Originally Aired: July 19, 2017
Topic: CPA/Attorney Jim Lange on Roth IRA Conversions: Why and How They Can Benefit You and Your Family
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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- Introduction of Jim Lange of Lange Financial Group LLC
- Roth IRA Conversion Can Create Long-Term Security
- Delay Social Security Payments Until Age 70
- Purchasing Power More Important Than Total Dollars
- Pay Taxes Earlier on Converted Roth IRA, But Never Again
- Software and Experts Calculate Benefits of Roth Conversion
- Children, Grandchildren Benefit From Roth Conversion
- Peer Reviews Support Roth Conversions
- It’s Never Too Late to Convert Your IRA
- Roth Conversion, Social Security Strategy Are Linked
Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
Dan Weinberg: And welcome to The Lange Money Hour. I’m Dan Weinberg along with CPA and Attorney Jim Lange. Our topic this week is Roth IRA conversions. Jim is, of course, a Roth IRA expert, nationally recognized in this area, and this has been an area of expertise for Jim since the Roth was passed into law in the late 1990s. So, you might be asking, what are Roth IRA conversions? Are they right for you? When’s the right time to do one? And how much money can a conversion save you and your heirs? Over the course of the next hour, Jim will lay out the basics of Roth IRA conversions and then go more in depth. He’ll get into some specific stories to help you understand the impact that this move can have on your finances and those you leave behind. And while many people think they’re too old to do a Roth IRA conversion, you’ll learn that it’s never too late. So, with that, let’s get right to our discussion with our host, CPA and attorney Jim Lange. Hi, Jim.
Jim Lange: Good evening. The question is, are you a one marshmallow person or a two marshmallow person? Or are you saying, “What the heck is he talking about?” Well, at Stanford University, there was a study, and they gave a whole bunch of little kids one marshmallow, and they said to the kids, “Now you have a choice: You can either eat the marshmallow right now, or you can wait 15 minutes and then we’ll give you another marshmallow.” Well, what do you think most of the kids did? Of course, they ate the marshmallow practically instantly. But there were a number of kids who had the patience, and they said, “Well, we’re going to wait 15 minutes, and that way, we get two marshmallows.” Well, anyway, they tracked these kids for 40 years, and the results were somewhat surprising. The kids who waited for the second marshmallow consistently did better in terms of success, and, of course, you could argue, what defines success? Is it the number of jobs you’ve had? Is it the length of your relationships? Is it how much money you’ve made? But anyway, using certain relatively well-accepted measures of success, the kids who waited for the second marshmallow did much better.
So, how does that relate to tonight’s topic of Roth IRA conversions, with maybe a little bit of Social Security analysis thrown in? The people who are thinking long term, and thinking about the long-term security for themselves and their families, will utilize some of the top Roth IRA conversion and Social Security strategies that we’re going to be talking about tonight.
So, let’s, for example, take two couples. Each couple has the identical amount of money. Each couple has the identical earnings records for the purposes of collecting Social Security, and the first couple, let’s call them the “one-marshmallow” couple, says, “We both want to take our Social Security when we’re 62 years old. We don’t want to wait at all. And a Roth IRA conversion, that means we have to write a check to the government before we have to. We don’t want to do that. We want to keep all our money and we want to spend it.” So, that’s what they did, and for a while, they were better off than the other couple, who we’ll call the “two-marshmallow” couple. The two-marshmallow couple said, “Well, we don’t like the idea of writing a check to the government to pay the taxes on a Roth IRA conversion, and, of course, we would rather collect our Social Security earlier rather than later, but we know, after looking at the numbers, that by holding off on Social Security, and particularly for the primary wage earner to hold off until age 70, and to be making a series of Roth IRA conversions over time, that we will be a lot better off.” Now, when they’re about 70 years old, the first couple’s doing a lot better because they got all that money that they collected from Social Security. They weren’t writing checks to the government to pay the taxes on a Roth IRA conversion, and then, depending on what assumptions you use, let’s say sometime in their early 80s, and other assumptions, probably even late 70s, that it’s a tie. That is, the couple that wanted to take their Social Security early and not pay tax on their conversion was roughly, measured in purchasing power, roughly the same as the couple who held off on Social Security and then did Roth IRA conversions. But then, afterwards, it gets much, much better for the couple that waited. In fact, if they live well into their 90s, they can be more than $1.5 million better off than the couple who took Social Security early and didn’t do Roth IRA conversions.
