Unlock the Benefits of Roth Conversions

Unlock the Benefits of Roth Conversions – Welcome to the Webinar (0:00)

Alek Johnson: Welcome, welcome everyone.

We’re just going to give it a minute here to let everyone start funneling into the webinar.

I hope everyone has been enjoying their summer. If you’re local here in Utah, it’s been extremely hot this week, so I hope you’re managing despite the heat. But it’s been beautiful weather, so hopefully, you have some good plans for July 4th and the upcoming holidays.

Alright, it looks like a good number of us are here, so I’m going to go ahead and share my screen, and we can get started.

Okay, perfect. Well, again, good afternoon. Welcome everyone. My name is Alec Johnson. I am one of the certified financial planners and the lead advisor here at Peterson Wealth Advisors. I’m excited to be here with you today. We’re going to discuss all things Roth conversions. As you can imagine, this is one of those questions that we, as advisors, are constantly getting, which makes sense. Everyone wants to be tax efficient, so hopefully today, we can help provide a little bit more clarity surrounding this particular strategy.

A couple of quick housekeeping items. First, my goal today is to keep this presentation around 30 minutes. It might go a little bit over, but hopefully, we can keep it close to about half an hour. I wanted it to be fairly comprehensive, but this is just one of those strategies where, realistically, I could spend hours going through example after example of when it does and doesn’t make sense to convert. Hopefully, 30 minutes is the sweet spot to give us a good understanding.

If you have any questions during the presentation, please feel free to use the Q&A feature located at the bottom of Zoom to ask a question. One of my colleagues, Zach Swenson, another advisor here at the firm who does an awesome job for us, will be answering some of those questions as we go. At the end, I will spend probably three to five minutes or so just answering any general questions that you have yourself.

If you have a more individualized question, please feel free to reach out to either your advisor at Peterson Wealth if you’re one of our clients. If you’re not a client and you want to know a little bit more, please feel free to schedule a free consultation with us; we are absolutely happy to help.

Lastly, as always, at the end of the webinar, we will have a survey that will be sent out to give me and our team some feedback. Any suggestions you have on future topics, things like that, please use it. It’s always super helpful for us to know what’s on your mind so that we can use these webinars to continue to best help you through your retirement or as you approach it.

Alright, so here’s a quick agenda of what I want to cover with you today. We’re going to start off by discussing the differences between traditional and Roth accounts. Then I’ll break down what a Roth conversion is, the benefits you can receive from it, some of the tax implications of these conversions, when you should and should not consider a conversion, and then finally, we will go through a couple of examples to hopefully clarify the things we’ll talk about today.

Now before we jump in, a quick disclaimer: I do need to say this is not investment advice; it is for general purposes. I especially want to highlight that when it comes to Roth conversions. This is one of those strategies that is so popular and talked about. But contrary to popular belief, it doesn’t always make sense to do a Roth conversion. So please don’t view this presentation as me recommending that you should convert, but rather as a way to get a better understanding of how this strategy actually works.

Traditional IRA vs. Roth IRA (4:08)

With that being said, let’s go ahead and dive in. I want to start by building a baseline and making sure everyone understands the differences between a traditional IRA and a Roth IRA.

A traditional IRA, or individual retirement account, is essentially a type of savings account designed specifically for retirement that has some tax advantages. These are very much like your 401(k)s, 403(b)s, TSPs, or any employer-sponsored plan. Generally, the biggest difference is you can contribute more to those employer plans than you can to a traditional IRA.

Regarding contributions, with traditional IRAs, you can contribute each year. There are limits on how much you can contribute annually. For 2024, the cap is $7,000. For those aged 50 and up, which is probably many of you, you can contribute an extra $1,000, totaling $8,000.

The money you contribute can be tax-deductible, meaning you can subtract it from your income to lower your taxable income and essentially lower your taxes. One requirement to contribute each year is that you have to have earned income. This is income you actually worked for, such as W-2 wages or self-employment income. Income from rental properties, pensions, or social security doesn’t count.

You can contribute to your IRA up until the tax filing deadline, generally around April 15th of the following year. So, for 2024, you can contribute to a traditional IRA until 2025.

