Bogleheads® Conference 2024 Roth Conversion Deep Dive with Mike Piper

00:00:00.000 | [APPLAUSE]

00:00:06.920 | All righty, so I get to introduce myself today.

00:00:10.320 | So hello.

00:00:11.360 | I am Mike.

00:00:12.720 | I am a CPA.

00:00:14.040 | And let's just get started.

00:00:16.280 | So as you can see from our title here,

00:00:18.680 | this is going to be a deep dive on the topic of Roth conversions.

00:00:22.400 | But before we do that, before we really dive deep,

00:00:26.640 | I want to take just a brief moment to make sure

00:00:28.600 | that everyone here is on the same page about one

00:00:32.400 | fundamental piece of information.

00:00:34.120 | And that is, what is a Roth conversion?

00:00:37.480 | So a Roth conversion is when you move money

00:00:41.480 | from a tax-deferred account to a Roth account.

00:00:45.080 | So for instance, you could be moving money from a traditional IRA

00:00:48.280 | to a Roth IRA.

00:00:49.800 | And when you do that, the money that you move over--

00:00:52.640 | so the money that you convert--

00:00:54.280 | it's generally taxable as income in the year

00:00:56.840 | that you do the conversion.

00:00:58.040 | So that's what a conversion is.

00:01:00.280 | And there are three primary things

00:01:01.920 | that we're going to be talking about today

00:01:03.640 | that all fall under the Roth conversion umbrella.

00:01:06.760 | The first one is, what are the effects?

00:01:09.240 | What are the pros and cons of a Roth conversion?

00:01:11.560 | In other words, how do we decide whether or not

00:01:13.760 | it makes sense for you to do a conversion in any given year?

00:01:18.240 | Topic number two, what can we hope to achieve

00:01:21.920 | with a smart conversion plan?

00:01:23.920 | In other words, what are the metrics

00:01:25.640 | that we can realistically hope would be

00:01:27.560 | improved by doing conversions?

00:01:29.680 | And our third topic, which we're going to hit on more briefly,

00:01:33.040 | is, how does a Roth conversion plan

00:01:36.160 | fit into a broader overall retirement tax plan?

00:01:40.760 | So digging right in here with the effects of a Roth

00:01:42.840 | conversion, in most cases, conversions

00:01:47.120 | are going to have up to three major effects.

00:01:49.180 | And these are the three things that you

00:01:50.760 | want to be looking at in any given year

00:01:52.920 | when trying to determine whether it does or does not make sense

00:01:56.080 | for you to do a conversion.

00:01:58.440 | The first effect is that you will end up paying tax now

00:02:01.520 | instead of paying tax later.

00:02:03.920 | The second effect is that conversions

00:02:05.840 | will let you use taxable account dollars to essentially buy

00:02:10.000 | more Roth space.

00:02:12.600 | And the third effect is that Roth conversions

00:02:14.520 | will reduce your future required minimum distributions,

00:02:17.380 | your future RMDs.

00:02:18.960 | And that can reduce the future tax drag on your portfolio.

00:02:23.360 | And we're going to go through these one by one.

00:02:25.360 | So pay tax now instead of later.

00:02:28.160 | The idea here is that when you do a conversion,

00:02:30.880 | the conversion is taxable.

00:02:32.400 | So you have to pay some tax right now, right?

00:02:34.920 | But then the money is going to be in a Roth IRA going forward.

00:02:37.800 | So Roth IRAs are allowed to grow tax-free.

00:02:40.320 | So you won't have to pay tax later as it grows.

00:02:42.960 | And as long as you meet the appropriate requirements,

00:02:45.160 | you can take the money out tax-free as well.

00:02:47.680 | Whereas, conversely, if you don't do a conversion,

00:02:51.200 | then you won't be paying any tax right now because you

00:02:54.480 | didn't do a conversion.

00:02:56.160 | But then the money is still in a traditional IRA or other tax

00:02:59.000 | deferred account.

00:03:00.200 | And so you most likely would have

00:03:03.160 | to pay tax at some point later whenever the money does

00:03:06.040 | come out of the account later.

00:03:08.680 | And of the three effects shown on this slide,

00:03:11.760 | this first one, paying tax now instead of paying tax later,

00:03:15.120 | this is the one that gets almost all of the discussion.

00:03:20.320 | And in fact, it's very common to see this treated as if it

00:03:24.160 | is the entirety of the analysis.

00:03:25.960 | It's very common to see articles and bogleheads threads where

00:03:28.800 | this is the only thing that gets brought up.

00:03:31.020 | But as we'll see in just a little bit,

00:03:32.600 | this is really only one piece of the picture.

00:03:34.480 | It's important to account for more than this.

00:03:37.720 | Now, this effect of paying tax now instead of paying tax

00:03:40.480 | later, it can be helpful or it can be harmful.

00:03:44.640 | So it can be a good thing or it can be a bad thing.

00:03:46.360 | It can be a point in favor of doing a conversion

00:03:48.320 | or a point against.

00:03:49.920 | And that all depends on the current marginal tax rate.

00:03:54.120 | And by that, I mean the tax rate that you would pay

00:03:56.380 | on a conversion of a given size if you did

00:03:58.240 | do that conversion this year.

00:04:00.240 | And how does that tax rate compare

00:04:02.440 | to the future marginal tax rate?

00:04:04.880 | And by that, we specifically mean

00:04:07.280 | the tax rate that would be paid on the dollars in question

00:04:10.880 | whenever they come out of the account later

00:04:13.040 | if you don't convert them.

00:04:14.880 | So we're comparing those two tax rates.

00:04:17.080 | And whenever the current tax rate,

00:04:18.800 | so the tax rate on the conversion,

00:04:20.500 | is the lower of the two, then this effect is helpful.

00:04:24.600 | It's a point in favor of doing a conversion.

00:04:26.940 | And conversely, whenever the current tax rate

00:04:29.080 | is the higher of the two, then this effect is harmful

00:04:32.400 | because it means you're paying tax now at a higher tax rate

00:04:35.600 | when you could have waited and paid tax later

00:04:37.840 | at a lower tax rate.

00:04:38.760 | So that's not a good thing.

00:04:40.240 | So this effect, it can be good or it can be bad.

00:04:42.640 | It just depends on the circumstances.

00:04:44.480 | Now, there are a number of caveats,

00:04:48.480 | complicating factors, that make this pay tax now

00:04:51.360 | or pay tax later thing more complicated

00:04:54.780 | than it might appear at first glance.

00:04:57.280 | The first one is that when we're talking

00:04:58.700 | about marginal tax rates, your marginal tax rate

00:05:02.660 | might be different than just your tax bracket.

00:05:05.040 | We often treat those two terms as if they're synonyms,

00:05:07.180 | but they're not because there are a ton

00:05:09.920 | of different things in our tax code

00:05:11.960 | where as your income goes up,

00:05:14.080 | your income tax does go up as a result of your tax bracket,

00:05:18.720 | but something else also happens.

00:05:21.400 | Like this additional taxable income causes you

00:05:23.260 | to become ineligible for a particular tax credit

00:05:25.400 | or something like that.

00:05:26.720 | And so when you account for that factor

00:05:29.160 | plus your tax bracket, your actual marginal tax rate

00:05:32.780 | can be considerably higher than just the tax bracket

00:05:35.440 | that you're in.

00:05:36.560 | And I wanna run through just a few things

00:05:39.000 | that can cause that type of effect

00:05:40.560 | that are most likely to be relevant

00:05:42.000 | in a Roth conversion analysis.

00:05:43.640 | The first one is the premium tax credit.

