Roth Conversions Before & After Retirement
In this webinar, Dean and JoAnn discuss the best part of the tax code that was ever created, the Roth IRA. Specifically diving into Roth conversions both before and after retirement.
Video Transcript
Dean Barber: Hello, everybody. I’m Dean Barber, founder and CEO of Modern Wealth Management. I want to welcome you to our educational series. JoAnn Huber, CERTIFIED FINANCIAL PLANNER™ and CPA, and I will be discussing the best part of the tax code ever created. It’s the Roth IRA. Stick around.
Roth Conversions Before & After Retirement
Dean Barber: All right, JoAnn, let’s get started talking about Roth conversions. We want to talk about Roth conversions, both pre-retirement and post-retirement.
A Trip Down Memory Lane
Before we talk about the Roth conversions, I want to take a little trip down memory lane. I want to back up to 1997.
JoAnn Huber: It was a year with a big change in retirement accounts which was the addition of the Roth.
Dean Barber: Right. And there was something special that Senator Roth did when he put the Roth IRA into place. That something special was it allowed people at that time to do a conversion from a traditional IRA to a Roth IRA. Now there were income limits, and you had to meet these income limits before you could do a conversion. But if you did the conversion, you got to spread the tax liability out over – was it five years?
JoAnn Huber: I believe it was five years the first time.
Dean Barber: Yeah.
JoAnn Huber: They’ve spread it over different periods at different times.
Many Didn’t Trust Conversions
Dean Barber: There were many people back then that didn’t trust it. They said, “I don’t trust the government. Why would I pay taxes on this? What’s to prevent them from making this Roth IRA taxable in the future?”
JoAnn Huber: We still hear that today.
Dean Barber: We do still hear that today. Yet I had several clients that did it, and they’re living a tax-free retirement today because of doing that.
JoAnn Huber: And it was the best thing that they did for themselves.
The Many Options to Get Into the Roth
Dean Barber: Yes. So people have opportunities to convert to a Roth IRA from a traditional IRA, or even from a traditional 401(k) to a Roth 401(k), or from a regular 401(k) to a regular IRA, and then convert to a Roth IRA. So all kinds of ways to get money into the Roth.
JoAnn Huber: Right. There’s a lot of options out there. And if you look, the government wants us to put money into the Roths because they’re collecting the money today if we do that.
Dean Barber: Right. So they do want us to put money into Roth. Let’s say somebody moves $50,000 from a traditional IRA over to a Roth IRA. That gets included in their taxable income this year, but there’s no 10% penalty for doing that.
Why Would I Pay Taxes Early?
JoAnn Huber: Right. And somebody might say, “Why do I want to do that today? Why do I want to pay taxes any earlier than I have to?” I think that’s the key that we have to address. Does it make sense for you to do the Roth conversion now, or is another time better? That’s why the before and after retirement is so crucial to discuss.
Dean Barber: We know that the longer time horizon a person has, the more powerful the Roth IRA becomes.
JoAnn Huber: Right.
Learn from the Expert
Dean Barber: My good friend and, I would say, tax mentor, Ed Slott is on The Guided Retirement Show™ with me for Episodes 31 and 45. Find it on your favorite podcast app or YouTube. We talk a lot about the Roth IRA.
Pay Tax on the Seed or the Harvest?
Ed puts it in a way, JoAnn, that I think is easy for most people to understand. He says, “If a farmer could, instead of getting a tax deduction when they buy their seed and plant it and then paying tax on the entire harvest, pay taxes on the seed and then get the entire harvest tax-free, which one do you think they’d rather do?” I’d rather get the harvest tax-free, right?
JoAnn Huber: Obviously.
Dean Barber: That’s the idea behind the Roth IRA.
JoAnn Huber: Right.
Dean Barber: They pay taxes on the money before it goes into the Roth, but then all the future earnings are tax-free.
JoAnn Huber: So it’s powerful when you have that period to let it grow; you get the time value of money. It does help to have that in the Roth at that early stage when you’re planting the seed and then let it grow.
Dean Barber: Right. Now, when we say Roth conversions, both pre and post-retirement, the reason why we’re not going to talk just about Roth contributions, both pre and post-retirement, is because there is an earnings limit on a Roth contribution. However, there is no earnings limit on a Roth conversion.
JoAnn Huber: That’s important for people to realize because I’ll get that question all the time. “I thought my income was too high to do a Roth conversion,” and as you said, there is no income limit.
Roth Conversions Before Retirement
Roth 401(k) When Changing Jobs
Dean Barber: Let’s talk about conversions early on in a person’s life. Let’s say that they went to work for an employer, that employer had a 401(k), but they didn’t have a Roth option in that 401(k). They worked there for five, six years, or whatever, they’re in their late 20s, and they switched jobs.
