Roth_IRA_Conversion
00:00:00.000 | Hello everybody, it's Sam from Financial Samurai, and in this episode, I want to talk about
00:00:04.360 | the Roth IRA conversion and why doing one is probably a waste of time and money for
00:00:10.780 | most of us.
00:00:11.780 | Now, if the House Ways and Means Committee has its way, there's a chance, a good chance,
00:00:17.840 | doing a Roth IRA conversion will be no more in 22 and beyond.
00:00:21.520 | And frankly, I'm pretty agnostic to ending our ability to convert our traditional IRAs
00:00:27.480 | to Roth IRAs.
00:00:29.200 | I've really had this kind of weird love-hate relationship with Roth IRAs since I started
00:00:36.520 | Financial Samurai in 2009 because I couldn't contribute to a Roth IRA about the second
00:00:42.760 | year after I started work.
00:00:44.580 | And so therefore, I felt kind of salty thinking, "Well, why do other people get to contribute
00:00:49.680 | to a Roth IRA and I can't?"
00:00:51.280 | And it's the same thing with traditional IRAs.
00:00:54.280 | Once you make above a certain amount for a traditional IRA, you just can't contribute.
00:00:59.040 | So I really forgot about contributing to a traditional and to a Roth IRA for a long time.
00:01:05.800 | But I slowly changed my mind and my way of thinking once I became a father in 2017 because
00:01:12.840 | I think about my kid's future and I think about how much more expensive things will
00:01:16.400 | be 10, 20, 30 years from now, right?
00:01:20.480 | Housing, food prices, tuition, healthcare, cars, everything.
00:01:26.460 | Everything is going to be much more expensive.
00:01:27.760 | So we need to continuously invest so we can beat inflation or at least keep up with inflation.
00:01:34.840 | Therefore, I put my kids to work, doing menial tasks, making a little bit of money.
00:01:41.040 | But thanks to the standard deduction, they don't have to pay taxes on their income.
00:01:46.480 | And given our forward thinking, I'm getting them to invest in their custodial Roth IRAs.
00:01:52.680 | So they get to contribute to a Roth IRA tax-free, which is very different from the way normal
00:01:58.560 | people contribute to a Roth IRA.
00:02:00.600 | It's with after-tax money and then it gets to grow and compound tax-free and it's tax-free
00:02:06.480 | when you pull it out.
00:02:07.780 | But for kids who are earning less than the standard deduction, which is $12,550, or not
00:02:13.860 | just kids, anybody, it's a good idea to contribute to a Roth IRA because it's tax-free in, tax-free
00:02:21.900 | growth and tax-free out.
00:02:23.760 | It's a win-win-win.
00:02:25.660 | But I didn't realize all the benefits and this way of thinking because in 1998, when
00:02:30.680 | a Roth IRA was first introduced as a savings and retirement vehicle, I was a junior in
00:02:36.360 | college.
00:02:37.360 | I was a junior in college looking for a job and the last thing on my mind was trying to
00:02:40.720 | save for retirement because I didn't have much money.
00:02:43.200 | I just needed to find a job.
00:02:45.480 | But now we know.
00:02:46.480 | Ah, so right now there's like no excuse not to contribute to a Roth IRA if you're in a
00:02:52.060 | very low income tax bracket.
00:02:55.020 | But what if you are in a moderate to higher income tax bracket?
00:02:59.660 | So once you make over $76,000 or more, you can't contribute to a traditional IRA.
00:03:07.180 | And once you make more than $140,000, you can't contribute to a Roth IRA either.
00:03:14.220 | So what is a person to do?
00:03:16.420 | Should you really do a Roth IRA conversion and pay taxes up front?
00:03:21.620 | I think the answer is probably not unless you are in the 0% tax bracket, 10%, 12%, 24%.
00:03:31.760 | And after that, I just think it's a wash or you're going to be losing money.
00:03:35.960 | And here's why.
00:03:36.960 | First of all, tax rates are unlikely to go up for the middle class because the politicians
00:03:41.700 | we have depend on the middle class for votes and to stay in power.
00:03:46.060 | Now the median household income is about $69,000 and a common definition of middle class is
00:03:52.100 | plus or minus 50% on the median.
00:03:54.980 | So we can talk about a middle class income going up to about $105,000 nationwide.
00:04:01.380 | However, half the population lives on the more expensive coasts.
00:04:06.420 | For example, for a family of four in San Francisco, you can be considered low income if you have
00:04:12.300 | a $117,000 income or less.
00:04:15.420 | Therefore, you can argue that a middle class income for a household of four or five can
00:04:22.500 | go up to about $300,000.