00:05:46.800 | So that's the credit for anybody buying health insurance

00:05:49.240 | on the Affordable Care Act exchange.

00:05:50.760 | So that's most often gonna be relevant

00:05:52.280 | in a scenario where you retire before 65,

00:05:55.040 | so you're not yet on Medicare, but you've retired,

00:05:57.520 | so you don't have insurance through your previous employer,

00:05:59.940 | most likely, so you're probably buying insurance

00:06:02.560 | on the exchange.

00:06:03.400 | And the way that credit works is that

00:06:06.800 | as your income goes up, the credit shrinks,

00:06:09.400 | and eventually it shrinks all the way to zero.

00:06:11.800 | And so let's say you're 63,

00:06:13.720 | and you're thinking about doing a conversion this year,

00:06:16.060 | and you're buying insurance on the exchange.

00:06:18.320 | Well, then this is something we have to account for.

00:06:20.920 | Is this taxable income from the conversion

00:06:23.520 | going to be shrinking this tax credit?

00:06:25.420 | And if the answer is yes, that doesn't necessarily mean...

00:06:31.320 | (audience laughing)

00:06:38.200 | Can we get that light switch back on?

00:06:39.800 | Thank you.

00:06:40.640 | So if a conversion would be shrinking

00:06:45.120 | your premium tax credit, that's not a good thing,

00:06:47.960 | but it isn't necessarily enough to say

00:06:49.680 | that we shouldn't do a conversion.

00:06:51.760 | It just is something we need to account for in the math

00:06:55.480 | in order to be doing it correctly.

00:06:57.180 | Then the way that Social Security benefits are taxed,

00:07:01.000 | that can also cause this type of effect.

00:07:02.880 | Basically, if your income is low enough,

00:07:04.960 | your benefits are not taxable,

00:07:06.960 | but then as your income proceeds upwards

00:07:08.720 | through a particular range,

00:07:10.200 | the portion of your benefits that are taxable, it goes up.

00:07:14.320 | So as your income is proceeding upward through that range,

00:07:17.880 | the actual marginal tax rate is much higher

00:07:21.040 | than just the tax bracket that you're in.

00:07:23.840 | And Medicare IRMA,

00:07:25.520 | that's Income Related Monthly Adjustment Amount,

00:07:28.160 | and it is just a rule that says that

00:07:30.000 | if your income crosses a certain threshold

00:07:32.920 | or various thresholds in a particular year,

00:07:35.680 | then your Medicare premiums two years from now

00:07:38.600 | are going to be higher.

00:07:40.040 | So if we're thinking about conversions in 2024,

00:07:44.360 | if you would be 65 or older in 2026, so two years from now,

00:07:48.080 | then we want to be thinking about,

00:07:49.880 | would this conversion push you over one of those thresholds?

00:07:53.320 | And again, if the answer is yes,

00:07:55.040 | that doesn't necessarily mean no conversions,

00:07:57.560 | it just means that's something we have to be accounting for

00:08:00.440 | in order to be getting the math right.

00:08:02.480 | And one thing to point out about this idea

00:08:06.200 | that marginal tax rate and tax bracket

00:08:08.680 | are not necessarily the same

00:08:10.600 | is that we need to be thinking about that

00:08:12.760 | on both ends of this analysis, right?

00:08:15.320 | We're talking about pay tax now or pay tax later,

00:08:18.600 | and we're looking at the current tax rate

00:08:20.600 | and the future tax rate.

00:08:22.600 | In both cases,

00:08:24.440 | we're concerned with your actual marginal tax rate,

00:08:27.320 | not just the tax bracket that you're in.

00:08:30.320 | Another important complicating factor

00:08:33.760 | that people often overlook is that for a married couple,

00:08:37.520 | one thing that often happens

00:08:39.720 | after either of the two people has died

00:08:42.120 | is that the surviving spouse

00:08:44.320 | is left with a higher marginal tax rate going forward.

00:08:47.920 | And the reason for that is that the standard deduction

00:08:51.720 | for a single filer is only half the size

00:08:54.920 | that it is for a married couple filing jointly.

00:08:57.720 | And the tax brackets only have half as much space in them.

00:09:00.920 | But typically, when one of the two spouses dies,

00:09:03.920 | what happens is that the household's income falls,

00:09:06.520 | but it falls by less than half

00:09:08.520 | because it's usually the smaller

00:09:09.920 | of the two Social Security benefit amounts that goes away.

00:09:12.920 | And the income from the portfolio

00:09:15.120 | usually doesn't change at all, or at least not very much, right?

00:09:17.720 | It's still there, paying interest and dividends and RMDs and so on.

00:09:20.520 | So the surviving spouse, they have half the standard deduction

00:09:23.720 | and half the space in the tax brackets

00:09:26.120 | but more than half as much income.

00:09:28.520 | And so the result is that they're often left with a higher tax rate.

00:09:31.920 | And the takeaway with respect to Roth conversions

00:09:34.520 | is that this can be a compelling point

00:09:36.720 | in favor of doing conversions while both people are still alive.

00:09:41.720 | Another caveat, another complicating factor here

00:09:44.920 | is that when we're talking about that future tax rate,

00:09:49.120 | it might not be your future tax rate that we're talking about

00:09:53.320 | for a significant portion of these dollars.

00:09:55.720 | It could be the tax rate that your heirs, your beneficiaries,

00:09:59.320 | would be paying on distributions

00:10:01.520 | from an inherited tax-deferred account.

00:10:04.120 | And so there's a couple of things we want to be thinking about there.

00:10:07.120 | Sorry, one moment.

00:10:11.120 | The first thing we want to be thinking about

00:10:12.920 | is how many beneficiaries will there be?

00:10:16.320 | Because imagine you've got one adult child

00:10:19.920 | and they have no kids of their own

00:10:21.920 | and there's nobody else you're planning on leaving any of these assets to.

00:10:24.920 | Well, then it's pretty darn likely

00:10:28.520 | that the distributions themselves,

00:10:31.320 | as in the distributions that this beneficiary would have to take

00:10:34.320 | from an inherited traditional IRA,

00:10:36.520 | it's likely that those distributions

00:10:37.920 | would be pushing this person up into a higher tax rate.

00:10:41.520 | And so that would be a compelling point

00:10:44.320 | in favor of doing conversions now.

00:10:46.320 | Pay tax at your current tax rate, whatever it happens to be,

00:10:49.320 | so your beneficiary doesn't have to pay a much higher tax rate later.

00:10:52.920 | But if you think about a different scenario,

00:10:55.120 | if you've got ten beneficiaries,

00:10:56.920 | four kids and six grandkids or something like that,

00:10:59.320 | and the accounts are going to be split up among all ten of those people,

00:11:02.320 | then it's a lot less likely

00:11:03.720 | that the distributions would be pushing them up into higher tax rates.

00:11:06.920 | And so this wouldn't necessarily be a point in favor of conversions

00:11:09.920 | and could be a point against doing a conversion.

00:11:11.920 | So it all depends on the circumstances.

00:11:15.320 | We also want to be thinking about what are the careers,

00:11:17.320 | or just more broadly, what are the earnings levels of these beneficiaries?

00:11:21.320 | The higher their level of earnings,

00:11:23.920 | the more likely it is that they're going to be paying very high tax rates

00:11:26.920 | on distributions from any inherited tax-deferred accounts.

00:11:30.320 | And so if all of these beneficiaries have high levels of earnings,

00:11:34.320 | that's a strong point in favor of doing conversions.

00:11:36.920 | Whereas if these beneficiaries have more modest levels of earnings,

00:11:40.720 | that could be a point against doing conversions.

