Roth_IRA_Contributions
00:00:00.000 | Hello everybody, it's Sam from Financial Samurai.
00:00:03.320 | In this episode, I want to talk about the Roth IRA, the tax now Roth IRA, because the
00:00:10.200 | tax cuts that were passed due to the Tax Cut and Jobs Act of 2017 will expire on December
00:00:18.600 | 31st, 2025.
00:00:20.640 | If Congress does nothing, which nothing is what they tend to do, taxes will revert to
00:00:26.480 | their pre-2018 levels on January 1st, 2026.
00:00:31.600 | This means tax rates will go up anywhere between 1% to 5%.
00:00:38.120 | And therefore, the logical conclusion and solution is to try and convert some of your
00:00:42.800 | tax deferred retirement money in your 401ks and traditional IRAs into a tax now Roth IRA.
00:00:50.860 | This way, you can potentially save on taxes during your retirement years.
00:00:56.340 | So I think it's important to talk about this subject now because we have slightly less
00:01:00.920 | than three years to convert our tax deferred funds to tax now funds in a Roth IRA.
00:01:09.200 | And sometimes or oftentimes you don't want to convert too much because it might bring
00:01:12.940 | you to a higher tax rate.
00:01:15.120 | So three years is a good amount of time to plan ahead.
00:01:18.960 | The question is, how much of your tax deferred retirement funds should you move?
00:01:23.980 | And at what marginal income tax bracket should you contribute or convert to a Roth IRA to
00:01:29.400 | minimize future retirement tax liability?
00:01:32.440 | Before I answer these questions, let me share my historical thoughts on the Roth IRA.
00:01:38.200 | I've long been an opponent of the Roth IRA since I haven't been able to contribute since
00:01:44.320 | I turned 25 in 2002.
00:01:46.680 | The arbitrary income limits to be able to contribute shut me out, so I decided to reject
00:01:51.640 | the Roth IRA as well.
00:01:54.040 | So I was completely biased for over a decade.
00:01:58.120 | Right now in 2023, you can contribute to a Roth IRA, which is 6500 max.
00:02:04.480 | If your income is under 153,000 as an individual single filer, or under 228,000 as a married
00:02:13.440 | filing jointly, you can contribute the maximum 6500 if you make under $138,000 as a single
00:02:20.800 | individual and under $218,000 as a married filing jointly.
00:02:26.240 | There is basically a prorated amount you can contribute less and less as you get to the
00:02:30.400 | 153,000 and over for singles and 228,000 and over for married filing jointly.
00:02:37.200 | Now these income levels in 2023 seem pretty reasonable, but at the same time, it's also
00:02:43.400 | rather arbitrary.
00:02:45.320 | Why not double the amounts?
00:02:47.200 | Shouldn't all American taxpaying citizens get to fund and take care of their retirement
00:02:53.360 | future?
00:02:54.360 | I think so.
00:02:55.360 | In addition, I was an opponent of doing a Roth IRA conversion.
00:03:00.280 | It just wasn't appealing to me after I left my day job in 2012, my overall income declined
00:03:06.360 | by 80% as a result.
00:03:08.440 | And the last thing I wanted to do was pay more taxes when I had way less income.
00:03:13.600 | Instead, I just wanted to hold on to as much cash as possible because I was facing an uncertain
00:03:19.000 | future.
00:03:20.080 | Was this the right idea at 34 years old?
00:03:23.280 | Didn't feel right, but I had the severance package and I had some passive income.
00:03:28.200 | And I also had hope that I could grow Financial Samurai and do other things to make supplemental
00:03:33.400 | retirement income.
00:03:34.920 | However, now that I'm 45 years old and I have two young children, I now believe contributing
00:03:40.080 | to a Roth IRA is a good way to tax efficiently diversify your retirement income sources.
00:03:48.240 | Roth IRA withdrawals don't face required minimum distributions.
00:03:53.400 | Further Roth IRAs do not count as provisional income and therefore don't cause any of your
00:03:59.880 | social security to be taxed.
00:04:03.080 | Just know that for required minimum distributions on December 29th, 2022, President Biden signed
00:04:09.780 | into law the Consolidated Appropriation Act of 2023.