Now, this is a pretty astounding number, because we’re not starting this analysis when they’re 30 years old. You know, I think we’ve all seen some of the graphs of when you put money into your retirement plan early, and you started at 30, and look where you’ll be when you’re 70. No, we’re talking about people starting at age 62 and having more than a million dollar difference in their lifetime just based on when they take Social Security and doing a series of Roth IRA conversions. So, that’s kind of what we’re going to be talking about today. We’ll get into a little bit of the nitty-gritty, but it just makes such an enormous difference in the quality of your life, and one of the things that I tend to do, because I tend to be quantitative, and I tend to think about charts and graphs and measurements like it’s really cool to be $1.2 million better off, but sometimes, every once in a while, it seeps in: Hey! If you’re $1.2 million better off, you can have a better lifestyle. You can spend more money. You can leave more money to your kids. You could help educate your grandchildren. You can give more money to charity. You can do a lot of things that make life much better. So, what I’m really talking about is improving the quality of you and your family’s lives, and yes, we’re going to get into some numbers and some analysis that might be slightly onerous to go through, but the rewards are just so enormous that I really think it is worth your time and effort to learn about some of these strategies, and then to actually find out the right thing for you and your family personally, and then to take action.
So, we’re going to start with some of the basics of Roth IRAs and Roth IRA conversions, and I was just in Philadelphia. I had an audience of around 80 attorneys, and I’ll tell you, the attorneys don’t really catch onto these concepts too quickly. In fact, I’m hoping that our audience today will do a little bit better than the attorneys, but the key to understanding IRAs, Roth IRAs, is to think about money in a different way. So, the way we usually think about money is, we think about money in terms of total dollars, all right? So, let’s say that Bob has a million dollars in his IRA, all right? And measured in total dollars, we would say Bob has a million dollars, where I might only have $900,000. So, measured with traditional total dollars, or, in conventional terms, Bob has a million dollars, I have $900,000; Bob has more money than I do. But my $900,000 isn’t in an IRA. It’s what I’ll call plain old after-tax dollars, meaning that when I cash it in, or when I take a distribution from it, it won’t be taxable. So, even though Bob has more money than I do, let’s say that we both want to go out and buy something. We want to buy a boat, and let’s say that the boat costs roughly $600,000, and the only money that Bob has to pay for that boat is his million-dollar IRA. So he cashes in his IRA. Let’s say that, after taxes, he has about $600,000, and he has $600,000 and he goes out and he buys the boat. Well, that’s great. He has a boat and he has an asset that is presumably worth $600,000 if you don’t take the enormous depreciation that you get after the first day of buying a new boat. I, on the other hand, only have $900,000, but since I don’t have to pay the income taxes, I go out and buy my boat and I still have $300,000 left. So even though he has more money than I do, at least to start before we cashed it in, I have more purchasing power. So I think for the further discussion that we go into, the more important it is to realize that we aren’t trying to get the total dollars. We are trying to get the most purchasing power, and if you think in terms of my goal is to get the most purchasing power for me and my family, rather than my goal is to make the most total dollars for me and my family, and you actually act accordingly, the difference of where you, let’s say, could be if you do this thing right, which is acting for purchasing power versus acting for total dollars, could literally be dramatic. It might end up being tens of thousands or even hundreds of thousands of dollars during your lifetime, and potentially even more afterwards.
So, why don’t we talk about Roth IRA conversions? And before I get into some of the technical nitty-gritty, let me tell you that I’ve been in practice, well, over 30 years, and Roth IRA conversions have been around since 1998, and I would say one of the greatest, if not the greatest, financial opportunities for most people is that sometime during their lifetime, is to become involved with Roth IRAs or Roth IRA conversions. The ideal years tend to be after you are retired but before you turn 70, for reasons that we’ll get to shortly. But I would say for the vast majority of people at some point in their lifetime, it might be early in their life or maybe in the middle of their lifetimes or towards the end of their lifetimes, that doing a Roth IRA conversion, or, more likely, a series of Roth IRA conversions, represents an enormous financial opportunity, and again, this financial opportunity isn’t just numbers in a bank. This is a difference in the quality of your life and the quality of the lives of your family.