00:11:43.120 | So this all just depends on the circumstances.

00:11:46.920 | And then our last caveat here on this paying tax now versus paying tax later idea

00:11:51.120 | is that to the extent that you would use qualified charitable distributions, QCDs,

00:11:56.720 | or to the extent that you would leave tax-deferred dollars

00:11:59.720 | to charity at your death by naming a charity

00:12:02.720 | as the beneficiary of your IRA or something like that,

00:12:05.720 | well, then, to that extent,

00:12:07.720 | the future tax rate that we're talking about,

00:12:10.120 | it's actually zero because nonprofit organizations are tax-exempt.

00:12:15.320 | They don't have to pay tax on dollars

00:12:17.320 | that they get from a traditional IRA or 401(k) or something like that.

00:12:21.120 | And so if you anticipate a large portion of your tax-deferred balances

00:12:27.320 | ultimately going to charity,

00:12:29.320 | well, then, that is a pretty compelling point against doing Roth conversions

00:12:35.720 | because it means you're paying tax now at whatever tax rate you pay on the conversion

00:12:39.120 | when ultimately a good chunk of these dollars

00:12:41.520 | could have come out of the account later at a 0% tax rate anyway.

00:12:45.120 | And paying tax now to avoid zero taxes later is not helpful.

00:12:48.920 | So that's one thing to have in mind.

00:12:52.520 | And that is the first effect of a Roth conversion.

00:12:56.120 | You pay tax now instead of paying tax later,

00:12:58.920 | and it can be good or it can be bad.

00:13:00.720 | It just depends on all the circumstances.

00:13:04.720 | The second effect of a Roth conversion

00:13:07.120 | is that conversions let you use taxable account dollars

00:13:11.920 | to essentially buy more Roth space.

00:13:15.120 | And before getting into how that works,

00:13:17.920 | I want to make sure we're all clear on a definition

00:13:20.520 | because I actually see this misunderstanding a lot on the Vogelheads forum.

00:13:24.120 | Sometimes people think that a taxable account means a traditional IRA,

00:13:28.520 | meaning that it's taxable because you take the money out and it's taxable,

00:13:31.920 | but that's not what we're talking about.

00:13:33.920 | A taxable account is any account that doesn't have special tax treatment.

00:13:38.720 | So a taxable account is not a traditional IRA.

00:13:41.120 | It's not a Roth IRA.

00:13:43.520 | It's not a 401(k) or a Roth 401(k).

00:13:45.520 | It's not a 403(b) or a Roth 403(b).

00:13:48.120 | It's not a 457 or a 529 or an HSA or an FSA.

00:13:51.120 | It's none of that stuff.

00:13:52.320 | It's basically a regular checking account or a regular savings account.

00:13:57.320 | Or if you went to Vanguard or Schwab or your favorite brokerage firm

00:14:00.120 | and opened up a new brokerage account that isn't an IRA,

00:14:03.520 | that's a taxable account.

00:14:04.720 | Those are the types of accounts we're talking about here.

00:14:06.720 | And we call them taxable accounts because they're the types of accounts

00:14:08.920 | where you have to pay tax every year on the interest and dividends

00:14:11.720 | that you earn and so on.

00:14:13.920 | And the idea of effect number two here is that you can use money

00:14:21.120 | from a taxable account to pay the tax on the conversion.

00:14:26.120 | And when you do that, what's happening essentially

00:14:28.120 | is that you're giving up money from a taxable account

00:14:31.520 | and you're getting more Roth money.

00:14:33.520 | And to illustrate how that works, I want

00:14:35.120 | to run through a very quick example of a Roth conversion.

00:14:38.520 | And as we'll see, this is actually an example

00:14:40.320 | of what not to do in most cases.

00:14:42.120 | But we'll get to that in just a minute.

00:14:44.320 | And so we're going to keep the math easy.

00:14:46.720 | We're going to assume it's a 25% tax rate.

00:14:49.320 | And we're going to assume it's a $100,000 Roth conversion.

00:14:52.420 | Easy math.

00:14:53.420 | So we have $100,000 coming out of a traditional IRA.

00:14:58.020 | And when you do a conversion, you have a choice.

00:15:01.320 | You can have taxes withheld if you want to at any percentage you want,

00:15:05.320 | including zero.

00:15:06.620 | So it's optional, but you can have taxes withheld.

00:15:10.020 | And so in this example, we're going

00:15:11.520 | to assume that you do choose to have taxes withheld.

00:15:14.320 | And you're anticipating a 25% tax rate.

00:15:17.420 | So again, easy math, 25% gets withheld.

00:15:21.020 | And that means that $75,000 of this conversion, $75,000

00:15:25.520 | is what actually ends up in the Roth.

00:15:28.120 | The other $25,000 gets withheld.

00:15:30.220 | It goes to the IRS.

00:15:32.420 | So that's one way you can do a conversion.

00:15:35.320 | Or instead of doing that, you can do this, what we have on this slide.

00:15:39.820 | Here we have $100,000 coming out of the traditional IRA.

00:15:44.720 | Nothing gets withheld.

00:15:46.720 | So the whole $100,000 goes into the Roth account.

00:15:50.420 | But you still do have to pay the tax.

00:15:52.020 | And so we're just writing a check, essentially, to the IRS for $25,000.

00:15:55.820 | We're using money from a taxable account to pay that tax.

00:15:59.220 | And so what has happened here is you gave up money from a taxable account,

00:16:04.220 | because that's what you used to pay the tax.

00:16:06.720 | But you got more Roth money.

00:16:08.220 | Because in this case, $100,000 made it into the Roth.

00:16:11.220 | The whole amount made it into the Roth instead of only $75,000.

00:16:16.920 | Now, this effect of using taxable account money to pay the tax

00:16:20.420 | and therefore, essentially, buy more Roth space,

00:16:23.020 | one thing to point out is that it doesn't apply to everybody.

00:16:26.120 | If you don't have taxable account dollars that you could use,

00:16:29.520 | well, then who really cares?

00:16:30.720 | It's not relevant.

00:16:31.420 | You don't need to be thinking about it.

00:16:33.220 | But in the cases where it is applicable, by definition,

00:16:39.120 | it's a point in favor of conversions.

00:16:41.120 | This one's never a point against conversions.

00:16:43.820 | The only two choices here are it does not apply

00:16:46.420 | or it's a point in favor of conversions.

00:16:48.920 | And the reason for that is that taxable accounts

00:16:52.720 | have what we call tax drag.

00:16:54.720 | And Roth accounts don't have that.

00:16:57.420 | And what I mean by that is that in a taxable account every year,

00:17:00.420 | you have to pay tax on the interest that you earn.

00:17:02.520 | You have to pay tax on the dividends that you earn.

00:17:04.220 | You have to pay tax on the capital gains when you sell something.

00:17:07.520 | And we call that tax drag

00:17:09.820 | because it's taxes dragging down your rate of return.

00:17:13.020 | And in Roth accounts, we don't have that.

00:17:17.120 | You don't have to pay those taxes.

00:17:18.420 | You get to keep the whole rate of return.

00:17:21.820 | And one thing that I know you all know,

00:17:24.520 | because this is one thing that we spend so much time

00:17:27.020 | talking about as Bogleheads,

00:17:28.220 | is that expense ratios of mutual funds,

00:17:31.620 | they're really important, right?

00:17:34.220 | And the reason that they're so important,

00:17:35.620 | the reason we spend so much time talking about that

00:17:38.120 | is because even a small difference

00:17:40.720 | in the annual rate of return

00:17:43.020 | when you compound it over many years

00:17:45.520 | is a really big deal.