00:04:25.780 | And that might sound like a lot to some folks who live in low cost of living areas.
00:04:31.100 | But the reality is the nation is not even in terms of cost of living.
00:04:36.600 | And I think it's very consistent because President Biden has said he would not raise taxes on
00:04:42.180 | anybody making less than $400,000.
00:04:45.540 | So $400,000 for an individual he clarified and $450,000 for a couple, which doesn't make
00:04:52.100 | sense because 400,000 plus 400,000 equals 800,000 and not 450,000.
00:04:57.300 | But this is a very traditional way of thinking the government has where one spouse or partner
00:05:02.580 | stays at home.
00:05:04.000 | The traditional IRA and Roth IRA are retirement vehicles for the middle class.
00:05:10.400 | And if middle class tax rates aren't going up, then it doesn't really matter if you do
00:05:15.980 | a traditional or you convert to a Roth IRA because the math dictates so.
00:05:21.340 | Let's say you're 40 years old and make $65,000 a year, you're a single person.
00:05:26.640 | This income level puts you in the 22% marginal federal income tax bracket.
00:05:31.740 | If you invest $6,000 in a traditional IRA, and it grows at 8% a year for 20 years, you'll
00:05:37.220 | end up with $27,965.
00:05:41.260 | And when you withdraw the money, you decide to withdraw all of it and pay the same 22%
00:05:46.100 | marginal federal income tax.
00:05:48.220 | Therefore, you end up with $21,813.
00:05:53.140 | Now let's say on the other hand, you contribute to a Roth IRA, you have to pay 22% tax on
00:05:58.620 | that 6,000 upfront, leaving you with $4,680.
00:06:04.420 | If it grows at the same 8% a year for 20 years at age 60, you can withdraw tax free $21,813.
00:06:14.460 | In other words, the results are the same.
00:06:17.780 | So if the math is the same, because the tax rates are the same, input output the same,
00:06:23.300 | then it really doesn't matter.
00:06:25.620 | So in that regard, you're wasting time trying to do a Roth IRA conversion.
00:06:30.100 | The other really important point is that your income will likely be lower in retirement
00:06:35.180 | than while working.
00:06:37.660 | This makes logical sense.
00:06:39.660 | In retirement, you're not working, you're relaxing, you're living off your savings and
00:06:43.980 | investments and Social Security and maybe a pension.
00:06:47.220 | Generally, that is much less than your highest income earning years or your average income
00:06:53.260 | earning years.
00:06:54.260 | Therefore, if you're making less in retirement, which most of us do, since we're not working,
00:07:00.340 | we're probably going to be in a lower marginal income tax rate.
00:07:04.500 | Further, your Social Security income actually isn't fully taxed.
00:07:08.740 | Did you know that?
00:07:09.740 | I didn't really know that until recently.
00:07:12.140 | The portion of your Social Security benefits subject to taxation varies with income levels.
00:07:17.780 | So you'll be taxed on up to 50% of your benefits if your income is $25,000 to $34,000 for an
00:07:24.220 | individual or $32,000 to $44,000 for a married couple.
00:07:29.260 | You'll be taxed up to 85% of your benefits if your income is more than $34,000 for an
00:07:34.300 | individual or $44,000 per couple.
00:07:37.300 | So in other words, not 100% of your Social Security benefits will ever be taxed.
00:07:43.380 | Pretty good.
00:07:44.380 | Now let's say you are a top 1% or you're going to end up being a top 1%.
00:07:50.100 | Now Roth IRAs are more valuable for those in the top 1% net worths or top 1% incomes
00:07:55.980 | in retirement because it could be used for tax planning for those dealing with a larger
00:08:01.060 | estate because their heirs can draw the money tax free.
00:08:06.260 | So let's say you're a lucky individual working 100 hours a week.
00:08:09.660 | You never see your kids, don't see your friends, gain a lot of weight, but you're making $700,000
00:08:14.700 | a year.
00:08:15.700 | You're living large, right?
00:08:17.020 | You're in the top 1% and you're concerned about paying 39.6% marginal federal income
00:08:23.420 | tax rate in retirement versus what you're paying now, which is 37%.
00:08:27.940 | So you decide to do a Roth IRA conversion and you pay 37% rate upfront.
00:08:34.700 | That's crazy.
00:08:36.060 | That is crazy.
00:08:37.180 | But you do it anyway, even though you were only in the 22% marginal income tax bracket
00:08:42.980 | years ago when you were contributing to your traditional IRA.
00:08:46.900 | So therefore you're locking in a 15% loss with the potential for only saving 2.6% in
00:08:52.820 | federal income taxes in the future.