Now, let’s say they’ve got 30 or $40,000 in a 401(k). What do most people do?
JoAnn Huber: They leave it there or roll it over to an IRA and just say, “I’ll take it out and put it there.” Then it just continues to grow tax-deferred until they retire.
Dean Barber: Then when they take it out in retirement, that’s-
JoAnn Huber: They have a lot of tax to pay.
Dean Barber: Then they have to pay the taxes, right? So if somebody in that scenario, as long as they have money to pay the taxes on that conversion, it may make sense for them to convert that to a Roth IRA.
But I think people must understand, JoAnn, that when we say, “Do a Roth conversion.” It’s not an all-or-nothing proposition. Maybe they say, “Well, I wouldn’t want to convert that entire $40 or $50,000, but maybe what I want to do is convert $10,000 a year so that over time, I get it all in there.”
Looking at Taxes Over Years
JoAnn Huber: Right. And that’s what we typically do with our clients is we do look at what amount do we do each year? Let’s do a little bit. Because if we do a large sum, quite often, they’re going to move to a higher tax bracket. That doesn’t make any sense to pay at a higher rate because we’re looking at: When can you pay the least amount of tax on that?
Dean Barber: That’s right. So that would be an example of how you might want to do that.
Another example would be what COVID did to a lot of people, okay? So they lost a job, right?
JoAnn Huber: At work.
Dean Barber: They didn’t have very much earned income in that year, so there was an opportunity to convert from a traditional IRA to a Roth IRA and be in a very low tax bracket because perhaps they were without a job.
Roth Conversions in 2020
JoAnn Huber: Right. I think that’s why in 2020, we saw so many Roth conversions. People lost employment or retired and didn’t have a required minimum distribution, so it was a perfect time to do that conversion.
Dean Barber: Yeah. I think we saw more Roth conversions last year than we’ve ever seen.
JoAnn Huber: Absolutely.
Dean Barber: Because it was a smart thing to do. If you know we can get money out at a lower rate today, and it grows tax-free forever, I’m in.
JoAnn Huber: Why not do it, right?
Pre-Retirement Roth Conversions Can Be Complex and Often Inadvisable
Dean Barber: So pre-retirement, the conversions pre-retirement are much more complicated and sometimes not as advisable as post-retirement.
JoAnn Huber: Right. And I think there’s a critical caveat on the Roth conversion when you’re working. Typically, that means you’re under age 59 and a half. So if you do a Roth conversion and you say, “Well, I can just have taxes withheld out of the conversion amount,” that amount that you withheld for taxes, that’s going to be subject to the 10% early withdrawal penalty.
Dean Barber: Right.
JoAnn Huber: So you have to make sure that you have outside funds that you can use to pay that additional tax on the conversion.
Dean Barber: Yeah, I agree with that, JoAnn. We know that makes the most sense because you don’t want to do a Roth conversion, typically, if you don’t have the money to pay the tax.
JoAnn Huber: Right. In almost all situations, that’s the right answer.
Dean Barber: Yeah. Not a hundred percent of the time, but most of the time, that’s the right decision.
JoAnn Huber: There are a few exceptions, and that’s on a case-by-case basis for the individual.
Does a Roth Conversion Make Sense for You?
Dean Barber: Right. And I think that to say that a Roth conversion makes sense for somebody, it needs to be coordinated in their overall financial plan.
JoAnn Huber: It does because it doesn’t make sense for everybody. If you have too much of something, it’s usually not good. We want moderation in all things.
Dean Barber: I don’t. If I could have all of my money in a Roth IRA, JoAnn, I’d do it.
JoAnn Huber: Well, right, but you wouldn’t do it all at once. You wouldn’t take everything that you have in your tax-deferred and move it over right now.
Dean Barber: No, no.
JoAnn Huber:
That’s what I mean by moderation. You’ve got to be smart and strategic about it because we’ll meet with people, and they’ll be so proud, “Oh, I’ve been doing Roth conversions.” Well, many times, they’re the wrong amount, either too little or too much, and we want to be Goldilocks and get to that just right amount.
How to Know if a Roth Conversion is Right for You
Dean Barber: Let’s talk about how you discover that, because people who have not watched many of our educational series or seen a lot of what we do may not be familiar with the term tax planning.
What is Tax Planning?
The concept behind tax planning is a coordinated effort alongside financial planning to reduce your long-term tax liability. So before you start doing Roth conversions, you need to have a financial plan completed, not some back-of-the-envelope math type of a deal, not an Excel spreadsheet, an actual living, breathing financial plan done by a CERTIFIED FINANCIAL PLANNER™.
Then let the CPA sit down and say, “All right, what is it we’re trying to accomplish, or what are we solving for? What are our income goals in the future and the resources that we have today? What’s our timeline look like?”