00:17:47.520 | And that same exact math applies to tax drag.

00:17:52.020 | Even a small difference in the annual rate of return

00:17:54.120 | when we compound it over many years

00:17:56.120 | can have a very big impact.

00:17:58.620 | And so whenever you can give up taxable account money

00:18:02.920 | where you don't keep the whole rate of return

00:18:06.120 | and in exchange get more Roth money

00:18:08.120 | where you do keep the whole rate of return,

00:18:10.820 | that's a good thing.

00:18:12.220 | That's a point in favor of doing a conversion.

00:18:16.220 | Now, exactly how beneficial it turns out to be,

00:18:18.920 | in other words, how big of a point

00:18:21.320 | this is in favor of a conversion,

00:18:23.920 | it varies based on the circumstances.

00:18:25.720 | And the most important factor here

00:18:27.720 | is how long will the money stay in the Roth account

00:18:30.620 | after you do the conversion.

00:18:33.020 | And the longer the money would be in the Roth account,

00:18:35.420 | the more beneficial this is,

00:18:36.520 | the bigger a point it is in favor of conversions.

00:18:38.520 | And that just, for the very simple reason

00:18:40.620 | that the longer the money is in the Roth,

00:18:42.520 | then the more years you had to take advantage

00:18:44.420 | of tax-free compounding.

00:18:46.820 | And the length of time in question here,

00:18:48.320 | it could be from the date that you do the conversion

00:18:52.320 | until the date that you take the money out to spend it.

00:18:55.720 | Or it could be from the date that you do the conversion

00:18:58.320 | until the date that the dollars are distributed

00:19:00.920 | at some point after your death to your beneficiaries.

00:19:04.720 | And so under the current rules,

00:19:07.820 | if somebody inherits a Roth IRA

00:19:09.020 | from someone other than their spouse,

00:19:11.320 | they have to take the money out, but not right away.

00:19:14.320 | They're allowed to keep the money in the Roth

00:19:15.920 | for up to 10 years beyond the date of death.

00:19:19.020 | So for some retirees here,

00:19:21.020 | we could be talking about from the date you do the conversion

00:19:25.120 | through the rest of your life plus 10 more years.

00:19:29.720 | And so your age and your health

00:19:31.220 | are really important factors in this analysis.

00:19:34.620 | The younger you are and the better health you're in,

00:19:38.320 | the more likely it is

00:19:39.520 | that we're talking about a really long time here.

00:19:42.520 | And for some retirees,

00:19:45.220 | particularly those early in retirement

00:19:47.220 | and who are in good health,

00:19:50.020 | the rest of their life plus 10 years,

00:19:51.820 | it's not out of the question

00:19:52.920 | that we could be talking about 40 years,

00:19:55.220 | maybe even 50 years.

00:19:57.320 | And 40 or 50 years of tax-free compounding in a Roth

00:20:00.220 | is a big deal.

00:20:02.120 | This is just a very quick

00:20:03.720 | back-of-an-envelope-style math example.

00:20:06.020 | If you imagine $1 invested today

00:20:08.120 | at a 4% rate of return for 40 years,

00:20:10.620 | at the end of those 40 years, it has turned into $4.80.

00:20:13.920 | If you instead assume a 3.5% rate of return,

00:20:16.320 | so in other words,

00:20:17.320 | we're modeling a half-percentage point of tax drag,

00:20:20.720 | then it only turns into $3.96.

00:20:22.920 | In other words, it would have been 21% more money

00:20:24.820 | in the Roth account.

00:20:26.420 | If we keep all of those inputs the same

00:20:28.720 | but crank it up to 50 years,

00:20:31.520 | now it's 27% more money in the Roth account.

00:20:34.420 | And I know that the people in this room,

00:20:35.720 | most of you could do this math in a spreadsheet

00:20:37.420 | or using your favorite calculator.

00:20:38.720 | So the reason I took a minute to put this in here

00:20:42.320 | is just to illustrate that this is a big deal.

00:20:44.820 | It can be very impactful.

00:20:46.120 | And in some cases,

00:20:47.920 | this is actually a bigger deal

00:20:50.320 | than the pay tax now or pay tax later thing,

00:20:53.420 | even though that pay tax now or pay tax later thing

00:20:56.120 | gets all of the discussion.

00:20:57.820 | In some cases, this is a bigger deal.

00:21:00.020 | And frankly, what ends up happening a lot of times

00:21:02.520 | if I'm doing a Roth conversion analysis for somebody

00:21:05.620 | is when we're doing that first part,

00:21:08.220 | we're looking at pay tax now or pay tax later,

00:21:10.220 | and we're looking at the current tax rate

00:21:11.520 | and the future tax rate.

00:21:14.120 | The current tax rate, we can calculate, right?

00:21:17.420 | We have at least pretty darn close.

00:21:19.220 | We have the inputs that we need

00:21:20.720 | to figure out what tax rate you would pay

00:21:23.320 | on a conversion of a given size this year.

00:21:25.820 | That's easy.

00:21:27.120 | We've got software that does that very quickly for us.

00:21:29.320 | No big deal.

00:21:30.820 | But the future tax rate,

00:21:33.720 | that is extremely uncertain

00:21:36.420 | because we don't know what investment returns

00:21:39.320 | you're going to get.

00:21:40.720 | So we don't know how big your tax-deferred accounts will be,

00:21:43.620 | and so we don't know how big the RMDs will be.

00:21:46.220 | And we don't know how long anyone's gonna live,

00:21:48.420 | so we don't know how long this filing status

00:21:50.120 | or that filing status applies,

00:21:51.520 | and we don't know at what point it'll be

00:21:53.520 | your beneficiaries taking money out rather than you,

00:21:56.220 | and we don't know exactly how much you're gonna spend.

00:21:58.920 | So that also compounds our uncertainty

00:22:00.520 | about how big the accounts will be

00:22:01.720 | and how big the RMDs will be.

00:22:04.320 | And the big one, we don't know what tax legislation

00:22:07.320 | we're going to see.

00:22:08.620 | So that future tax rate that we're trying to compare,

00:22:12.020 | you know, current tax rate versus future tax rate,

00:22:14.520 | the future tax rate is, we don't know, is the short answer.

00:22:18.420 | It's extremely uncertain.

00:22:19.620 | It's a big question mark.

00:22:20.720 | And so in a lot of cases,

00:22:23.420 | if you're comparing this known future tax rate

00:22:26.920 | to an extremely uncertain,

00:22:29.020 | or known current tax rate

00:22:30.320 | to an extremely uncertain future tax rate,

00:22:33.320 | if that's the only part of the analysis that you look at,

00:22:36.820 | that can make a Roth conversion look like a wash, right?

00:22:39.120 | How would we possibly know?

00:22:40.520 | Is this good? Is it bad?

00:22:42.520 | Really hard to say.

00:22:44.820 | But if we account for this other factor,

00:22:46.420 | the one on the slide,

00:22:48.020 | where you can use money from a taxable account

00:22:50.820 | to pay the tax on the conversion,

00:22:52.320 | and when you do that, you're giving up your,

00:22:55.720 | essentially your less tax-efficient dollars

00:22:57.820 | from a taxable account

00:22:58.620 | where you don't keep the whole rate of return,

00:23:00.620 | but you get more Roth dollars

00:23:02.020 | where you do get to keep the whole rate of return.

00:23:05.220 | And when you account for that as well,

00:23:07.520 | in many cases, that's enough to take this analysis

00:23:10.520 | that at first glance looks like a who-knows

00:23:13.420 | and let us see that, oh, yeah, actually,

00:23:15.620 | in these circumstances,

00:23:16.720 | conversions probably are a good idea.