So, what is really going on with a Roth IRA conversion? That is where you’re taking an IRA, and by the way, I say IRA, but it could also be a 401(k) or a 403(b), but, for our purposes, let’s assume it’s an IRA. You’re taking an IRA, or a certain amount of an IRA, and you’re paying income taxes on that money before you have to, which just really sounds counterintuitive. So, let’s say, for discussion’s sake, that you had $100,000 that was in a retirement plan, or in an IRA, and your plan was not to touch that for many years. So, what you could do is you could do nothing. So, you have your $100,000 in your IRA, and let’s just assume, for discussion’s sake, you have $25,000 outside your IRA. So, let’s call it the “status quo” of owning $100,000 in an IRA and $25,000 outside an IRA, is that the $100,000 in the IRA will continue to grow income tax deferred, not income-tax free, you don’t have to pay the taxes on the IRA now, but someday, perhaps when you turn 70 and you’ll have to take money out, or before that, or even well after that, or possibly even after you’re gone, and it will apply to your spouse or your kids, but someday, somebody will pay income taxes on not only the amount in the IRA now, but the growth on the IRA. Then, the $25,000, or the money outside the IRA, again, for, let’s call it, Mr. Status Quo, they’re just going to invest that money, it’s going to earn dividends, interest and capital gains, they’ll have to pay some income taxes on the dividends, the interest and the capital gains, and they then get the growth on their IRA and their after-tax dollars.
Now, the couple that I called couple Number 2, the two-marshmallow couple, they might, after hiring the appropriate advisor to run the numbers, and we can talk a little bit more about that later, what they might do is say, “Hey, after running the numbers, it looks very clear to us that the long-term best strategy is to make a Roth IRA conversion of our $100,000.” Now, to keep life simple, let’s assume a flat income-tax rate of 25 percent. So what they do is they fill out the appropriate form. Let’s say their money is at Schwab or wherever it might be, and they fill out the form to take their regular IRA and make it a Roth IRA. So now, what’s going to happen is Schwab is going to send them a 1099 and say, “Please add $25,000 to your income.” So, they say, “OK, well, we have to pay income taxes on the $100,000 Roth IRA conversion. We knew that was coming all along, and we had this $25,000 set aside to do it.” So they do that.
Now, what do they get for that $100,000 Roth conversion? Well now, they have $100,000 in a Roth IRA compared to the one-marshmallow couple who has $100,000 in a traditional IRA, and remember, the first couple has the $25,000, and I’ll call it after-tax dollars, where the two-marshmallow couple, they have $100,000 in a Roth. Well, that Roth IRA is going to grow income-tax free for the rest of the IRA owner’s life. If the IRA owner dies and passes it to his spouse, the spouse also gets tax-free growth, and the bonus for both of them is that … and this is just a bonus. This isn’t the reason you do a Roth IRA conversion. This is just a bonus, is that neither of them will have to take any minimum required distributions from that Roth IRA when they turn 70, or, technically, April 1st after the year they turn 70½. So, that money’s growing income tax free, and by the way, after they pass, depending on which law is in effect at the time of their passing, but let’s assume, for the moment, it is the present law, that money will grow income-tax free, at least to some extent, for the lives of the children and the grandchildren. Yes, the children and grandchildren will have a minimum required distribution of the inherited Roth, but those distributions will be income-tax free and they will be relatively small in the early years and will grow and grow as the child or grandchild or any other type of non-spousal heir ages.
So, whereas Mr. and Mrs. One Marshmallow, they’re having to pay income taxes every time they make an IRA distribution. They’ll have to when they’re 70½, but they also have the $25,000. So which one is better off? The one-marshmallow person, or couple, or the two-marshmallow couple? Well, when you run the numbers, and again, this is a very important concept, but when you run the numbers, what you’ll find, and I’m going to skip all the assumptions because I would bore people to tears, is that the two-marshmallow people, just 20 years after they make the conversion, are $50,000 better off than the first couple that didn’t make the conversion. Now, think about this. You make a Roth IRA conversion. Now, of course, your exact situation is going to be different, and maybe a Roth IRA conversion of $100,000 might not be the best thing for you, maybe it would be $20,000, maybe it would be $40,000. In some cases, it might be zero for a number of years, perhaps while you’re working and you have a high income, and it might be even more than $100,000 in the years between retirement and 70½. But just think about this: you yourself, forget your heirs for a moment, you and your spouse are better off by $50,000 or more if you make this Roth IRA conversion.