00:04:15.040 | That includes the Secure Act 2.0, which basically increases RMD age to 73 in 2023 and to 75
00:04:24.560 | in 2033.
00:04:26.320 | So this is good if you don't need the money because it enables you to pay less retirement
00:04:33.680 | taxes, but you've got to live that long.
00:04:37.320 | But if you die before the RMD and you never spend your retirement funds, well, then it
00:04:42.340 | goes to your heirs.
00:04:44.360 | But that also shows that maybe you didn't properly consumption spend throughout your
00:04:48.880 | life and you spend too much time working and investing and stressing about the money.
00:04:53.400 | Those are just some things to think about as you plan for retirement.
00:04:57.080 | To decide on paying taxes upfront by contributing or converting assets into a tax now Roth
00:05:03.000 | IRA, we should make three assumptions.
00:05:07.080 | One, Congress will let taxes return to previous levels on January 1st, 2026.
00:05:13.280 | Two, tax rates may go even higher than pre-2017 levels due to an even larger budget deficit.
00:05:21.400 | We've got to pay for all this pandemic spending, stimulus spending.
00:05:25.400 | Three, you believe your tax rates in retirement will be higher than your tax rates while working.
00:05:31.900 | This is the most important variable.
00:05:34.800 | Do you believe you're going to pay more taxes when you're not working or more taxes when
00:05:40.060 | you're working?
00:05:41.720 | Now I know it's human nature to think we are smarter, better looking, more charismatic,
00:05:47.960 | charming than we really are.
00:05:51.300 | But the reality is we probably hover around the average plus or minus one standard deviation.
00:05:57.520 | That's just what it is.
00:05:58.520 | Therefore, I just don't think the vast majority of Americans will be paying a higher tax rate
00:06:04.400 | in retirement than while working because most Americans won't be making more money in retirement
00:06:11.440 | than while working.
00:06:12.440 | If you do a gut check, this makes sense.
00:06:15.700 | It makes a lot of sense.
00:06:17.300 | You're working, so you're making more money.
00:06:19.640 | What kind of person makes more money in retirement?
00:06:21.840 | Well, maybe a really lucky person who got a huge windfall or maybe someone who invested
00:06:27.920 | amazingly well, or we just have super high inflation, high risk-free rates, high dividend
00:06:34.160 | yields, high returns in retirement, and we're just crushing it.
00:06:38.120 | But is that going to be reality?
00:06:40.600 | I just don't think so.
00:06:42.120 | Just look at what the median retirement balance is in America.
00:06:46.040 | It's about $100,000, right?
00:06:48.960 | And the median Social Security payment is around $22,000 to $24,000.
00:06:54.520 | So even if you withdraw $10,000 a year from your median retirement balance of $100,000,
00:06:59.340 | your total income, if you add on Social Security, is around $32,000 to $34,000.
00:07:05.680 | And that falls within the 12% marginal federal income tax rate, which is low.
00:07:11.520 | And if you're making that money, do you think the government is really going to go after
00:07:14.720 | you?
00:07:15.720 | I don't think so.
00:07:17.480 | Politicians crave power more than anything else.
00:07:21.100 | So if politicians raise taxes on the middle class, they will lose the most number of votes.
00:07:27.240 | And if you lose the most number of votes, you're not going to stay in power for very
00:07:30.520 | long.
00:07:31.520 | It's the same thing with Social Security.
00:07:34.040 | Cost of living adjustment went up huge, 8.6% in 2023.
00:07:38.180 | This was an opportunity to actually lower the COLA.
00:07:42.400 | And it's been an opportunity every single year since we realized the Social Security
00:07:45.960 | pension fund is underfunded by 22 to 25%.
00:07:49.760 | But politicians aren't willing to raise that retirement age or reduce the Social Security
00:07:56.400 | benefits during retirement, because that would mean political suicide.
00:08:00.900 | They will not get reelected.
00:08:03.540 | Even President Biden, who is a Democrat, who is for bigger government, has said he will
00:08:08.840 | not raise taxes on any person or any household making less than $400,000 a year.
00:08:16.920 | $400,000 a year is a top, I would say 3% income, because top 1% income is over $500,000 a year
00:08:24.640 | now.