00:23:19.620 | That's how it ends up panning out a lot of the time.

00:23:23.420 | So that's our second effect of a Roth conversion.

00:23:25.720 | They let you use taxable account money to pay the tax,

00:23:28.620 | and when you do that,

00:23:29.320 | you're giving up taxable account money

00:23:31.520 | and you're getting more Roth money,

00:23:33.620 | and that is a good thing.

00:23:36.220 | Our third effect of a Roth conversion

00:23:38.620 | is that they will reduce your future

00:23:40.120 | required minimum distributions, your future RMDs,

00:23:43.420 | and that can reduce the future tax drag on the portfolio,

00:23:49.520 | and the reason that conversions reduce your future RMDs

00:23:51.920 | is very straightforward.

00:23:52.820 | It's that Roth accounts don't have RMDs

00:23:55.420 | while the original owner is still alive,

00:23:57.320 | so when you do a conversion,

00:23:59.720 | you're moving money out of tax-deferred and into Roth,

00:24:01.920 | so you're just reducing the portion of your portfolio

00:24:04.720 | that is subject to RMDs, so your RMDs go down.

00:24:10.120 | Now, when I say that reducing the RMDs

00:24:14.520 | can reduce the future tax drag on the portfolio,

00:24:17.520 | I want to make a distinction here

00:24:18.620 | because this is the least obvious thing

00:24:20.620 | that we're going to talk about today.

00:24:23.320 | When I say this, I'm not actually talking about the taxes

00:24:26.320 | that you would pay on the RMDs themselves.

00:24:29.120 | We're not talking about that,

00:24:31.220 | and the reason we're not talking about that

00:24:32.520 | is because we already talked about it.

00:24:34.920 | When we talked about the pay tax now or pay tax later,

00:24:37.920 | the pay tax later chunk of that, to a significant extent,

00:24:41.320 | that's the taxes you would pay on RMDs,

00:24:44.020 | so we've already talked about that.

00:24:45.620 | We already accounted for it.

00:24:47.720 | What we're talking about here is something completely separate.

00:24:51.720 | What we're talking about here is what happens

00:24:54.920 | to any unspent RMD dollars.

00:24:59.220 | In other words, your RMDs kick in.

00:25:01.120 | You take out however much you're forced to take out

00:25:02.920 | in a given year.

00:25:03.920 | You spend, let's say, half of it or whatever amount.

00:25:07.720 | What do you do with the rest of it?

00:25:10.220 | In a lot of cases, the answer is that the money

00:25:12.120 | is going to end up getting reinvested

00:25:14.220 | in a taxable brokerage account,

00:25:16.620 | and guess what happens in taxable brokerage accounts?

00:25:18.620 | The same thing that we were just talking about.

00:25:20.120 | You have tax drag.

00:25:21.220 | You have to pay tax on the interest and dividends

00:25:22.820 | and capital gains when you sell stuff,

00:25:27.220 | whereas, conversely, if you do the conversion,

00:25:30.620 | then the RMD never happens, and so the tax drag

00:25:33.820 | from being in a taxable account also never happens.

00:25:36.720 | The money is just allowed to stay in the Roth

00:25:38.920 | for up to the rest of your life plus up to 10 years.

00:25:43.120 | Now, this is another one that isn't necessarily applicable

00:25:46.420 | because if you would spend your entire RMD every year

00:25:50.520 | or if you would donate any portion that you don't spend,

00:25:54.120 | if you would have it sent directly

00:25:56.120 | from your traditional IRA to charity

00:25:58.120 | as what's called a qualified charitable distribution,

00:26:01.120 | then you don't need to be worrying about this third effect.

00:26:03.220 | It doesn't apply to you.

00:26:04.620 | This effect is only applicable in the cases

00:26:07.020 | where you expect that you'd be taking out your RMD

00:26:10.320 | and then ultimately reinvesting a portion of it.

00:26:13.220 | That's what we're concerned with here,

00:26:15.720 | but if this does apply, if you do expect

00:26:18.420 | you would be reinvesting a portion of your RMD,

00:26:20.420 | this is another one where, by definition,

00:26:22.120 | it's a point in favor of doing conversions.

00:26:24.120 | It's never a point against doing a conversion,

00:26:27.620 | but just like with effect number two,

00:26:30.020 | here, same thing where how beneficial it turns out to be,

00:26:33.520 | in other words, how strong a point it is

00:26:36.520 | in favor of doing a conversion

00:26:38.120 | depends on the circumstances

00:26:39.320 | and specifically it depends on how long the money

00:26:41.420 | would be in the Roth account.

00:26:43.420 | Now, in this case, the, oh, and again,

00:26:46.920 | the longer it's in the Roth account,

00:26:48.320 | the more beneficial this is,

00:26:49.820 | but in this case, the length of time

00:26:51.420 | that we're concerned with, it's essentially

00:26:55.020 | how long would the money be in a taxable account,

00:26:58.820 | incurring tax drag, if you don't do the conversion,

00:27:02.320 | whereas it instead would have been in the Roth account

00:27:04.420 | if you did do the conversion.

00:27:05.520 | So essentially, it starts when your RMDs start,

00:27:09.220 | which is some point in your 70s,

00:27:10.820 | depending on when you're born,

00:27:12.520 | and it goes through potentially the rest of your life

00:27:14.920 | plus up to 10 years,

00:27:16.720 | and so this is another one where your health

00:27:19.120 | is really important.

00:27:20.520 | The better health you're in, the more likely it is

00:27:22.320 | that this is a long time,

00:27:23.920 | and for a lot of retirees,

00:27:27.020 | from the date that RMD starts, 73, 75,

00:27:31.320 | through the rest of their life plus up to 10 years,

00:27:34.120 | likely to be multiple decades,

00:27:36.020 | and multiple decades of compounding in a Roth tax-free

00:27:39.420 | can be a big deal.

00:27:40.520 | So those are our three effects of a Roth conversion.

00:27:43.720 | Number one, you pay tax now instead of later.

00:27:46.520 | That can be good or it can be bad.

00:27:48.020 | It just depends on the tax rate you pay on the conversion,

00:27:51.320 | how that compares to the tax rate

00:27:52.620 | that would have been paid on the dollars later

00:27:55.120 | whenever they come out of the account later

00:27:56.620 | if you don't convert them.

00:27:58.620 | Second effect is that conversions let you use money

00:28:01.720 | from a taxable account to pay the tax on the conversion,

00:28:05.120 | and when you do that,

00:28:06.320 | you're giving up your least tax-efficient money

00:28:09.120 | where you don't keep the whole rate of return

00:28:11.020 | and you're getting Roth money,

00:28:12.020 | which is your most tax-efficient money,

00:28:14.520 | and the third effect is that conversions

00:28:15.920 | are gonna reduce your RMDs,

00:28:17.420 | and that can reduce the future tax drag on your portfolio

00:28:20.120 | if you expect that you would be reinvesting

00:28:23.420 | your excess RMDs every year.

00:28:25.220 | So moving on to primary topic number two,

00:28:33.720 | what are the goals that we can hope to achieve

00:28:38.120 | with a smart conversion plan?

00:28:40.320 | Or another way to say this would be

00:28:41.520 | what are the metrics that we can realistically expect

00:28:44.520 | would be improved by doing conversions?

00:28:48.120 | And to back up just a step,

00:28:50.120 | one thing that I have found

00:28:51.420 | in doing retirement tax planning for a lot of people

00:28:54.320 | is that a tax-efficient spending plan

00:28:57.320 | usually improves financial security in retirement,

00:29:02.120 | and what I mean by that is that it improves two metrics.

