve already done a Roth conversion. I am in the 35% tax bracket. Some of my investments, or some of the accounts, have been profitable while others have shown reluctance, some 33% and some 10%. The larger ones have been reconverted back to an IRA and then back to a Roth by the end of 2010, so I have a lower basis. What about the ones that are in between? Next year, I believe, the income tax rate for someone in my practice will go from 39.6% to 35%. Is it practical for me to, basically, look at the accounts where there’s a two or three percent loss and just simply bite the bullet and keep it in the 2010 year Roth conversion, or, you know, should I kick it over to 2011, even though the tax rate will be higher?
Jim: Alright, well, that’s a good question, and in order to answer the question accurately, I’m going to have to give our audience a little base information of a strategy that it sounds like you already did, but most people don’t know about. By the way, what I’m about to tell everybody is a pretty sophisticated strategy, and it is not to be done by the meek, and if we’re talking about a high tax bracket, I’m going to assume it’s a considerable amount. I’m not going to ask you because I think that would be too personal. But, let’s just assume, for discussion’s sake, that you had a million dollars of traditional IRAs and you or, perhaps, a financial professional have run numbers and have established that it would be an appropriate thing to convert the entire one million dollars in an IRA. Now, if it was all in one account consisting of a variety of investments, stocks, bonds, mutual funds, etc., and then even different asset allocation categories within that account, and some of them went up and some of them went down, you’re really not in a very good situation to recharacterize, or undo, the conversion. The reason why you might want to undo a Roth IRA conversion is in the event that you make a Roth IRA conversion and the underlying investment goes down and then you’re stuck paying taxes on the higher amount. So, what we recommend and it sounds like what you have been doing, Andrew, is rather than making one big massive Roth IRA conversion is that you segregated the accounts. I’m going to simplify it and say that you segregated it into ten different Roth IRAs and/or ten separate IRAs, and you made conversions. So now, let’s say, your starting point at the day of conversion is $100,000 for ten separate Roth IRAs. Alright, and let’s say that you did that, I’m going to assume that you did that in 2010 because if you’re in the 35% bracket, you weren’t allowed to do it last year. So, let’s assume at some point in 2010, you made ten $100,000 Roth IRA conversions. First of all, you should know, you don’t have to recharacterize, or undo, the conversion until October 15, 2011, which is a tremendous benefit because that gives you more time to decide if you’re going to keep it or not. It will also give you more information. You’re going to have more time to see if there are winners or if there are losers. Now, presumably, what you will do is, you will keep your winners and you will recharacterize, or undo, your losers, and specifically, your question was well, what if they just lost a little bit? Well, you’re probably better off just keeping it. Now, there are some advanced strategies that flow from that, but I think that that’s the general idea. So, here’s what I would probably do. I would not necessarily make the decision of what you’re going to keep or recharacterize this year, but I would probably wait until October, well actually, I don’t want to do anything at the last minute, let’s say, September of 2011, and then make your decision. I don’t know if that answers your question, but that’s what I would do. Now, there’s an advanced strategy where you can do some things this year, but I don’t want to get into that. But I think the general idea is that you segregate the accounts before you make the conversion, then you make the conversion to multiple accounts, and then you determine on an account by account basis mainly based on performance which account you’re going to retain and which account you’re going to recharacterize. Does that answer your question, Andrew?
Andrew: Yeah, pretty much. Now, would your cutoff be that different in your change in tax bracket assuming it goes to 39.5% from 35%?
Jim: Well, yeah. See, that’s another great reason to do it this year, is because when I say you have until October to recharacterize, that’s not a random date. October 15, 2011 is the deadline for filing your 2010 return. Now, you might say, “Hey Jim, it’s April 15th.” Well, that’s true, but if you get two extensions, that’ll carry you out until October, 2011. So, you’re still paying taxes on 2010 rates, but you’re making the decision as late as September or October of 2011.
Andrew: Okay. So if, let’s say I decide to kick it back to the IRA in March, 2011…
Andrew: …and then convert it to a Roth. That will then be for 2011 then, and not for 2010?
Jim: Yeah, you can, but you have to be careful, because there are rules that say you cannot make a conversion, recharacterize and make another conversion of that same money in the longer of 30 days or the same calendar year. So, you could not recharacterize on March 1st, and then on March 2nd, make another conversion.
Andrew: But I could do it, let’s say, December 30th, and then do it in January?
Jim: Well, if you did it on December 30th, you’d have to wait until, I guess you could do it on January 31st. It’d be thirty days.
Andrew: So, it’s the longer, rather than the shorter in the tax year.