Now, let’s take it a step further. Let’s say that you’re in your 60s and you make this Roth IRA conversion, and yes, you yourself, measured in purchasing power, are better off by $50,000 20 years from now, but then you die and you leave the money to your adult children. Let’s take a look at your children, that is, Mr. and Mrs. Two Marshmallow children versus Mr. and Mrs. One Marshmallow children. The children of the Two Marshmallow family are better off by over $600,000. Now, think about this: $600,000, that’s how much your kids are better off if you make a conversion of $100,000 using certain reasonable assumptions. Then, if you leave the money to your grandchildren, they’re literally better off by probably around $8 million, again measured in purchasing power. Now, I will grant you that there is a flaw to my analysis, and the flaw is I have not taken into consideration for inflation. So, you’re not really better off by $50,000, you’re better off by $28,000. That is in today 2017 dollars. Your kids aren’t really better off by $608,000, they’re really better off by $160,000, and your grandkids really aren’t better off by $8.9 million. Measured in today’s dollars, they’re better off by $838,000.
But this is still just such an enormous opportunity, and you don’t often hear it spoken about correctly, and I’m going to go off on a tangent here, but let me tell you that this is not a matter of an opinion. Before the Roth IRA conversions came out, there were roughly 15 top IRA experts in the country, and it’s hard to measure expertise, but let’s say by speaking fee commanded and number of books sold, Ed Slott is at the very top of that list. I’m probably closer to the bottom of that list. But all of us thought about, wrote about, spoke about IRAs at length. Anyway, we’re all still around right now and we’re all advocates of Roth IRA conversions. Now, there are some who have some slightly different ways of looking at it. Some, like me and Bob Keebler, we like to run the numbers. Some, like Natalie Choate, think it’s a matter of balance where you should have some Roth and some traditional, and by the way, she’s, like many other things, she’s right. But there’s no such thing as an IRA expert who thinks Roth IRA conversions are always a bad idea for everybody. And the other thing is, I don’t think it’s a matter of voodoo or a matter of guessing as to how much and when you should make a Roth IRA conversion. I actually believe that this can be mathematically calculated, and it’s not nuclear physics. It’s actually much easier. There’s a number of good software programs out there. By the way, the ones that are typically available to the consumer for free or little money have some major, major problems in my opinion, because they don’t use purchasing power as their measurement tool. They use total dollars, and their conclusion is that Roth IRAs are good for young people because it will take them a certain number of years in order to catch up to paying the taxes on the conversion, but not so good for older people who don’t have that many years left. Actually, measured in purchasing power, as we’re going to see, it’s actually a tie on Day One. But anyway, before we break, the idea here is you can, with the right people and the right software, come up with the ideal long-term Roth IRA conversion plan, and it would be well worth your while to either on your own, or to engage the appropriate firm that knows how to do this, come up with a long-term Roth IRA conversion plan, and then, as the tax laws change, as the portfolio goes up and down, as your particular situation changes, then update that analysis every year, and I think by doing that, both you and your family can have a much more enriched life.
Dan Weinberg: All right, and we are going to continue our discussion about Roth IRA conversions after this quick break. You’re listening to The Lange Money Hour, Where Smart Money Talks.
Dan Weinberg: And welcome back to The Lange Money Hour, Where Smart Money Talks, featuring CPA and Attorney Jim Lange, and this week, Jim is talking about Roth IRA conversions. Now, in the last segment, Jim, you covered the basics. How about now sharing with our listeners some Roth IRA conversion stories?