00:08:25.640 | So he's unwilling to raise taxes on the top 3% income earners.
00:08:30.400 | Maybe it's top 2%.
00:08:31.760 | So what makes you think if you make $250,000, $200,000, $150,000, $100,000, or $50,000,
00:08:38.760 | you're going to pay more taxes in the future?
00:08:42.720 | I don't think you will.
00:08:44.040 | Yes, we are at the historical lows of tax rates.
00:08:49.580 | We are.
00:08:50.580 | If you look since 1950, we haven't been lower.
00:08:53.520 | The problem is, once you give goodies, right, once you start giving people what they want,
00:09:00.200 | they are loathe to give up what they have.
00:09:03.760 | And once politicians have power, they are loathe to give up that power as well.
00:09:08.660 | So we are actually in cahoots with the politicians.
00:09:11.600 | We want lower tax rates and the politicians want power.
00:09:15.000 | So the majority is going to vote to keep tax rates probably the same.
00:09:20.880 | So we need to figure out at what marginal federal income tax rate is it worth converting
00:09:28.160 | to a Roth IRA or contributing.
00:09:31.320 | And my answer is this.
00:09:33.440 | At a 24% rate, it's a wash, break even.
00:09:38.520 | As a single individual, that means you're making between $95,376 to $182,100.
00:09:47.580 | For married filing jointly, that means you're making between $190,751 to $364,200.
00:09:57.400 | So in other words, if you start converting at a 24% marginal federal income tax rate
00:10:02.960 | to a Roth IRA, when you retire, I think it's going to be a wash.
00:10:08.200 | These income levels are the protected class.
00:10:12.240 | They're protected because this is mass affluent class, including middle class for some people
00:10:16.880 | who live in more expensive countries.
00:10:18.840 | And politicians don't want to raise your taxes.
00:10:22.020 | So this leaves us with the 22%, 12%, and 10% marginal federal income tax rates.
00:10:29.880 | At these rates, I think you can convert.
00:10:32.720 | You'll probably end up okay.
00:10:34.980 | Even if you don't end up okay, the most you'll probably pay more in taxes is maybe 1% or
00:10:40.680 | 2%.
00:10:41.680 | So let's just do some quick math on the 24% marginal federal income tax profile, where
00:10:46.720 | it's a wash.
00:10:47.880 | So let's say you're an individual making the bottom of the range of the 24% marginal income
00:10:52.480 | tax bracket, $95,736.
00:10:57.200 | As a worker, you're paying that 24% marginal income tax rate on $1.
00:11:02.760 | But to generate that same amount of income in retirement would require amassing about
00:11:09.040 | $2.4 million at a 4% rate of return.
00:11:13.200 | Now remember, the median retirement balance is only $100,000.
00:11:17.080 | So we're talking about you accumulating 24 times the medium.
00:11:22.500 | It's possible, but again, we got to be a little bit realistic.
00:11:25.940 | Even with $25,000 a year in Social Security, which is, you know, today's dollars probably
00:11:30.880 | what you would earn if you were making that kind of income for 35 years.
00:11:36.540 | You'd still need about $1.9 million in retirement to generate $70,736 a year at a 4% rate of
00:11:43.040 | return.
00:11:44.040 | I got $70,736 by subtracting $25,000 a year in Social Security by that income of $95,736.
00:11:53.040 | $1.9 million is a lot of money for someone who's been averaging $96,000 for 35 years.
00:12:03.560 | But it's doable.
00:12:04.720 | I just don't think the majority of people who make that kind of money will accumulate
00:12:09.640 | that much in retirement.
00:12:11.400 | Just look at the data.
00:12:12.560 | Therefore, most retirees making that $96,000 level will likely earn less.
00:12:20.520 | And if they earn less, they will likely pay a lower marginal federal income tax rate.
00:12:27.220 | Maybe 12%, maybe 10%.
00:12:30.240 | Because here's another thing, the standard deduction, the standard deduction is used
00:12:35.020 | whether you're 25 and making money or 70 making Social Security money.
00:12:39.960 | In 2023, the standard deduction for an individual is $13,850.
00:12:46.040 | And their standard deduction for married couples filing jointly is $27,700.