00:29:04.020 | Number one, makes it less likely

00:29:06.020 | you're gonna run out of money during your lifetime.

00:29:08.620 | Number two is that it makes it so that

00:29:11.420 | in the unlucky scenarios,

00:29:12.820 | like if we're doing Monte Carlo simulations,

00:29:15.120 | in the unlucky scenarios where you still do run out of money,

00:29:18.320 | at least it happens later in life.

00:29:20.020 | So that's still an improvement at least.

00:29:22.620 | And so when you improve both of those two things together,

00:29:26.020 | in my head I just think of that as,

00:29:27.420 | okay, you're now safer, more financially secure.

00:29:31.420 | Now one thing that honestly surprised me

00:29:33.720 | when I started digging into this

00:29:35.820 | is from modeling Roth conversions

00:29:39.320 | for a lot of clients in a very, very broad range

00:29:44.020 | of financial circumstances

00:29:45.520 | and using a bunch of different assumptions

00:29:47.120 | for all of the various inputs,

00:29:49.520 | is that Roth conversions don't usually have those effects.

00:29:53.020 | They don't usually improve financial security in retirement.

00:29:56.520 | And I know that surprises a lot of people,

00:29:58.520 | and in fact you're probably thinking,

00:29:59.520 | well, why the heck not?

00:30:00.820 | Because we just spent all that time

00:30:03.120 | talking about the three effects of a conversion

00:30:04.920 | and how they can be helpful.

00:30:06.620 | So how can that be true and this can also be true?

00:30:09.720 | It's not very intuitive.

00:30:12.020 | And the way I've come to think of it is,

00:30:14.120 | if you think about the problems that Roth conversions solve,

00:30:18.420 | number one is RMDs, right?

00:30:21.120 | They make your RMDs smaller

00:30:22.320 | and that has various beneficial effects.

00:30:24.720 | And number two is the tax drag

00:30:26.320 | that occurs in taxable accounts.

00:30:27.520 | Basically the two things

00:30:28.620 | I've spent the last half hour talking about.

00:30:31.620 | Those are the problems Roth conversions solve.

00:30:34.620 | But if we make a list,

00:30:36.420 | what are the things that are likely

00:30:37.720 | to cause portfolio depletion in retirement?

00:30:40.720 | Those two things aren't on that list, right?

00:30:43.120 | RMDs, they don't cause people to run out of money.

00:30:45.920 | If you haven't run into that math yet,

00:30:48.320 | they just don't.

00:30:49.720 | In fact, RMDs are often recommended

00:30:52.020 | as a retirement spending strategy

00:30:54.020 | with the idea being look up

00:30:55.120 | whatever the RMD percentage would be

00:30:56.720 | for somebody your age

00:30:57.920 | and then spend that percent of your whole portfolio.

00:31:01.420 | And they're recommended as a spending strategy

00:31:03.820 | precisely because they're so unlikely

00:31:06.720 | to cause portfolio depletion.

00:31:10.220 | And that second factor there,

00:31:11.820 | the tax drag that occurs in a taxable account.

00:31:15.220 | If you think about how an unlucky retirement scenario

00:31:19.020 | is likely to look,

00:31:21.120 | that problem solves itself most of the time

00:31:25.720 | because as we'll get to in just a minute,

00:31:28.220 | the first dollars that you usually spend in retirement

00:31:31.020 | are the taxable account dollars.

00:31:33.520 | And so if we're thinking about

00:31:34.520 | an unlucky retirement scenario

00:31:36.120 | where the portfolio is getting depleted

00:31:37.620 | and you're spending it down rapidly,

00:31:39.620 | that's the first thing that gets spent down.

00:31:42.120 | And remember, the tax drag is a small percentage.

00:31:47.120 | It's only a big deal

00:31:48.120 | when we're compounding that small percentage

00:31:49.820 | over 30, 40 years of having a taxable account.

00:31:53.820 | If you're talking about

00:31:54.720 | maybe a half percentage point of cost

00:31:57.220 | on an account that's only a part of your portfolio

00:32:00.520 | and that account is going to disappear

00:32:04.020 | within the first maybe four or five or six years,

00:32:06.820 | half a percent on a part of the portfolio

00:32:08.920 | for a handful of years

00:32:10.820 | wasn't really the big thing that caused the depletion, right?

00:32:14.220 | So the tax drag in taxable accounts,

00:32:16.320 | it doesn't cause portfolio depletion.

00:32:18.420 | And so Roth conversions are solving problems.

00:32:21.120 | They're just not the things

00:32:22.220 | that cause people to run out of money.

00:32:24.620 | Now, if we think,

00:32:25.820 | what are the things that cause people to run out of money?

00:32:29.220 | The first one that comes to mind for me

00:32:30.620 | is sequence of returns risk.

00:32:32.020 | And I know many of you have heard that term.

00:32:33.420 | The idea is if you get bad investment returns

00:32:36.620 | in your early retirement years,

00:32:38.920 | you can have this situation where the portfolio,

00:32:41.420 | if it's just getting smashed in the stock market, right,

00:32:43.420 | and you're spending from it at the same time,

00:32:45.620 | it can end up getting severely depleted really quickly.

00:32:48.920 | And so even if you get good returns going forward from there,

00:32:52.320 | it might not save the day.

00:32:54.320 | And then the second thing that comes to mind for me

00:32:56.720 | is the term spending shocks.

00:32:58.520 | This is a term that came from the late Dirk Cotton.

00:33:00.820 | He was one of my favorite retirement writers.

00:33:02.920 | If you ever get a chance, look him up.

00:33:04.820 | And the idea of a spending shock

00:33:07.320 | is it is an unexpected but unavoidable big expense

00:33:13.220 | or a series of expenses.

00:33:14.320 | So it could be a healthcare cost

00:33:15.520 | that wasn't covered by insurance

00:33:17.420 | or major house repairs or whatever it is.

00:33:20.820 | And the reason those are so problematic

00:33:22.820 | is exactly the same reason

00:33:24.720 | as sequence of returns risk, actually.

00:33:26.720 | If that happens early in retirement,

00:33:28.720 | you get hit with this big expense

00:33:30.120 | that you hadn't planned on and you can't avoid it,

00:33:33.320 | it can result in the portfolio getting depleted

00:33:36.020 | too severely, too rapidly.

00:33:37.620 | And then even if you get good returns after that,

00:33:40.420 | it might not save the day.

00:33:42.620 | So those, in my head,

00:33:44.420 | those are the two things that are the biggest problems,

00:33:47.020 | the biggest risks,

00:33:48.920 | things that are likely to cause portfolio depletion.

00:33:50.920 | But if we think of both of those things

00:33:52.920 | and think about Roth conversions,

00:33:55.320 | Roth conversions don't solve those.

00:33:57.120 | They don't make sequence of returns risk go away.

00:34:00.420 | They don't make unavoidable healthcare expenses go away.

00:34:04.120 | That's just not what Roth conversions do.

00:34:06.120 | So they're helpful, but they're just not helpful in this way.

00:34:09.820 | And so that might lead somebody to ask,

00:34:12.420 | "Why would I bother with a Roth conversion

00:34:14.020 | if it's not improving my financial security?

00:34:16.120 | What can I hope to get out of it?"

00:34:19.420 | And the answer is that in a case of a smart conversion plan,

00:34:22.220 | and I specify smart conversion plan

00:34:23.920 | because this is something

00:34:25.220 | that we need to be putting thought into, right?

00:34:27.320 | We don't just want to start willy-nilly Roth conversions

00:34:30.020 | because in most years for most people,

00:34:32.520 | conversions aren't a good idea.