Jim Lange: OK, well, how about if I start with my own Roth IRA conversion story? So, we now have to go back to 1998, and in 1998, it was actually February 16, 1998, our office, and, at the time, we had a CPA firm and a law firm and just the beginnings of a financial-planning firm, our office suffered a horrendous fire. We were located right above a pizza shop, and there was a devastating electrical fire and our office was pretty much wiped out. This is on February 16, 1998. We still had about 500 tax returns or more to do. Now, we do over a thousand, but we still had quite a few back then, and our office was literally in flames. So what do you do then? Well, the first lesson is never, ever put your office above a pizza shop, all right? Let’s get that straight right now. Bad idea, don’t ever do it. But then, you know, you learn these things through experience, so we were lucky enough to get an office nearby, and we were pretty much scrambling, at least for the year, and then, to make the financial issues worse, even though I did have good insurance, I didn’t receive the insurance proceeds until the following year. So, just think about all the expenses of having to move, having to restart an office, having to get all new computers, all that type of thing, but not having the cash flow to do it. So, obviously, 1998 was a pretty miserable financial year for me, and at the time, my wife and I, we were in our early 40s at the time, we had roughly a quarter million dollars in our combined retirement plans, and I said to my wife — and she’s a pretty sharp cookie; she has a Master’s in electrical engineering from Carnegie Mellon University, which she attended, by the way, because she heard it was a good party school. That’s a true story, by the way. She had a boyfriend that was going to school nearby. She wanted to have a good time. No, she was into computers, to be fair, but she went to CMU because it was a good party school. Anyway, she ended up doing just fine with her career and her education. But anyway, she’s a smart cookie and a quantitative cookie. So, I said to her, “I think we ought to make a Roth IRA conversion of our entire $250,000 in our retirement plans, add that to our income and pay income taxes on it.” Well, this didn’t sit too well with her, but, like other engineers, and this is what I hope for when I work with engineers, and particularly the spouses of engineers will appreciate this even more than the engineers, engineers sometimes have a certain view of the world and it’s usually pretty difficult to show them any other view of the world, and they kind of have their own mind-set on the way that they want to do things, and I get that, and I’m, frankly, a lot that way myself.
On the other hand, what I hope when I have this type of client or prospect who has certain ideas, that if they are data-driven, that is, you could show them on whether it’s a computer screen or even just an old-fashioned pad of paper and a pen, you can show them that there is a better way, and you show them mathematically why the idea that you have is going to be better for them. If they are truly data-driven, they will say, “Yes, that’s a good idea. Let’s do it.” And that’s what my wife did. So we ran the numbers. Again, back then, we didn’t have all the fancy Roth IRA conversion software that we do now. We just did it, frankly, kind of in a primitive Excel spreadsheet, and yes, I did convince her that the right thing to do was to make a Roth IRA conversion of the entire $250,000 and pay income taxes on the entire amount, which we did. At the time, we figured, “OK, so we have this $250,000 that’s going to grow income-tax free for the rest of our lives, and when we are older, we will be able to make withdrawals from that Roth IRA converted money income-tax free. If there’s money left over, that’ll even be better, because that money can eventually go to our daughter,” who was 4 years old at the time. Well, as it turned out, and very frankly, part of the reason for my financial success is me educating clients and prospects and readers and listeners on Roth IRA conversions. So, partly and due to that, that we ended up in a situation where it is possible we will never need that Roth IRA conversion because other monies that I have accumulated and worked for since then, and my wife has also, we won’t need the money that was originally $250,000, which will be a couple million dollars probably by the time we’re both gone, in a Roth IRA. So, that money will ultimately go to our daughter, again, who was 4 years old at the time. Now, our daughter, we are, let’s say, overly protective, at least in the financial area, we are planning to leave a lot of money to. We have a second-to-die life insurance policy, meaning that after both of us die, our daughter will get a certain amount of money income-tax free, and other monies that we have saved. It is possible that our daughter won’t need that money in the Roth IRA, or the inherited Roth IRA, and that money could then be disclaimed using Lange’s Cascading Beneficiary Plan, which is, let’s say, perhaps, a whole focus of a different show, or if you wanted to read about the best retirement and estate plan for IRA owners, you could get my book Retire Secure! You can actually get it online for free at www.paytaxeslater.com/book and read Chapters 13, 14 and 15 to learn about the best estate plan. But through a concept called “disclaimer,” our daughter could disclaim into a trust for her children. So, we’re talking about the children of a girl who was 4 years old when we made the conversion. Our family will be millions and millions of dollars better off because we made that Roth IRA conversion, and yes, I was probably one generation younger than many of our listeners now, and yes, the facts were particularly good for a Roth IRA conversion, but the key is that I took action and our family will be way, way better off.