Jim: That’s correct. It’s the longer of them. By the way, there are a couple of advanced strategies that you might be a good prospect for, and I’m not really trying to push business, but, oh yes, that’s not true. That’s what I am. That’s why I’m doing this radio show. But there are actually a couple of advanced strategies that I’m not going to get into, because I think they’re going to be a little bit too detailed for the radio, that we could talk about. But, I think that you are on the right track of separating your accounts, making multiple conversions, and then determining later on based on performance which accounts you’re going to keep and which ones you’re not. And I also think you’re smart if you’re in a high bracket now, and you’re likely to be in a high bracket indefinitely, 2010 is a very good year to convert, because I think it’s a little bit unclear what’s going to happen in taxes in the future, but I think that if anybody’s going to get dinged, and I think we are, it’s going to be the high income taxpayers.
Andrew: Okay. Thank you very much for your advice.
Jim: Alright. And if you want to call the station and give us your contact information, I can help you with a few of those advanced strategies.
Andrew: Great. Thank you.
Jim: Alright, thank you.
Nicole: Thanks, Andrew. You know what, Jim? You know what I think?
Jim: What do you think?
Nicole: I think Andrew should come to the workshop. I wonder if he’s read “Retire Secure!”?
Jim: I don’t know if he has or not, but he would actually be an ideal candidate.
Nicole: He would.
Jim: It’s interesting though that sometimes Roth IRA conversion planning is actually easier for people who have more money and are in a higher tax bracket, and I’m going to say the tougher calls are people with a net worth of, say, between $500,000 and $2 or $3 million, which is probably the majority of our clients, and that’s actually harder than Andrew’s situation.
Jim: But yeah, he would be a good candidate to come to the workshop, because there are some interesting nuances that we didn’t have time to get into.
Nicole: Absolutely. It’s hard. Again, we are live, obviously, 412-333-9385. We still have a lot of time left in the show. Jim, do you want to go to the three pots of money story?
Jim: Okay, fine.
Nicole: I love the three pots of money story, because it sounds simple, however, it can make an enormous difference for people just knowing this little story right here.
Jim: Alrighty. The three pots of money story. I’m going to simplify the facts. A gentleman came to me when he was 69 years old. So, that means he did not have to take his minimum required distribution. Without his minimum required distribution, his income was less than $100,000, so he qualified to make a Roth IRA conversion. And again, to oversimplify, he had what I would call three pots of money, or he will, after seeing me, have three pots of money. One was a, what I would call, after-tax dollars. Money that isn’t an IRA, isn’t a Roth IRA, isn’t an annuity, but is just old savings, investments, money that he has already paid tax on. The second pot, which was probably the majority of his estate, as is many of my clients, was IRAs, and he came to me, and he was looking for long-term strategies, which is actually what we like to do probably more than anything, and he basically said, “Hey, what should I do?” Now, at that time, there was a $100,000 limitation, so that if your income was more than $100,000, you weren’t allowed to convert. So, we actually thought that that was going to be his last chance to make a Roth IRA conversion, and we calculated that the optimal amount for him to convert was a $500,000 Roth IRA conversion. And the plan was, and we had done projections, that his spending, and this is important in terms of the lesson here is which assets to spend first. In general, if you have, or end up with, three pots of money, the first pot being what I would call plain old after-tax dollars, the second pot being IRA dollars, and the third pot being Roth IRA conversion dollars, in general, what I like to do is spend the after-tax dollars first, then the IRA dollars and then the Roth dollars, which was the advice that I gave him is that first you should do this Roth IRA conversion, spend your after-tax dollars first. If you spend all of those, now he was still, by the way, having to take a minimum required distribution of the IRA that he didn’t convert, because remember, there’s no minimum required distribution on a Roth IRA, but if you only make a partial, that is, you don’t convert your entire IRA, which is usually what we end up recommending, you won’t have a minimum required distribution on the Roth portion, but you still will with a traditional. So, I was basically saying spend your minimum required distribution that you have to take out, spend your Social Security, and then, assuming that’s not enough, spend your after-tax dollars. If you eventually exhaust your after-tax dollars and you need more than your minimum required distribution, then spend your IRA dollars. If you spent all your IRA dollars, and by the way, there are some exceptions to this, but I’m giving the general rule, spend your Roth dollars last, and the reason for that is the Roth dollars will grow income tax free for the rest of your life, the rest of your spouse’s life, the rest of your children’s lives and the rest of your grandchildren’s lives. There’s no minimum required distribution. Also, the Roth dollars are the best dollars to leave behind to your children or grandchildren or other heirs. So anyway, we actually ran numbers proving that his family literally would be millions and millions of dollars better off by making this Roth IRA conversion, and spending in the right number.