00:34:33.920 | It's just in the years where they are a good idea,

00:34:36.820 | the things that we can typically hope to see from it

00:34:39.720 | is that it's going to be increasing,

00:34:42.220 | improving the after-tax bequest

00:34:45.020 | that is likely to be left to heirs.

00:34:47.620 | And they do that without changing financial security

00:34:50.420 | in either direction.

00:34:51.720 | So one way to think of that would be conversions

00:34:54.120 | don't make the bad scenarios any better,

00:34:57.620 | but they also don't make them worse in a smart conversion plan.

00:35:02.220 | But they do make the medium-to-good scenarios better.

00:35:06.220 | That's typically what we can hope to get out of conversions.

00:35:11.120 | And moving on to our last topic, topic number three,

00:35:14.020 | of how does a Roth conversion plan

00:35:15.920 | fit into a broader overall retirement tax plan?

00:35:19.320 | We're going to move through this a little more quickly.

00:35:22.220 | And the question here is,

00:35:24.320 | which dollars do we want to spend every year?

00:35:26.520 | We can spend tax-deferred, Roth,

00:35:28.220 | or taxable dollars in every year of retirement.

00:35:31.320 | And the plan that we want to follow --

00:35:33.020 | and again, this is the very brief summary --

00:35:34.720 | is that every year the first dollars we want to spend

00:35:38.320 | are the checking account dollars.

00:35:40.620 | So what I mean by that is everything in the checking account

00:35:43.320 | and all the stuff that automatically shows up

00:35:45.020 | in the checking account.

00:35:46.220 | So earned income while you still have it,

00:35:48.720 | Social Security once that kicks in,

00:35:50.720 | RMDs, pension or annuity income

00:35:53.120 | if you have either of those, all those things.

00:35:55.720 | After that, we go to the savings accounts next.

00:35:58.720 | And then after that, we go to the taxable brokerage accounts,

00:36:01.620 | specifically the investments in those accounts

00:36:04.220 | where you would not have to pay any tax costs

00:36:06.320 | from selling them.

00:36:07.420 | So things that have unrealized losses and money market funds

00:36:11.320 | where your basis is equal to the market value,

00:36:13.220 | so you can just spend it.

00:36:15.020 | That's the first stuff we want to spend every year.

00:36:17.720 | And it's actually only when we've already spent

00:36:20.420 | all of those dollars and then still need to spend more,

00:36:23.420 | that's when we have to start making some hard decisions,

00:36:25.620 | making judgment calls where we weigh the pros

00:36:27.220 | and cons of our options.

00:36:29.120 | And in most cases, the first dollars to go after next

00:36:34.120 | are actually just the other dollars in a taxable account.

00:36:37.620 | In other words, the investments in a taxable account

00:36:39.420 | where you would have to pay tax if you sold them.

00:36:42.420 | And the exception there is if you expect

00:36:45.520 | that you would be donating or bequeathing those assets soon.

00:36:48.920 | In that case, you want to leave them alone.

00:36:50.720 | And the example I always give here is

00:36:52.920 | imagine a 98-year-old retiree.

00:36:55.620 | And let's say she's the only person in her household.

00:36:59.020 | No matter how old we get,

00:37:01.020 | we obviously don't know how many years we have left.

00:37:04.020 | But at age 98, probably fair to say that her heirs

00:37:07.220 | will be inheriting these dollars roughly soonish, right?

00:37:10.720 | Like, we don't know exactly what that means, but soonish.

00:37:13.520 | And so let's say she has a mutual fund in a taxable account

00:37:18.020 | and she bought this mutual fund like 30 or 40 years ago.

00:37:21.020 | And so it has a cost basis that's way down here

00:37:23.520 | and market value way up here.

00:37:25.420 | Well, for her, if she sold that,

00:37:27.720 | she'd have to pay a capital gains tax.

00:37:29.820 | And so what probably makes sense for her

00:37:32.320 | is to leave that appreciated taxable asset alone,

00:37:37.120 | spend from her retirement accounts,

00:37:39.520 | and then when her heirs do inherit these dollars,

00:37:41.720 | which, again, is likely to be not the terribly distant future,

00:37:45.220 | they'll get a step up in cost basis.

00:37:47.420 | And so that appreciated taxable asset,

00:37:50.120 | no one had to pay tax on all of that appreciation.

00:37:53.120 | But then if you flip the example around,

00:37:54.920 | now think about a couple who are early in retirement,

00:37:58.120 | age 60 and 62 or something like that.

00:38:00.820 | Statistically, they have a lot of years of retirement

00:38:02.920 | ahead of them, right?

00:38:04.220 | So for them, if they have a mutual fund

00:38:08.520 | in a taxable account that has a basis way down here

00:38:11.420 | and market value way up here,

00:38:13.620 | for them it probably does actually make sense

00:38:16.220 | to just bite the bullet and sell that

00:38:17.920 | when they need it for spending

00:38:18.920 | in order to preserve their retirement accounts.

00:38:21.420 | Because for them, the step up in cost basis

00:38:24.820 | is probably not coming anytime soon to save the day.

00:38:27.320 | So for them, we're probably selling that taxable asset first

00:38:31.520 | and preserving the retirement accounts.

00:38:33.020 | So again, just a brief summary there is the younger you are,

00:38:35.920 | the more likely it is to make sense

00:38:37.820 | to go after the appreciated taxable assets

00:38:40.020 | to preserve the retirement accounts.

00:38:42.120 | And the older you are, the more likely it is to make sense

00:38:44.720 | to spend from their retirement accounts

00:38:47.120 | to preserve the appreciated taxable assets

00:38:49.620 | for the step up in cost basis.

00:38:51.820 | Now, whenever we do have to spend from retirement accounts,

00:38:55.020 | whether we're spending from tax deferred or from Roth

00:38:58.020 | is actually just the same question

00:38:59.320 | that we're always talking about with Roth conversions.

00:39:01.020 | It's current marginal tax rate, future marginal tax rate,

00:39:05.220 | how do they compare?

00:39:06.720 | And whenever your current tax rate is the lower of the two,

00:39:10.120 | then we want to spend from tax deferred, right?

00:39:11.820 | Take advantage of the low tax rate.

00:39:13.820 | And whenever your current tax rate is the higher of the two,

00:39:16.420 | then we spend from Roth.

00:39:18.520 | Now, as you can see, this last point here,

00:39:21.120 | what we're actually getting at

00:39:23.020 | is how does a Roth conversion plan fit into this?

00:39:27.320 | And the idea here is that when you're following a plan

00:39:29.620 | like this, most likely in the early years of retirement,

00:39:35.520 | you're going to be spending those taxable assets.

00:39:38.220 | And so you won't be spending or maybe not spending very much

00:39:42.320 | from the tax deferred accounts.

00:39:44.420 | And so what that's going to mean is that, right,

00:39:46.720 | you've retired, so your income has gone down.

00:39:49.320 | We're not spending from tax deferred yet.

00:39:50.920 | Social Security probably hasn't started yet.

00:39:53.020 | So you've got some years with low taxable income

00:39:56.320 | and low tax rate space available to you.

00:39:59.420 | And so what we're going to do is fill up

00:40:01.620 | that low tax rate space with Roth conversions.

00:40:04.620 | These two ideas, they fit hand in hand.

00:40:06.120 | It's the tax-smart spending plan

00:40:08.220 | that creates the space for the Roth conversions.

00:40:11.820 | They fit together.

00:40:13.120 | It's one broad, integrated retirement tax plan.

00:40:17.420 | And that's it.

00:40:18.420 | So, yeah, we have about 10 minutes for questions.