The second thing here is tax-deferred growth.

So the money in your IRA is going to grow tax-deferred. You put it in, get a deduction, and then it grows tax-deferred. This means you’re not going to pay any taxes on the earnings and gains you see each year.

You can invest this money in all types of stocks, bonds, mutual funds, and ETFs, giving you full access inside of that IRA account. All of that growth will be tax-deferred as long as it’s in there.

However, when you withdraw it, all of those withdrawals are taxed as ordinary income, just like your wages or self-employment income.

One thing to note here, if you take money out before 59 and a half, there are a few exceptions, but generally speaking, you will have to pay a penalty. That penalty is about 10% on whatever you take out, so they do incentivize you to hang onto this until you’re retired.

And the last point here is the required minimum distribution (RMD). Starting at either age 73 or age 75, depending on the year you were born, you will be required to take money out of those accounts, whether you need the money for income or not. The government has been patient waiting to tax this money, but eventually, they will start forcing you to take it out.

So what’s the difference between a traditional and a Roth IRA? A Roth IRA is a similarly designed retirement savings account that offers tax benefits, but those benefits are a little different.

You can contribute to a Roth IRA and are capped at the same dollar limit, so that same $8,000 contribution limit applies to Roth IRAs. However, how you contribute to this account is with money that you have already paid taxes on. This means you don’t get any upfront tax deduction like you would with a traditional IRA.

There is also an income restriction on contributing to a Roth IRA. For example, if you’re a married couple filing jointly in 2024, you can’t make over $240,000 of income and still contribute to a Roth IRA. There are sometimes income limits depending on if you’re covered by an employer plan on a traditional IRA, but for Roth IRAs, you can’t exceed that $240,000 income threshold.

The second thing here is tax-free growth and withdrawals. The biggest benefit of a Roth IRA is that your money grows 100% tax-free. You won’t pay any taxes on the earnings, and when you go to pull that money out in retirement, it will also be tax-free, assuming a couple of conditions are met: the Roth IRA must have been open for at least five years, and you must be over the age of 59 and a half to avoid penalties.

A significant benefit of a Roth IRA is that it is not subject to Required Minimum Distributions (RMDs). You will not be forced to take money out of these accounts during your lifetime, allowing it to stay in there as long as you want.

Now that we’ve had our appetizer, so to speak, and gone through a quick overview of the two different accounts, let’s dive into the main course and talk about what a Roth conversion is.

For most retirees, it is much more common to have retirement accounts in the pre-tax category, such as traditional IRAs, 401(k)s, and thrift savings plans. A Roth conversion allows you to take a traditional IRA or another pre-tax retirement account and convert it, either all of it or a portion, to a post-tax Roth account. This moves the money from an account where you pay taxes to one where it will grow tax-free forever.

So what’s the catch? Why not just convert everything into a Roth and never worry about paying taxes again? The catch is that any money in a pre-tax account has never been taxed before. Therefore, any amount you choose to convert becomes taxable in the year the conversion is performed. As you take money out of the account, you create a tax liability.

For this reason, it’s uncommon to convert an entire account all at once, as it would likely push you into a higher tax bracket and make your tax bill unnecessarily large. For example, if you had a million dollars in your IRA and converted all of it at once, you could expect to pay close to 40% in taxes. We want to convert enough to get the future benefits of the Roth conversion, but not so much that it pushes us into a higher tax bracket.

If not already evident, a Roth conversion and a Roth contribution are not the same. Here are some key facts surrounding Roth conversions:

First, there are no income limits on a conversion. Whether you make $1 or a million dollars a year, you can still convert from a traditional IRA into a Roth IRA.

Second, there are no age restrictions for Roth conversions. However, if you’re doing it before 59 and a half, be aware of some specific rules.

So, you can do this at any time.

Number three, there’s no limit on how much you can convert. You’re not limited to converting only that $7,000 or $8,000 like you are with contributions into a Roth. You can convert your entire account if you really wanted to.

Fourth, the conversion must be completed within the tax year. This is very different from contributions, which you can do up until the tax filing deadline. The conversion has to be done by December 31st.

For business owners, this can be troublesome because they may not know their income until the end of the year. So, the closer you can dial in your income, the better.