00:12:50.880 | In 20 years, at a 3% annual increase, the single taxpayer standard deduction will rise
00:12:56.040 | to $25,000.
00:12:57.800 | And the married couple standard deduction will rise to $50,000.
00:13:02.240 | So in other words, you could make $25,000 a year in Social Security as an individual
00:13:07.800 | and pay zero taxes because of your standard deduction.
00:13:10.880 | So my argument is that not only will you likely be making less money in retirement, you also
00:13:17.720 | have standard deduction you can take to lower your income even further, which lowers your
00:13:23.960 | retirement taxable income even further.
00:13:26.920 | We've already agreed the government isn't going to crush the middle class taxpayer who's
00:13:31.880 | paying a 10, 12, or 24% marginal income tax rate by jacking tax rates higher.
00:13:38.720 | The government is going to go for the top income earners, the top 1%, maybe the top
00:13:42.800 | 0.1% for sure, right?
00:13:44.840 | The deca millionaires, the centa millionaires and the billionaires.
00:13:49.120 | So wouldn't that mean they should start converting more of their tax deferred funds into a rough
00:13:54.680 | IRA?
00:13:55.680 | I don't think so.
00:13:57.400 | Okay, so look, 37% is the top marginal income tax rate for individuals making over $578,125
00:14:06.320 | in 2023.
00:14:07.840 | That's a top 1% income for sure, because the threshold is about $500,000.
00:14:12.120 | Now if I look at what tax rates were, what they were pre the Tax Cut and Jobs Act passage,
00:14:20.640 | at over $500,000, the marginal income tax rate was 39.6%.
00:14:25.840 | So it was 2.6% higher.
00:14:28.800 | Okay, that's relatively significant.
00:14:32.080 | And if you can make over, let's say $578,000 a year in retirement, well, yes, you'll be
00:14:38.640 | paying more than 2.6% in taxes.
00:14:41.800 | But in order to make $578,000 a year or more in retirement, you need to have capital of
00:14:48.160 | at least $14.4 million at a 4% rate of return.
00:14:52.760 | Now how many people have that?
00:14:54.400 | Well, less than 1% because the top 1% net worth figure is about $12 million right now
00:15:00.920 | in 2023.
00:15:02.880 | Might be less since 2022 was a bear market.
00:15:06.220 | So if you are a top 1% income earning person, you appreciate the lower tax rates now.
00:15:13.600 | But are you really going to be enthused about paying 37% upfront to convert your tax deferred
00:15:20.360 | money to a Roth IRA?
00:15:22.080 | I don't think so.
00:15:23.200 | I think instead what you'll do is you'll keep hope alive that tax rates won't go up or won't
00:15:27.920 | go up as much.
00:15:29.320 | Or what you might do is move to a lower income tax state when you retire because the optimal
00:15:36.780 | time to do a Roth IRA conversion is after you retire or in a lower tax bracket, but
00:15:44.680 | before claiming Social Security benefits, right?
00:15:48.080 | So if you retire at 50, 55, 60, 61, and then you drop to the lowest marginal income tax
00:15:56.040 | bracket, yeah, start converting.
00:15:58.500 | That makes a lot of sense.
00:16:00.080 | I just think that if you're making that kind of money, there are too many ways for you
00:16:05.160 | to shelter your taxable income and your assets from the government.
00:16:10.120 | You can set up a graft, you can set up revocable trusts, irrevocable trusts, and so forth.
00:16:16.620 | You can move to different states, you can move out of the country, you can renounce
00:16:20.520 | your citizenship.
00:16:21.520 | There's just all these different things you can do.
00:16:23.760 | So to pay taxes upfront when the government is so spendy and so inefficient with our dollars
00:16:29.880 | feels like giving up a war, frankly, because we all have the responsibility to minimize
00:16:35.980 | our tax liability in the most legal way possible.
00:16:39.580 | And paying that much upfront, ooh, that just seems too painful to me.
00:16:43.800 | So in conclusion, I count on politicians to keep tax rates low because I count on politicians
00:16:50.960 | to want to remain in power.
00:16:52.840 | I assign only a 20% probability that tax rates are going up in 2026 and beyond for sub $250,000
00:17:01.340 | income earners.