Then you can start to say, “All right, as long as we live in the US and have money or make money, taxes are going to be a fact of our life.” So if we know that as a baseline, how do we pay as little as possible over our lifetime? Not in a given year, but over our lifetime. Many times Roth conversions will play into those tax planning opportunities. Not always, but many times they do.
JoAnn Huber: Often they do because most people have some period in their life where they’re in a lower tax bracket than they have been in the past, or they will be in the future.
We want to take advantage and smooth those tax brackets out. That way, we don’t go from a 12% bracket up to a 32%, and so on. We want to make sure that we’re taking advantage of the middle brackets and using those to our advantage.
Congress Will Continue to Change the Tax Code
Dean Barber: Well, one thing’s for sure, Congress can’t keep their hands off the tax code.
JoAnn Huber: No.
Dean Barber: So, there will be changes. It looks like the changes will likely be increased tax rates, and I think that that’s something that we could look forward to in the next 20 to 30 years is higher taxes than what we have today.
Current Tax Laws Sunset in 2026
JoAnn Huber: Well, we know that if nothing happens, let’s say that Congress can’t reach any agreement. Come 2026, the current tax law sunset, and we go back to those higher tax rates. So the real question is, is, are we going to have a tax increase before then? Or are we going to wait until 2026?
Additional IRA Education
Dean Barber: Right. I want to make sure that everybody knows if you’re not as familiar with the Roth IRA as what you want to be on The Guided Retirement Show™. Episodes one, two, and 18 are all about Roth versus traditional and Roth conversions. JoAnn and I go into a great amount of detail on each one of those podcasts. You can subscribe and listen on your favorite podcast app and YouTube.
Roth Conversions After Retirement
Dean Barber: So JoAnn, let’s talk about my favorite time to convert, and that is post-retirement. So, after somebody has quit working, it is my favorite time to convert, and I like to plan for those conversions 10 to 15 years before retirement.
JoAnn Huber: Right. And I think it makes sense to tell people why it is that that’s your favorite time.
Dean Barber: Because at that point, you’re in control of what money to spend and the tax liability behind spending that money.
Why is a Roth Conversion After Retirement So Advantageous?
That’s my favorite time because you can actually control your taxes for the first time in your life. Unlike when you’re working, all your wages are always taxable.
If you’ve done a good job creating a financial plan with tax diversification – money in traditional IRAs or 401(k)s, Roth IRAs or 401(k)s, and taxable accounts. If you’ve done a good job there, you can ease into retirement.
You can say, “Okay, I’m going to spend out of that taxable bucket here for the first four or five, six years. I’m going to delay my Social Security, let that thing grow. While I’m spending out of that taxable bucket, I’ll start moving some from the tax-deferred over to the Roth, keeping myself in a low tax bracket. Over time, I can get most of my money moved over into a Roth before I start taking Social Security. The income coming from the Roth IRA doesn’t cause the Social Security to become taxable. I can get myself or a client into more of a tax-free or a very low tax environment into their late 60s or early 70s.”
JoAnn Huber: Right. I was looking at a plan earlier this week, and we’ve been doing this series of Roth conversions for a number of years. Once they retired and now they’re getting close to required minimum distributions, they’re like, “Well, what is the required minimum distribution going to be?” I said, “This is kind of what we’re projecting,” and they said, “Well, that’s less than what we’re taking currently.”
I can tell you when we started, that wasn’t the case, but they’ve been able to control their taxes during that phase where they’re leading to the required minimum distribution age.
Now they will be in a situation where they will not be forced to have this huge influx of money they don’t need. That’s the real magic, I think, of the Roth conversions is to give you the control and the choosing when to pay taxes.
The Roth IRA Makes More Sense the Longer Your Runway Is
Dean Barber: Oh, I agree, JoAnn. I said earlier that the Roth IRA makes more and more sense if you have a long runway. What I think a lot of people forget about is that they think, “Well, if I’m already retired, I don’t have a very long runway.”
Well, I bet you’ve got a 25 or 30-year runway, and the shortest runway you’re going to have is ten years because that’s how long the money can stay in the Roth if you died tomorrow, and it goes to your beneficiaries.
Your Tax Bracket Will Go Up if You Become a Single Taxpayer
JoAnn Huber: Right. And a lot of times, we’re not talking about the child as the beneficiary, either. We’re looking at a surviving spouse because people forget about that. That, to me, is the most crucial beneficiary we’re looking at for benefiting from the Roth because their tax bracket goes up.
Dean Barber: Yeah, I explained that because I don’t think people get it. A single individual will pay a higher tax on income, and it’s about half of a married filing jointly, right?