And the last point here is regarding required minimum distributions (RMDs). If you are 73 or older and subject to RMDs, you have to take your RMD first for the year before you can convert. Your RMD cannot be converted to a Roth IRA. You have to take it as income and either use it or invest it in another brokerage account, but it cannot go into the Roth IRA. A conversion must be in excess of your RMD.

Benefits of a Roth Conversion (13:37)

So, what are the benefits then? If I have to pay taxes on these conversions, what am I actually getting out of this? Despite the immediate tax liability, there are several benefits to doing a Roth conversion.

First, we’ve already discussed tax-free withdrawals. Once the money is in that Roth IRA, any future withdrawals on earnings and contributions will be tax-free. This can be especially advantageous if you expect to be in a higher tax bracket during retirement.

Second, as we mentioned, there are no RMDs. Unlike traditional IRAs, you won’t be forced to take money out.

Third, is tax diversification. You often hear about diversification in terms of investments, but it also applies to taxes. Having both traditional (pre-tax) and Roth (post-tax) retirement accounts can provide flexibility when managing your taxable income during retirement. You can strategically withdraw from each account type to minimize your tax burden. For instance, if you need a lump sum during retirement, withdrawing from the Roth IRA won’t increase your taxable income.

Fourth, estate planning benefits. Roth IRAs can be very advantageous for estate planning because your beneficiaries will inherit those accounts tax-free and can leave the money in them for up to 10 years after your death, gaining another decade of tax-free growth, which helps preserve your wealth across generations.

Fifth, is the future tax rate hedge. If you expect tax rates to increase in the future, converting to a Roth IRA now can lock in the current tax rate. This is particularly useful if you foresee making more money due to income increases or anticipate legislative changes that might increase tax rates. Locking in now at a lower rate can be beneficial.

Lastly, is the reduction of future RMDs. By converting some of your traditional IRA balance into a Roth IRA, you reduce the future RMDs on that traditional IRA, thereby lowering your taxable income in later years.

When to Consider a Roth  Conversion (16:38)

Now, a lot of times you hear sayings like “Roth is king” or “Roth accounts are no-brainers.” A common misconception is that it’s always better to pay taxes now and let the money grow tax-free. However, the truth is it doesn’t matter whether you pay taxes now or in the future if the tax rate is the same. Deciding which is more advantageous comes down to several factors.

Here are some factors you need to consider:

  • How long you will work.
  • How long you expect to live, especially if you have a family history of illnesses.
  • What tax bracket you are in currently versus what tax bracket you will be in during retirement. This is a big factor in planning out your Roth conversions.
  • What types of income sources you will have in retirement, such as social security, pensions, rental income, and other types of income.
  • Whether the government changes tax rates and in what direction. Currently, we are at historically low federal tax rates, so they are likely to go up, but if they go down, that also impacts when you want to do those conversions.
  • What state you live in and when. State taxes matter significantly when it comes to Roth conversions.

Here are some common scenarios when it may make sense to consider doing a Roth conversion. However, even though this is speaking in generalities and it may make sense, it doesn’t necessarily mean it will for you.

So even with these examples, please be thoughtful when considering these conversions.

The first scenario is when you have a low-income year. If you have a year with unusually low income, such as during a job transition, if you’re a business owner, on sabbatical, or taking early retirement, converting to a Roth IRA during that year could be very advantageous. You’ll pay taxes at a lower rate on the converted amount.

For example, this is where serving a senior mission can come in handy. We have a good number of clients who want to serve missions and generally spend less on their mission than they do at home. Missions can provide a really good opportune time to make those Roth conversions.

Second, if you believe your tax bracket will be higher in retirement. Paying taxes now at a lower rate can save you a lot of money if, in retirement, you’ll be in a higher tax bracket than you are now.

Third, if you foresee an RMD issue down the road. Let’s say you have a large IRA and know you’ll be forced to take out big chunks of money. That could bump you into a higher tax bracket. If you can foresee this and are now at the age of 73 or 75, you might want to start chipping away at your IRA through Roth conversions.

Fourth, if you expect tax rates to increase in the future due to changes in tax laws, converting now locks in that lower rate.