And by the way, some of you might be saying, “Well, gee, Jim, if this information is so great, how could you possibly prove this to the world?” The answer is, if you’re a physician and you want to prove that you have the best protocol for a particular illness, or you have the best medication, typically what you’ll do is you’ll write a peer-reviewed article, get it published in the New England Journal of Medicine or a different journal, and you can say, “Hey, my peers have studied this material and they have said, ‘Yes, it’s fine, it passes muster.’” Well, all the analysis that I just gave you on Roth IRA conversion, all that has passed muster with the American Institute of CPAs, which is the peer-review article for CPAs. I think about 60,000 CPAs who are members of the tax division of the AICPA subscribe to that journal. Anyway, so everything I’m telling you is peer reviewed, and that Roth IRA conversion worked out enormously well for my family. We have also been very proactive in recommending Roth IRA conversions. I’ve written a book about it. By the way, that book is also available for free at the same site, www.paytaxeslater.com/book. You can look at a book called The Roth Revolution: Pay Taxes Once and Never Again, and that’s the essence of a Roth IRA conversion. You pay taxes once and you never do it again. And I have helped literally thousands of people with Roth IRA conversions. At an early point in my career, I didn’t really offer the running numbers like we do on a regular basis now. That is now a staple of asset under management clients for the Lange Financial Group. We actually run the numbers, and we determine many things, of which Roth IRA conversions are just one facet. We haven’t talked about Social Security tonight, but if we have time, we will slip that in because it is really critical to get Social Security right.
The other thing about Roth IRA conversions is it is a particularly intriguing strategy in light of the potential death of the stretch IRA. So, if you’ve been following our show, or following my literature, I am extremely concerned that the Senate Finance Committee’s vote of 26 to 0 to basically kill the stretch IRA is going to become law, probably in 2018, possibly even this year, and that’s going to just change radically what the estate plan is going to look like for our children and grandchildren for people who have significant IRAs, and by significant, I mean $450,000 or more. That’s not an arbitrary number. That is the amount that is excluded from the death of the stretch IRA. Anyway, without going too much into the death of the stretch IRA, one of the main strategies to reduce the impact of the death of the stretch IRA is to make a series of Roth conversions. Now, interestingly, the Roth IRA conversions will work out even better under the existing law than under the proposed law, but it is one of the defenses to protect your money from Uncle Sam and to protect your family with the pending death of the stretch IRA.
Another one, by the way, is having flexible estate-planning documents. I had mentioned earlier Lange’s Cascading Beneficiary Plan. We’ve actually developed a five-step process to help your tax planning and tax-savvy retirement and estate planning now and in light of the death of the stretch IRA, and guess what? That’s also been written up in a book, The Ultimate Retirement and Estate Plan for Your Million-Dollar IRA, and that book is also available for free. There, it’s the first thing that you see on the website, although we might change it at some point. So, it’s either www.paytaxeslater.com or, perhaps a little later on, www.paytaxeslater.com/book. But at the moment, all you have to do is just go to the website and you can download that book. I think it’s about 40 pages. I have taken the best concepts of Retire Secure!, which is my flagship book, boiled it down to its essence, and I have included analysis on the death of the stretch IRA. Anyway, the reason I went through all that is because it is one of the defenses against the death of the stretch IRA.
OK. The other thing is, you might be thinking, “Gee, I wish I had done Roth IRA conversions earlier, but I think it’s too late for me.” Well, I think that you will be heartened at our next story that we will take right after the break.
Dan Weinberg: That’s right. It is time for our final break of the hour. We’ll be back with more on Roth IRA conversions right after this quick message. This is The Lange Money Hour, Where Smart Money Talks.
Dan Weinberg: Welcome back to The Lange Money Hour, Where Smart Money Talks, featuring CPA and Attorney, Jim Lange. And this week, Jim is talking about Roth IRA conversions, and Jim, there might be some listeners out there who are thinking, “You know, I’m too old to do this. A Roth IRA conversion just isn’t for me. I’ve missed my chance.” What would you say to them?