00:17:02.340 | For those households making over $400,000, perhaps the probability is over 60%.
00:17:08.520 | But who knows who's going to win the presidency and who knows how the makeup of Congress will
00:17:13.480 | be.
00:17:14.480 | If you find yourself ever in the 10% or 12% marginal income tax bracket, I think you should
00:17:20.960 | convert as much as possible to a Roth IRA.
00:17:23.920 | Definitely contribute as much as you can afford.
00:17:26.100 | If you find yourself in the 0% marginal income tax bracket because your earned income is
00:17:30.380 | below the standard deduction amount, then definitely try to max out your Roth IRA contributions.
00:17:37.860 | And in this situation, it's mostly probably because you're a student or you're just underemployed.
00:17:42.820 | But it's hard, right?
00:17:44.000 | Because you're not making that much money.
00:17:45.780 | And then to ask to put away more money for your future.
00:17:48.820 | It's a little tough.
00:17:49.940 | But that's where we parents who understand the Roth IRA and care about taxes can come
00:17:55.720 | in and help our young children or adult children plan for their future.
00:18:01.380 | I wished I was able to contribute to a Roth IRA when I was growing up, but it only just
00:18:07.140 | began when I was growing up.
00:18:08.700 | And so many of us didn't know much about it.
00:18:11.300 | And then by the time I turned 25, well, I couldn't contribute anymore.
00:18:15.580 | And so I just forgot about it.
00:18:17.600 | But I don't forget about it now because I have two kids.
00:18:20.380 | And I find it actually really exciting and somewhat of a challenge to try to grow their
00:18:26.460 | Roth IRA portfolio large enough so that by the time they graduate high school or college,
00:18:31.700 | they can hit the ground running and not feel so constrained by life's many inflationary
00:18:36.940 | expenses.
00:18:38.140 | A diversification of retirement income sources is a good one.
00:18:43.460 | Whether we pay taxes now or in the end, it's simply unavoidable.
00:18:48.740 | We just have to decide what we think future tax rates will be.
00:18:53.660 | And just like inflation.
00:18:54.940 | Yeah, it's a 40 plus year downward trend.
00:18:58.260 | We've had a couple years of anomaly spikes, right?
00:19:01.940 | 2022 and 2023.
00:19:02.940 | But I think that trend is going to go back down.
00:19:05.700 | So we could have several years of anomaly spikes of higher taxes, but then the people
00:19:11.100 | are going to get angry and they're going to vote the politicians out.
00:19:13.860 | And then we're going to revert back to the long term trend since the 1950s of lower tax
00:19:19.740 | rates for longer.
00:19:21.360 | That's my opinion.
00:19:22.360 | I'd love to hear yours.
00:19:23.900 | If you want to run some smart scenarios about when to do a Roth IRA conversion for your
00:19:28.780 | retirement, check out new retirement at financialsamurai.com/nr.
00:19:35.460 | I spoke to the founder, Steve Chen, and he said one of the most popular tools they have
00:19:40.900 | is the Roth Conversion Explorer.
00:19:43.460 | It enables you to test out your Roth IRA conversion plan under various tax and wealth scenarios.
00:19:49.280 | This is what we all want.
00:19:50.280 | So I do recommend you sign up and check it out.
00:19:52.580 | Then you can get a better idea of exactly what your tax liability will be in the future.
00:19:58.140 | Thanks so much everyone for listening.
00:19:59.700 | I'm not a tax professional, but I'm a tax enthusiast who studies tax law every single
00:20:05.660 | year because it's our largest ongoing liability that we cannot escape.
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00:20:30.300 | I go through my posts and my podcast and highlight many of your comments that add a lot of value
00:20:36.940 | to the discussion.
00:20:38.000 | There are a lot of things that I don't think about that you share based on your experience.
00:20:43.420 | And many of these insights are so wonderful.
00:20:46.100 | You know, we're talking about retirement planning in your mid sixties and seventies,
00:20:51.340 | and I'm only 45.
00:20:52.620 | So I don't know what I don't know.
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00:20:59.340 | And this is the best way to learn.
00:21:01.060 | Thanks so much, everyone, and have a great day.