Fifth, I hesitate to put this one on here because at Peterson Wealth Advisors, we do not do any market timing when it comes to investment management. Converting during a market downturn can be beneficial because you’re converting at a lower value. This means that once you convert at the bottom, all of the future growth will be tax-free within your Roth IRA.

Next, state taxes can play a significant role. If you live in a low-tax-rate state and plan to move in the future, converting now can save you money. For example, if you lived in Wyoming, which has no income tax, and planned to move to Utah, you would save an extra 5 cents on the dollar by converting while in Wyoming compared to Utah.

Now, there are also times when you should not consider doing a Roth conversion. This list is not comprehensive, but it gives a good idea.

Number one, if you’re currently in a high tax bracket and expect to be in a low tax bracket during retirement. In this case, it may not make sense to convert. You should be contributing to a traditional IRA or 401(k) to avoid the higher tax rate now and pull it out at a lower tax rate in retirement.

Second, if you have insufficient funds to pay the taxes on your conversion. If you don’t have money in a savings account or a regular brokerage account to pay the taxes on the conversion, it may not be wise to convert. For example, if you want to convert $50,000 from a traditional to a Roth and are in the 20% tax bracket, you would need to withhold $10,000 for taxes, leaving only $40,000 in the Roth IRA. We would prefer to have the full $50,000 in there and pay taxes with outside money.

Third, if you anticipate needing to withdraw these funds for living expenses or a large expense, it’s probably not beneficial to convert the money into a Roth. Conversions are best when you can leave the money in the Roth IRA to grow tax-free over a long period.

Fourth, if you are close to or at RMD age. If you are forced to take RMDs, converting on top of that might increase your taxable income more than desired. Although it can make sense for some clients, it often doesn’t.

Fifth, if you have children applying for college financial aid. A Roth conversion increases your taxable income, potentially reducing the financial aid your children qualify for.

Sixth, if you’re eligible for certain tax credits and deductions, a conversion might reduce your eligibility. For example, it could affect the child tax credit, education credits, or medical expense deductions.

I’m sorry about that. I don’t know what is beeping in here.

My apologies. I think it was my desk. Smart desks.

Alright, number seven here is if you’re very charitably inclined. If you find yourself giving to different charities, there are other tax moves that may be more advantageous for you, such as a qualified charitable distribution (QCD) that you can start doing at age 70 and a half. With a QCD, you can take money out of your IRA and give it to a charity completely tax-free. Even if you do Roth conversions at the lowest tax brackets (10% or 12%), that’s still 10% or 12% you wouldn’t have to pay if you used a QCD. So if you’re very charitably inclined, a Roth conversion may not make the most sense.

Alright, and the last one here is basically Medicare, marketplace insurance, and Social Security considerations. Increasing your taxable income through conversion can make more of your Social Security benefits taxable and increase your Medicare premiums. Generally speaking, I think the baseline for Medicare premiums is around $170 per person, and it only goes up from there. If you convert unknowingly, you could increase the cost of your Medicare premiums. Additionally, if you’re on marketplace insurance (also known as Obamacare), converting and increasing your income could mean you have to pay back a big chunk of the government subsidy you receive to help cover your premium. So definitely consider these factors when doing Roth conversions.

Practical Examples (26:45)

Okay, so I know I just did a big information dump, which I apologize for. Just as a quick reminder, you will get a recording of this webinar, so you can go back through it to make sure you understand it thoroughly.

With that being said, I want to show you three examples to illustrate how these conversions can significantly impact your financial situation.

For example number one, we’re going to show you why a low-income year can be an advantageous time to convert. Let’s look at the Parkers, who are retired and planning to serve a two-year church mission in 2025 and 2026. Before they leave on their mission, and again when they return home in 2027, their income needs are $12,000 a month. Mr. Parker has a $7,000 monthly pension, so he’s pulling out $5,000 from his IRA to sustain their lifestyle. With $12,000 a month, the Parkers are squarely in the 22% federal tax bracket. This means if they were to convert any money from a traditional IRA to a Roth IRA, it would cost them 22% in federal tax.