Jim Lange: Well, why don’t we talk about one of my clients, who was literally at the end of his life? He was terminally ill, and nobody was pretending at this point. He was going to die within the year, and usually, I ask for people to come to my office, but occasionally, if somebody is not ambulatory, I will go to their house, and he was not ambulatory and I went to his house. A smart old engineer, and he was not a regular client. I’ve done something similar much more frequently for regular clients, but he had heard that I had a clue as to how I could presumably help him, although, for him, there wasn’t really that much I could do, but how could I protect his family from unnecessary taxation. Well, let’s oversimplify his finances. He had roughly a million dollars in his IRA and roughly $300,000 outside his IRA, and he basically said, “OK, here’s the deal, Jim. I’m going to die this year. There is no chance I’m going to live beyond the year, and I want to know what can I do for my family with my million dollars in my IRA and my $350,000 outside the IRA?” I’m going to oversimplify the analysis, but anyway, I kind of knew as soon as I met him, what the answer was, and then that, let’s say, gut instinct was confirmed after running the numbers, but the conclusion was that he should make a million dollar Roth IRA conversion. So, literally, a deathbed Roth IRA conversion. So, he basically had to pay the $350,000 that he had outside the IRA to the IRS in taxes, and he was left with a million dollars in a Roth IRA, and then, of course, he died, leaving the Roth IRA to a combination of children and grandchildren.
Now the children and grandchildren are currently receiving what’s called the minimum required distribution of the inherited Roth IRA from that account, and that account is growing income-tax free and will continue to do so for the rest of their lives. Now, had he not made the million dollar deathbed Roth IRA conversion, the children and grandchildren would have been receiving an inherited IRA instead of an inherited Roth IRA, meaning that they would have to pay income taxes on their distributions. “But,” you say, “they would also have the $350,000.” Well, actually, that’s not true because the way it worked out is this was back in the days when there was only a million dollar federal exemption amount, is that we reduced his estate by $350,000 because even though the status quo was he would die with $1,350,000, meaning $350,000 would be over the exclusion amount and his family would have to pay federal estate tax on it, we ended up in a situation where his total estate was a million dollars, and even though at that moment of his death, it was equal purchasing power, having the lower amount, that is, having the money in the Roth, saved him inheritance and estate tax, and yes, I will concede that federal estate tax is not an issue for most of us with married couples being able to exempt almost $11 million now, but there’s still PA inheritance tax. But even forgetting that, the ability for his children and grandchildren to have tax-free distributions for the rest of their lives ended up, when you run the numbers over the period of their lives, that they will be millions of dollars better off. So, it’s never too late to make a Roth IRA conversion.
Now, again, we are big fans of running the numbers, and that’s pretty rare that we are going to recommend a million dollar Roth IRA conversion. What is much more typical is that we recommend doing a series of Roth IRA conversions. I haven’t really gotten too much into some of the, let’s say, quantitative part, but if you think about it, when you’re taking the income on a Roth IRA conversion and adding it to your existing income, you might literally throw yourself into a higher tax bracket. So, does it really make sense, let’s say that your taxable income is somewhere in the, let’s say, high to mid-60s, and you’re still paying at the 15 percent marginal tax bracket. Does it make sense for you to make a $100,000 Roth IRA conversion? Well, that might throw you into a higher bracket, maybe the 25 percent bracket. On the other hand, let’s say that that is your income, but when you turn 70, that the combination of the minimum required distribution of your IRA that you don’t convert and your Social Security will push you into the 25 percent or 28 percent bracket, then it very well might make sense to do a series of conversions. Now, again, we don’t want to push you into too high a bracket, which is why typical advice is do a series of small ones.