JoAnn Huber: It is, and that’s just because of how the tax tables are set up. The single brackets are about half of the married filing joint brackets. So, we’re going to go through the 10%, the 12%, the 22% faster than we do on a married couple.
Dean Barber: Yeah. So not only does the surviving spouse have to pay higher taxes on the same amount of income, but they will also lose a Social Security benefit. There could also be a loss of pension or something else that could come along there.
So, having tax-free income coming from the Roth because we did conversions along the way helps that surviving spouse tremendously.
JoAnn Huber: Right. So that’s something that we’re looking at it in that long-term tax planning is what’s your current rate, but what happens if one of you is left alone?
Dean Barber: It’s a big deal, and many people don’t really get it.
JoAnn Huber: No, and they don’t like to think about it. Nobody wants to think about death. You know, “We’re going to be married forever; we’re going to stay here.” But we know that life and death happen, and we have to plan for that.
Roth Conversions are Part of a Long-Term Tax Planning
Dean Barber: Right. So Roth conversions are part of a long-term tax reduction strategy.
Dean Barber: Now I want to switch gears because I talk about saying Roth conversions in retirement are one of my favorites. And some people think, “Well if my company offers a Roth 401(k) option, I should be contributing to the Roth portion of my 401(k).”
JoAnn Huber: Maybe.
Dean Barber: But I don’t always agree with that.
When Does a Roth 401(k) Not Make Sense?
Let’s take somebody that’s in their mid-50s, probably in their peak earning years, and they’re up in that top bracket, and they have a Roth option in their 401(k), but they plan to retire, say ten years from now, maybe five years from now, and they’ve got some good tax diversification. That person, I’m going to say do not put money into the Roth 401(k).
JoAnn Huber: Dean, what I’m going to say? “Let’s look at the plan and see what we think your long-term rate will be, and how much will you be forced to take for required minimum distributions? Then we can make that decision where to save.”
Tax Diversification and Roth
Once again, it’s not all-or-nothing. Maybe we put some in the traditional and some in Roth and split that to continue adding tax diversification.
Dean Barber: Right. I look at it from a pure math standpoint, JoAnn, so I’m going to explain to you why I would say that. By the way, I agree that you got to put it into the plan to make sure.
JoAnn Huber: Yeah, because, I mean, there’s been more than once that I’ve been surprised because I would be like, “Yeah, well, you’re in this top bracket. Why in the world are we doing that?”
But you look at how much tax-deferred they have already accumulated, and it might not make sense to add to the burden coming in the future.
Utilizing Different Tax “Buckets” for Tax Reduction
Dean Barber: Right. Well, what I would do is put that into the tax-deferred piece. I want to reduce my tax burden today. So with the tax savings, I’m going to set that money aside, okay?
So say I put $20,000 into the 401(k). If I’m in that top bracket, it will save me around $8,000 in taxes. I’ll take that $8,000, and I’ll set it at the bank. Okay. I’ll take that $20,000. I’ll do that for five years. I put a hundred thousand dollars in for five years, and I’ve saved $40,000 in taxes.
When I retire, I don’t have any earnings, and I have some cash to live on.
JoAnn Huber: Which are your tax savings and other things.
Dean Barber: So now I’m going to take, and I’m going to convert, $20,000 a year for five years, and how much am I going to pay tax?
I’m not going to be in that top bracket anymore, right, because I’ve got some cash that I’m going to live on for a few years. I can convert that maybe now at 15%. That $40,000 in taxes I saved, I only need to use about $15,000 to get it all over into Roth.
No Situation is Exactly the Same
JoAnn Huber: Right. So what we have to look at is each individual circumstance and say, “What makes sense for you?” Because for a lot of people in that situation, I agree with you. But if their facts are different, it might not make sense.
That’s why it’s so important to go through the planning process because sometimes the numbers are not what we think they’re going to be. But when we look at the plan, and we play with things, that’s when we get that overall picture and can say, “Yeah, this makes sense for you to do,” and it gives them the clarity and the confidence to do what they need to do.
Dean Barber: You’re right. I mean, everything always should come back to the plan. There’s zero question about that. I just thought it would be nice for the audience to hear a little bit of black and white numbers there. Because in that instance, you did take advantage of the tax code.
You paid a lot less to get the money into the Roth than what you would have had you contributed to the Roth portion of the 401(k).
JoAnn Huber: It’s one of those things where if you’re doing a Roth conversion, you need to talk with a planner and a CPA and say, “This is what we’re doing, and does it make sense?”
Never Put Money Into Something Until You Know Cost of Taking it Out
Dean Barber: Well, and JoAnn, you and I’ve said this many times, and that is that a person should never put their money into anything until they know what they’re going to do and how they’re going to take it out.
JoAnn Huber: What’s the cost to get it out?
Dean Barber: There’s so much we could go into.
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