When they go on their mission, they only need $7,000 a month because their discretionary spending goes down. They’re living off his pension only, so they’re in the 12% tax bracket since they’re no longer pulling money out of the IRA. A Roth conversion now means that if they convert, it will only be at a 12% tax rate, contrary to the 22%.

How much can they convert before hitting the 22% bracket? It’s about $42,000 to fill up the 12% tax bracket. This creates a tax bill of about $5,040 from that conversion. If they were to do that same $42,000 conversion while at home, they would have to add it to the $5,000 a month they’re already taking out to meet their living expenses, resulting in a $9,240 tax bill. That’s a $4,200 savings, or 10% savings, created by serving their mission. This example shows why serving a mission can often present opportunities for Roth conversions.

Just a quick reminder, if you’re in the same tax bracket before, during, and after your mission, Roth conversions lose their appeal. The 10% savings in this example was solely created because they had a low-income year.

Example number two is a bit extreme, but it shows cases where it may not make sense to convert. In this example, we’ll look at the Smiths, who have been retired for three years. Mr. Smith claimed his Social Security benefit at age 67 and is now 70 years old. He receives $42,000 a year from Social Security, and his wife receives $21,000, for a total of $63,000 a year.

We’re assuming Social Security is their only income in retirement, which is rare but is our assumption here. Given how Social Security tax works, they are not showing any taxable income, which they love because they have had zero income taxes over the last three years.

Now Mr. Smith also has $210,000 in a traditional IRA. He’s heard about RMDs before and, being an overly concerned citizen, decides he wants to get rid of the traditional IRA. He’s heard good things about the Roth IRA, so he wants to convert $70,000 a year for three years to eliminate the traditional IRA and only have a Roth IRA. His thinking is if he can do $70,000 a year and stay in the 12% federal tax bracket, he can be very tax-efficient with his conversions.

Let’s take a look at what happens. He converts $70,000 and, as expected, stays within the 12% federal tax bracket. He thinks that with the standard deduction, his tax bill will be about $4,060.

However, what actually happens is that by converting $70,000, he creates a tax bill of $10,486. What was his mistake? After three years of not having taxable income, Mr. Smith failed to realize that by converting $70,000, he caused 85% of his $63,000 of Social Security income to become taxable. While it’s still taxed at the 12% federal tax bracket, it added an additional $6,426 of unexpected tax. So, in this situation, even though they stayed within the low tax bracket, it was probably not very advantageous to do those conversions.

Example number three, our last example, shows how state income taxes can have an impact. We’ll look at the Nelsons. The Nelsons are currently retired and live in Nevada. For those who don’t know, Nevada does not have an income tax. Their annual income needs are $160,000. They considered a Roth conversion in the past but didn’t think it would be advantageous because they’re in the 22% bracket and don’t expect to go below or above that.

However, they plan to move to Oregon within five years to be closer to their kids and grandkids. Like many of you, their kids have been guilt-tripping them into moving, and they decided to make the jump to Oregon.

Let’s see how a Roth conversion could impact the Nelsons. Their income needs in Nevada and Oregon will remain the same at $160,000. Although there may be cost of living adjustments, for simplicity’s sake, we assume it’s the same. In both states, they find themselves in the 22% federal tax bracket. Knowing that, they understand that converting wouldn’t make a difference at the federal level, as the tax bill would be $11,000 regardless of whether they’re in Nevada or Oregon.

However, Nevada doesn’t have an income tax, so by converting $50,000, they only incur a federal tax liability. In Oregon, they would find themselves in the 8.75% marginal tax bracket. This means that the same $50,000 conversion in Oregon would cost an extra $4,856 due to state taxes. So, it may well be worth the Nelsons’ while to consider doing some Roth conversions to avoid the future taxes they would pay on withdrawals if they did it in Oregon.

Alright, so I know that was a lot of information. My summary is simple and straightforward.

  1. Understand the differences between a traditional and a Roth IRA. Both are great tools and can be extremely advantageous. Don’t always think you have to contribute to a Roth; sometimes a traditional IRA makes more sense for your situation.
  2. Understand the rules regarding conversions. Remember, conversions and contributions are two different things, so make sure you know the ins and outs.
  3. There are many benefits to converting, such as tax-free income and tax diversification. However, sometimes a conversion is not right for you, and it might be better to stick with a traditional employer plan or IRA.
  4. Lastly, having an income plan in place can make your Roth conversions much more effective. Knowing your current and future income streams is crucial for accurately planning Roth conversions. So, ensure you have a plan before implementing these conversions.