Nicole: Alrighty, Jim. We’re going to take a quick break, one more before the end of the show, and we’re going to come back. I see a caller all the way from Detroit, so we’ll be right back. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back to the Lange Money Hour. I am Nicole DeMartino, and I’m here with Jim Lange. We’re telling stories that are going to be in Jim’s third book “The Roth Revolution: Pay Taxes Once and Never Again.” We’re also taking a lot of calls tonight, and I’m looking here, we have Jim from Detroit. Jim, are you on the line?
Jim from Detroit: I am.
Nicole: Well, thank you for listening all the way out there in Detroit.
Jim from Detroit: My pleasure.
Nicole: What’s your question for Jim?
Jim from Detroit: It’s just a quick clarification of what I thought I heard him say about the five year rule on converted dollars. I’ve done several conversions over the years, and my custodian, one of the biggest in the country, has told me that each of those conversions starts its own five year clock, and I understand there is possibly a difference between the converted dollars, and then those dollars plus gains. In Jim’s example, he said a $100,000 conversion and then a $125,000 value at the time that you’re considering converting. Could you just repeat what you said on that topic?
Jim: Yeah, I will, and I think I will get to what I think is the heart of your question. By the way, some of the Pittsburgh listeners might be wondering, “Hey, how does this guy from Detroit listen and call in?” Even though KQV is a local radio show, we actually stream on the web. Jim, so, are you listening at KQV.com?
Jim from Detroit: I am, yeah.
Jim: Okay, so you should know that. And by the way, even for Pittsburghers, you will most likely get a better sound quality at KQV.com than listening to your radio, depending on where you are. Obviously, if you’re in your car, that’s not much of an option, unless you can get the web on your car, but I just thought I would mention that. But anyway, here’s the deal with the five year. In a very simple situation, day one, you make a conversion, and you can’t take out income tax free the gain on that until five years have passed. Now, Jim, you have made multiple conversions, and let’s say you’ve done it in multiple years, and let’s say, for example, that you make a conversion in year one, year two, year three, year four and year five. In year one, you clearly have to wait five years in order for the Roth and the gain on the Roth to be income tax free.
Jim from Detroit: Is that because you would assume then that that was a brand new Roth account?
Jim: That’s right. This is your first Roth conversion
Jim from Detroit: In my case, it’s already been seasoned five years before even the first conversion took place.
Jim: Well, here’s the deal, and here’s where the confusion is. Let’s forget about conversions. Let’s just talk about plain old Roth contributions. You know, you’re putting in $5,000. If you’re fifty or over, you’re putting in $6,000 into an IRA and you decide at one point to make a Roth IRA conversion of a certain portion of it. You’re contributing money into an IRA, and you make the Roth IRA conversion. You must wait five years. Now, let’s say, for discussion’s sake, that you add to that existing Roth IRA. So, the first Roth IRA that you have, yes, you still have to wait five years. Now, year two, you make another Roth IRA contribution. The question is when does your clock for the five years start? Does it start at year two or does it start at year one? And it starts at year one, okay?
Jim from Detroit: Right, that part I understand.
Jim: Right, so that’s a favorable thing. Now, let’s instead say that you did what you did, which is you made a series of conversions in multiple years. What happens is, each conversion starts its own new clock, and it sounds like the advice that you got in that area was right.
Jim from Detroit: Okay. But I thought you had said that you convert a hundred, and then one day before five years, well, you didn’t specify when you did your previous example with the other caller whether that was an already five year seasoned account or not, but in my case, it is. So, and you said one day short of five years that anytime up to one day short of five years, you can pull out that converted amount.
Jim: You can pull it out, but you have to pay the tax on the gain.
Jim from Detroit: Okay. You put a hundred in, and then three years and 364 days later, that whole time, you can pull out one hundred in that case without taxes?
Jim: That’s correct.
Jim from Detroit: It’s only on the gain that has the five year clock. So, that converted amount is treated as a contribution immediately?
Jim: I don’t want to say that the converted amount is treated as a contribution. I think it’s more accurate to say that the five year clock on a conversion starts on day one, and you have to wait five years in order to pull it out. If you do another conversion, you have to start again.
Jim from Detroit: But that’s only on the gains?
Jim: Yeah, that’s correct.
Jim from Detroit: Not on the converted amount?
Jim: Right. Now, what I can’t remember off the top of my head is if they make you prorate if you take out less than the full amount. So that one, I’m going to hold up on. I think that you can still get your principle back without having to pay tax. There’s a possibility that they would prorate that. Let me address a bigger issue, as long as we’re at it.
Jim from Detroit: Alright.
Jim: Why do you care? And I’ll tell you why I asked that question. I don’t mean to be cynical, but I get this question a lot, and that’s what I really wonder, because typically, when I’m making Roth IRA conversion recommendations, it is usually with the idea that this money is going to be in the IRA, or in the Roth IRA, for a lot of years. So usually, if I anticipate a situation where I’m going to need the money, and I’m probably not going to need the money for five years, I’m probably not going to do a Roth IRA conversion in the first place. Now, maybe it’s too personal…
Jim from Detroit: I agree with you on that. Why do I care is simply I just like to know the details. I don’t like surprises in the event something comes up.