00:08:54.780 | Does that make sense?
00:08:55.780 | I don't think that makes sense, but you're really, really bullish on your future.
00:09:01.340 | So what happens 20 years from now?
00:09:03.620 | 20 years from now, you amass a fortune of let's say $15 million.
00:09:08.100 | And out of the 15 million, 5 million is in a Roth IRA conversion.
00:09:12.580 | 5 million is in your after tax brokerage accounts because you need that passive income.
00:09:17.500 | 3 million is in your primary residence and 2 million is in rental properties.
00:09:22.620 | So okay, you're in the top 1% net worth, which currently has a cutoff of about $10 million
00:09:29.980 | at the minimum.
00:09:30.980 | So it's already hard enough to generate a top 1% income.
00:09:36.060 | It's another thing to consistently save and invest 50% of your after tax earnings for
00:09:41.980 | that long.
00:09:43.220 | Most people don't.
00:09:44.700 | We've all heard plenty of stories of people making a lot of money, way more than $700,000
00:09:48.460 | a year and ending up broke.
00:09:50.900 | So these are two unlikely things that are going to happen, right?
00:09:55.660 | Huge income, huge savings.
00:09:57.980 | But regardless, you did it.
00:09:59.960 | You are just the man or the woman with the financial plan and everything is going fantastically
00:10:06.260 | well.
00:10:07.260 | So in those 20 years, you were actually living off "only" $200,000 a year, right?
00:10:13.220 | Because after taxes and saving 50% of your after tax income, you only got about $250,000
00:10:19.140 | left out of your $700,000.
00:10:21.980 | So let's say you're in retirement, life is short, so you decide to bump up your target
00:10:26.880 | spend from $200,000 a year to $300,000 a year.
00:10:32.140 | I don't think it's feasible to comfortably spend that much more money, 50% more money
00:10:37.580 | when you're used to spending a certain amount for two decades.
00:10:41.680 | But let's just continuously be conservative with this example.
00:10:45.680 | Now after withdrawing 2.4% from your $5 million Roth IRA conversion, you get your total income
00:10:53.420 | up to about $336,000.
00:10:56.500 | That's pretty good.
00:10:58.360 | But the marginal federal income tax rate at $336,000 is 35%, which is still lower than
00:11:04.860 | your 39.6% when you did the Roth IRA conversion.
00:11:09.140 | So once again, you lose.
00:11:11.020 | Now obviously tax rates could be higher, but we just made an argument that up to about
00:11:16.500 | $300,000, inflation adjusted, politicians aren't going to raise taxes on people making
00:11:22.740 | that much because that is considered middle class for some people in the country.
00:11:26.980 | You would probably have to start withdrawing closer to 4% from your Roth IRA or $200,000
00:11:33.480 | to add on to the passive income your dividend stocks and your rental properties are generating
00:11:39.080 | to get to $400,000 plus to potentially pay more in taxes and retirement than while you're
00:11:47.240 | working, potentially.
00:11:48.720 | Now again, to have all that, to generate all that income, you need to have a net worth
00:11:54.080 | of about $15 million and we know that less than 1% of people have a net worth of more
00:12:01.400 | than $10 million.
00:12:02.880 | So to get to $15 million, it's definitely less than 1%.
00:12:06.760 | Getting to $15 million is unlikely to happen for more than 99% of the population.
00:12:12.680 | Inflation adjusted again.
00:12:14.280 | So let's please be realistic with your expectations.
00:12:17.720 | If you're doing a Roth IRA conversion because you believe you're going to pay higher taxes
00:12:22.440 | in retirement than while working, it's illogical.
00:12:26.200 | It's unlikely.
00:12:27.200 | It could happen.
00:12:28.200 | It could happen.
00:12:29.200 | You could certainly win the lottery, invest in some massive multi-bagger that goes public.
00:12:35.920 | It could happen.
00:12:36.920 | It happens all the time with less than 1% of the population, but you've just got to
00:12:42.360 | be realistic with the numbers.
00:12:44.560 | For a quick calculation, take whatever you're making right now and divide it by 3% and 4%.
00:12:51.000 | The result is your likely liquid net worth target necessary to be able to generate a
00:12:55.960 | similar level of income in retirement.
00:12:58.920 | If you have a similar level of income in retirement, your tax bill likely won't increase.
00:13:04.020 | So instead, divide your current income by 2% to get to a liquid net worth target that
00:13:09.800 | may cause for your tax rate to increase in retirement.
00:13:14.880 | The other thing with doing a Roth IRA conversion is this.