Before I open it up to questions, I want to address something we’ve had many inquiries about in previous webinars. Most of you attending today probably have the book “Plan on Living.” If you don’t, please request one. It’s free, and we’ll send it out to you. This is the book our founder, Scott Peterson, wrote.

It gives really sound investment knowledge and explains how we recommend setting up an income plan with a Perennial Income Model™. Since we have received so many questions about it, if you would like to share a copy of the book with a friend, you can absolutely do that. Please feel free to either email me or email marketing@petersonwealth.com and include either their name and address if you want us to send it directly to them or your own name and address if you just want to be the one to give it to them yourself. That’s totally fine too.

Question and Answer (37:26)

Okay, before I turn it over to Zach for any questions, I first want to thank you for attending today. We’re a little over half an hour, so apologies for not being too dialed in there, but hopefully, it was very beneficial for you.

I also want to give another quick plug for the survey right after this. If you wouldn’t mind taking three to five minutes to fill that out, any feedback is always super helpful for us, especially on any topics you would like to hear more about. That being said, Zach, I’ll turn it to you. Any questions that we have?

Zach Swenson: We just have one that I’ll go ahead and answer live if that’s okay. Perfect. It came through as a question that says if you’ve had a Roth IRA account for five years but want to make an additional contribution to that account, do you have to wait another five years to access that additional money? The short answer is no. That five-year timetable is a cumulative table. Once that account’s been open for five years, anything you contribute beyond that is considered to have been in there for longer than five years. It’s based on your first contribution.

Alek Johnson: Yep, absolutely. And the one caveat I’ll throw into this is if you were to ask the same question about a Roth conversion and you’re before age 59 and a half, that’s where it gets a little interesting. If you’re before 59 and a half, it’s actually based on a five-year period per conversion up until that point. But as far as contributions go, it’s just that initial contribution you make when you open it up.

Any other questions, Zach, that have come in, or is that the biggest one there?

Zach Swenson: We did have one more. I think your second example did a pretty good job of answering this, but we had one come across asking if you could address how the Social Security tax torpedo affects planning Roth conversions.

Alek Johnson: Yeah, so basically, I actually don’t know if I have the exact equation off the top of my head. It’s essentially you take half of your Social Security benefit and add it to other income that you have to get your provisional income. Basically, your Social Security is not taxable up to certain limits, which are around $30,000 for a married couple. If you go beyond that, your Social Security starts to become taxable. Don’t quote me on that exact figure. If you want, feel free to send your email, and we can send you the exact limits as well as the Social Security code equation for it. But just know that if you only have Social Security, you’re not showing taxable income. If you have other income streams like pensions, rental income, or withdrawals from your investments, you’re increasing the amount of your Social Security that will become taxable.

Zach Swenson: Perfect. And then one more for you, if we could. It says, if my IRA or Roth IRA is owned by a trust, how does that affect the tax consequences?

Alek Johnson: Yeah, that’s a great question. Generally speaking, we usually recommend that you keep your retirement accounts outside of the trust. If you were to leave it outside of the trust, your beneficiaries generally have ten years after you pass away to keep the money inside that IRA account and be more tax-advantaged with it. If it goes to the trust, it creates more of a tax consequence for your beneficiaries.

So generally speaking, we recommend keeping it out unless there’s a specific reason to include it in the trust, such as if your kids have any type of addiction where a windfall of money could harm them. In such cases, we’d want to be more strategic and leave those assets to the trust, knowing there’s a tax consequence but prioritizing control. This is something I would encourage you to reach out to your advisor about because it can get more particular regarding beneficiaries when it comes to the trust.

Zach Swenson: Other than that, that was our last question.

Alek Johnson: Okay, perfect. Well, once again, thank you all for joining today. If you have any questions, please feel free to reach out to me or your advisor here, and we look forward to speaking with you at our next webinar.