Jim: Alright, well, that’s a good answer, because if it’s for curiosity, it’s good information to know. By the way, are you ready for this one, Jim? In practice, not only have I rarely seen somebody cash in a Roth, I have rarely even heard of somebody cashing in a Roth. Typically, these people who make Roth IRA conversions, and it might be just the type of people who are attracted to our workshops, or to me as an advisor, typically, the people who are making Roth IRA conversions are holding them until their deaths.
Jim from Detroit: So that’s the plan. Like I said, I just like to know the details. I’m one of those engineers, you know, who like to know all the ins and outs.
Jim: Yeah, I have a lot of you guys.
Nicole: He has a ton of engineers as clients.
Jim: It’s funny. I have a lot of engineers and I have a lot of college professors. In fact, those are the two biggest groups that I have, and I was reading some information on how to build a financial practice, and it said “The worst clients are engineers and college professors.” But I actually enjoy you guys, and I enjoy your questions. So, thank you very much for calling.
Jim from Detroit: Bye-bye.
Nicole: Well, we’re getting down to the wire. I think it might be fair, Jim, there is a story that is here. You know, we talk so much about the conversions, and I don’t want people to think that’s always the answer, because you meet with a lot of people, and after you do the analysis, it wouldn’t be in their best interest, right?
Jim: That’s correct. And by the way, that’s a good point, because sometimes I’ve heard people say, “Well, I didn’t want to go and see Jim because I didn’t want to make a Roth IRA conversion.” I don’t make any money, in fact, if you really analyze it, I sometimes make less money if people make a Roth IRA conversion than if they don’t. My goal is to present the best objective information and the best objective advice. Now, the best objective information and advice often leans in the direction of Roth IRA conversions, but frankly, I think a good advisor who really understands these issues is not going to necessarily encourage a Roth IRA conversion, and frankly, people have paid me for the analysis, and at the end of the analysis, I said “Don’t do anything.” So that is one of the possibilities.
Nicole: Sure, absolutely. Well, you have a story here about two people here actually from eastern Pennsylvania. These two people, just to give you a picture of it, the gentleman was 78 and his wife was 74. They were very active seniors and in excellent health. As a matter of fact, their parents lived until they were in their nineties, so they had heredity and genetics on their side. So, they thought that they were going to live that long too. They were very busy. They had two daughters and four grandchildren and everybody was doing well financially. Now, this older couple wasn’t as wealthy as some of the other people you’ll find in this book and the people that you talk about, but they had come to Jim. They were more conservative. Their money was in CDs and cash and they really didn’t like the stock market, but they were interested in the Roth IRA conversion. So, see, they were savvy. They jumped on the internet at 78 years old, did their research, found Jim and found “Retire Secure!” They actually drove that three hours from Chambersburg to meet with Jim, and when you come and see Jim, he does a thorough job of looking at the picture, and the picture was they had $50,000 of after-tax assets. Their retirement plan assets were $450,000. Their home and personal belongings was $200,000. They were currently spending $60,000 a year, and they had all this information. Jim did a thorough fact find, and the question was is it appropriate to do the Roth IRA conversion?
Jim: Right, and I’ll tell you why I remember that one, and we came to the conclusion that they should not do a conversion, because what happened was if you analyze, obviously, you gave the short version of the facts…
Nicole: I did, because we’re short on time.
Jim: But if you analyze their income, after all their deductions and after all their exemptions and everything else, their income was right around $68,000 which took them to the top of the 15% bracket. Any additional Roth IRA conversions that we would have made would have thrown them into the 25% bracket, and actually, in some variations for people who have even lower incomes, the tax bracket increase goes up even more than that because what you really have to be careful of is sometimes, if you make a Roth IRA conversion and you add to your income, you add to the taxability of Social Security. So, I was not willing to take people that were in the 15% bracket and push them into the 25% bracket or more, and particularly when their heirs were already in the 25% bracket. So, the advice to them was not to do that. Now, the other advice that came out of that, by the way, was they were probably very good candidates for an immediate annuity, meaning they give the insurance company a chunk of money, and the insurance company gives them a check every month for the rest of their lives because of their long life expectancies and their aversion to the tax market. Much different than a commercial annuity, but that actually came out of it. We held up on that because the interest rates are a little bit low right now for a great return on an immediate annuity.
Nicole: Alright, Jim, thanks. We’re at the end of the hour already, and this was a lot of fun. Thank you to everyone who listened, and thank you to our callers. We’ll be back in another two weeks with more of 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.