Now, we don’t know what’s coming up with tax reform, but if tax reform does lower the income tax brackets, it would probably be a great time to start thinking about Roth IRA conversions because what has happened literally every single time a Republican administration or president has managed to get a tax-reform billed at lower taxes, it was followed by a Democratic president and/or administration that raised taxes. So even if President Trump and the Republican Congress are successful in lowering our taxes, I think it is inevitable in the long run, plus I think this country is so debt-laden that we have to get the money from somewhere to pay for it, that the taxes will go up again. If that happens, that would be kind of like an artificially low income period or tax-rate period in order to make a Roth conversion. On the other hand, more typically, it would be what’s going on with your life. So, let’s say you’re in your mid-60s, money’s good, you’re making a lot of money, you’re in a high tax bracket, well, now’s not a great time to make a Roth conversion. But let’s say your plan is to retire at 66, at which time you’re not going to have the income from your job or your business. You’re not going to have a minimum required distribution from your IRA. Let’s assume you’re also going to use my advice and hold up on Social Security. So, you’re going to have a really low income-tax bracket between 66 and 70. Well, that would be a great time to make Roth conversions because then, you’re going to be paying income taxes on the Roth conversions at a low rate, and if we were to run the numbers and compare them to some of the numbers I had mentioned earlier, they would be even much more favorable than the numbers I had mentioned. So, that’s kind of my favorite time to do a Roth conversion. On the other hand, we do plenty of Roth conversions for people who are still working. We do plenty of Roth conversions for people who are over 70.
Now, you’ll notice that I had the person who I wanted to wait until 70 to take minimum required distributions, and I also wanted him to wait until 70 before he took his Social Security. Well, if you think about it, if you hold off on taking Social Security, you’re going to reduce your income for the purposes of Roth IRA conversions, meaning you’re going to be able to make a bigger Roth IRA conversion at a lower tax rate than if you had actually taken your Social Security early. So now we find that the ideal time to take Social Security and the ideal amount to make a Roth IRA conversion are not two independent calculations. It’s actually a synergistic calculation, and the real synergy comes in holding off on Social Security and then making a series of Roth IRA conversions between retirement and age 70. And we have done this many, many times over the years for clients, and it is just a joy for clients to see the benefits of this, and, you know, when we run numbers to just show what a huge, huge difference it does make over time.
Now, there’s all kinds of nuances that we have not talked about. We haven’t talked about, what we would call, the “back door” Roth IRA conversion for high taxpayers. We haven’t talked about the in-plan Roth IRA conversion in the event that money is in your 401(k) or 403(b). And then you might be thinking, “You know, this just doesn’t seem right. These little tricks where we do these Roth conversions and we hold up on Social Security and we do all these things to reduce our taxes, and it’s just really tomfoolery and it just doesn’t seem fair. Why shouldn’t I, who’s making a certain amount of money and have a certain amount of assets, why should I and my family be hundreds of thousands of dollars, sometimes a million dollars or more, better off than the family of my next door neighbor who has the identical resources, but he just doesn’t use all these techniques?” And these issues have come up in the past, and I’d like to quote a judge who actually was involved in a case where a taxpayer was using a technique to reduce his taxes, and the judge was named Learned Hand. That’s not a misprint and I didn’t pronounce his name incorrectly. It’s Judge Learned Hand, and he said, in his opinion, “Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose the pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” And frankly, Judge Learned Hand, that is what I base my business on. I think people want to get the absolute most out of their money for themselves, for their families, so they can do the things that they want to do and have financial security so that they can lead a life of dignity, and, after they pass, that their spouse will be better protected. Of course, Roth IRA conversions are only one part of it. You want to get the estate planning right. You want to get, if you have a traditional family, Lange’s Cascading Beneficiary Plan. You want to get gifting, if appropriate, right. You want to get your Roth conversions right. As many of you know, I’m a big fan of low-cost indexing, and the home run is to get all of these strategies right, which I would urge you to do whether it’s through me or through somebody else. It will make an enormous difference on the quality of your life and the lives of your spouse if you are married, and children and grandchildren.
Dan Weinberg: All right, Jim, thanks so much, and listeners, we hope that you got a lot out of this hour about Roth IRA conversions. If you’d like to meet with Jim Lange in person, give the Lange Financial Group a call at (412) 521-2732 to see if you qualify for the Lange Second Opinion service. That number again is (412) 521-2732, or you can connect with Jim’s office through his website at www.paytaxeslater.com. While you’re there, you can also get a free digital copy of Jim’s latest book, The Ultimate Retirement and Estate Plan for Your Million-Dollar IRA. For now, I’m Dan Weinberg. For Jim Lange, thanks so much for listening this week, and we will see you next time for another edition of The Lange Money Hour, Where Smart Money Talks.