00:13:18.480 | Once you do it, it's like surrendering to the government.
00:13:21.400 | Sure, you'll get the tax-free benefits upon withdrawal, but even that is not a certainty.
00:13:26.960 | The government could always pass new legislation, right?
00:13:31.240 | And all of us have the ability to adjust our income and therefore our tax rates in retirement.
00:13:37.320 | We could move to more tax-efficient states.
00:13:41.320 | We could rebalance our portfolios to non-dividend paying investments.
00:13:44.800 | We could donate more of our wealth to charity while living, gift more of our wealth to our
00:13:49.080 | children and other individuals.
00:13:51.600 | We can invest in non-income producing investments like venture capital, start a business with
00:13:57.600 | lots of deductions, and we can withdraw at different rates.
00:14:02.600 | There's no rule that says once you hit age 59 and a half and over, you have to withdraw
00:14:07.160 | 100% from your 401(k), Roth IRA, traditional IRA, and so forth.
00:14:13.840 | You can keep that there.
00:14:14.840 | You can just dribble it out if you want and you can play with the numbers based on your
00:14:18.440 | needs and desires.
00:14:19.960 | So I think more of us should keep that call option, keep that flexibility.
00:14:25.240 | Now in terms of the best time to do a Roth IRA conversion, I got to thinking about my
00:14:30.400 | own scenario.
00:14:31.720 | For me, that year was 2013.
00:14:35.000 | It was my lowest income earning year because the first full year I didn't have a job.
00:14:40.080 | I stopped receiving a steady paycheck in June 2012.
00:14:45.280 | Unfortunately or fortunately, even as an unemployed person, I was still in the 28% marginal federal
00:14:50.480 | income tax bracket, which is $87,000 to $183,000 for individuals because tax rates were higher
00:14:58.400 | back then.
00:14:59.720 | Further, I was earning passive income, some online income, and had deferred investment
00:15:05.500 | income as part of my severance package coming in for the next four years.
00:15:09.640 | So the last thing I want to do as an unemployed person who just saw over 60, 70% of his income
00:15:17.160 | go away is to pay six figures in taxes to do a Roth IRA conversion.
00:15:23.560 | Therefore I decided to just roll over my 401(k) into a traditional IRA and just keep what
00:15:28.760 | I had.
00:15:31.000 | You'll probably feel the same way in terms of desiring to hold on to as much wealth as
00:15:36.120 | possible if you ever lose your job.
00:15:39.520 | Or it's not as easy as you think once you're in a very low income tax bracket after being
00:15:46.680 | in a high income tax bracket or a higher income tax bracket for many, many years.
00:15:50.800 | So the best time to do a Roth IRA conversion is when you are unemployed with little to
00:15:55.000 | no other income sources.
00:15:57.360 | At a 0%, 10%, or 12% marginal income tax bracket, it's probably a no-brainer to do a Roth IRA
00:16:04.120 | conversion.
00:16:05.120 | But even paying 10% to 12% of your traditional IRA in taxes is going to hurt.
00:16:11.840 | So I'm not sure you'll want to do it even though it's probably the right move.
00:16:17.400 | So in conclusion, I say if you are currently in the 24% tax bracket or lower, you have
00:16:25.400 | a positive probability that doing a Roth IRA conversion will save you taxes in the long
00:16:30.720 | run.
00:16:31.720 | If you are in the 32%, 35%, 37%, and future 39.6% tax rate, I would say don't bother.
00:16:40.400 | If you can contribute to a Roth IRA when you're coming up, you know, you're in college, first
00:16:45.800 | years of work, go do it.
00:16:47.960 | Diversify your retirement income streams.
00:16:51.320 | But after you've surpassed those income limits, I would just stick to your 401(k) traditional
00:16:57.480 | IRA and just save aggressively in your after-tax investment accounts.
00:17:02.640 | And at the end of the day, if you end up paying more in taxes than you could have in retirement,
00:17:08.120 | then just feel grateful you did so well because paying more taxes means that you ended up
00:17:13.360 | making more money.
00:17:15.680 | So thanks so much everyone for listening.
00:17:17.560 | And if you are vehemently against what I just said, and if you strongly believe that a Roth
00:17:22.840 | IRA conversion makes sense, I'd love to hear from you.
00:17:25.760 | I want to hear both sides of the story because this is real life and this is real money and
00:17:30.560 | we have a deadline potentially of 2022.
00:17:34.000 | And if you enjoyed this podcast, I'd love a positive review.
00:17:36.720 | I read all the comments and I appreciate them so much.
00:17:39.720 | Cheers.