00:40:21.120 | All right, when can it be worth it

00:40:39.720 | to donate appreciated taxable assets

00:40:42.020 | to a donor-advised fund to reduce your tax bracket

00:40:45.920 | to enable more traditional IRA, 401(k) conversions to Roth?

00:40:50.120 | OK, so that's an interesting question.

00:40:53.920 | And I wouldn't-- that's a very interesting question.

00:41:00.520 | And there's a lot going on here.

00:41:01.920 | So donating appreciated taxable assets,

00:41:07.620 | that is usually the second best way

00:41:13.120 | to donate once you've reached age 70 and 1/2.

00:41:17.120 | Once you've reached 70 and 1/2, that's

00:41:18.620 | when QCDs, Qualified Charitable Distributions, kick in.

00:41:21.520 | Most of the time, QCDs are our best way

00:41:23.520 | to be donating once you're eligible for them.

00:41:25.920 | But before 70 and 1/2, your best way

00:41:28.020 | to be doing charitable giving is by donating

00:41:31.020 | appreciated taxable assets.

00:41:32.220 | And the reason that's such a good idea

00:41:34.020 | is that you get an itemized deduction

00:41:37.920 | for the current market value.

00:41:40.220 | And you don't have to pay tax on that appreciation,

00:41:43.120 | as long as you owned the investment

00:41:44.320 | for longer than one year.

00:41:45.320 | So don't forget that bit.

00:41:46.720 | But I wouldn't necessarily say that we

00:41:51.720 | want to be donating just to reduce the tax bracket

00:41:58.320 | so that you can be doing Roth conversions.

00:42:00.620 | Because in my mind, if you've got

00:42:03.620 | significant charitable intent--

00:42:05.720 | we want to be doing some donating--

00:42:08.120 | that itself is a strong point against the Roth conversions.

00:42:13.120 | Because we can be listing the charity

00:42:15.120 | as the beneficiary of the IRA to begin with,

00:42:18.320 | or just waiting a little bit and then using QCDs.

00:42:21.920 | So donating appreciated taxable assets makes a lot of sense.

00:42:27.420 | But I wouldn't think that that's a great motivation

00:42:29.620 | to be doing it.

00:42:30.320 | Because if you have a lot of charitable intent,

00:42:32.820 | we probably don't necessarily want

00:42:34.520 | to be doing conversions anyway.

00:42:35.820 | If you max out your employer 401(k) contributions in pre-tax,

00:42:45.920 | can you still execute a backdoor Roth IRA contribution?

00:42:50.720 | Yeah, potentially.

00:42:52.920 | So the big hang up there doesn't have anything--

00:42:55.320 | so backdoor Roth IRA.

00:42:56.820 | That is when you earn too much to contribute

00:42:59.220 | to a Roth IRA in the normal way.

00:43:01.620 | So you make a non-deductible traditional IRA contribution,

00:43:06.020 | and then do an immediate conversion.

00:43:09.120 | The big caveat, the thing you need to look out for,

00:43:11.220 | is if you have other money in a traditional IRA--

00:43:15.620 | and it doesn't even have to be this traditional IRA.

00:43:17.820 | The IRS considers them all to be one IRA for this purpose.

00:43:20.420 | So even if you've got some other traditional IRA,

00:43:22.620 | some other brokerage firm, that's still a problem.

00:43:25.520 | Basically, in order to be doing backdoor Roth,

00:43:27.520 | we need to make sure that the only money in traditional IRAs

00:43:32.820 | for you-- we don't count your spouse, but for you--

00:43:35.320 | is this non-deductible contribution

00:43:37.520 | that you just made.

00:43:38.320 | That's what we're looking to do.

00:43:39.620 | So a lot of times, if you have traditional IRA money--

00:43:42.220 | and in this case, we have a 401(k) also, so that's our out--

00:43:45.520 | what we're going to do is take the traditional IRA that

00:43:48.220 | exists and has tax-deferred dollars,

00:43:50.520 | roll it into the 401(k).

00:43:52.720 | So now we don't have any traditional IRA anymore,

00:43:55.420 | and that frees us up to be doing non-deductible IRA

00:43:58.420 | contributions and then immediately converting them.

00:44:00.620 | If I have more money in my traditional IRA

00:44:05.620 | than my Roth IRA, do you advocate

00:44:07.720 | chunking a portion from traditional to Roth

00:44:10.320 | over a period of several years?

00:44:11.720 | So it's not necessarily a function

00:44:17.120 | of exactly how big this account is

00:44:20.120 | relative to another account.

00:44:23.120 | That's not usually the number one thing we're looking at.

00:44:26.220 | But because, again, we're usually

00:44:27.620 | looking at exactly the stuff we talked about--

00:44:29.520 | current tax rate, future tax rate.

00:44:30.920 | And so how big the traditional IRA is certainly

00:44:34.720 | plays into that future tax rate.

00:44:36.920 | But we're not necessarily looking to get--

00:44:40.220 | we're not trying to say, you should

00:44:41.720 | have 50/50 tax-deferred and Roth.

00:44:43.420 | There's not a tax-deferred Roth allocation that is the best.

00:44:49.320 | But with conversions in general, yes,

00:44:52.520 | chunking them is usually a good idea.

00:44:54.320 | We don't, in most cases, want to just go whole ham

00:44:56.620 | and hit the whole IRA in one year.

00:44:58.420 | Most of the time we're spreading it out over several years

00:45:00.920 | so that we can do it at lower tax rates over time.

00:45:05.220 | Let's see.

00:45:05.720 | How do you decide the amount to convert in a specific year,

00:45:12.720 | for example, up to amount when next tax bracket kicks in?

00:45:15.520 | Yeah, exactly.

00:45:16.120 | So in any given year when you're doing a conversion,

00:45:19.020 | we're picking an income threshold.

00:45:20.520 | And then we're going to try to stay

00:45:22.020 | right below that threshold.

00:45:23.620 | So often, it will be we're going to the top of this tax bracket.

00:45:27.920 | Or it could be right below an IRMA threshold.

00:45:30.920 | Or it could be right below the phase-out for some tax credit

00:45:33.620 | or whatever.

00:45:35.620 | And there isn't a rule of thumb, because there

00:45:38.820 | isn't the sort of thing where you can--

00:45:41.920 | I use software for this.

00:45:43.720 | Trying to manually do it out in a spreadsheet

00:45:45.520 | is going to be bordering on impossible.

00:45:48.520 | [AUDIO OUT]

00:45:51.520 | Turn this mic?

00:46:01.820 | Yeah, all right.

00:46:02.520 | So there isn't--

00:46:05.120 | I'm just going to keep saying this.

00:46:06.620 | There aren't rules of thumb for a lot of this.

00:46:08.520 | So we are usually going to be picking

00:46:10.920 | some particular threshold.

00:46:12.320 | And usually that's-- a part of that

00:46:14.620 | is we're looking at the current tax rate, future tax rate idea,

00:46:17.820 | trying to get some ballpark of that future tax rate.

00:46:21.120 | But sometimes, whatever we might very roughly ballpark

00:46:24.520 | that future tax rate at, it still

00:46:26.720 | often makes sense to do conversions

00:46:29.720 | slightly beyond that point.

00:46:31.920 | Again, if we're using taxable account money

00:46:34.120 | to pay the tax and all that stuff.

00:46:35.820 | Because that's what we're getting at here,

00:46:37.620 | is that there's other benefits to conversions other than just

00:46:40.320 | reducing that future tax rate.

00:46:42.520 | There was another piece of this question.

00:46:45.320 | Oh, one other point, by the way, is

00:46:46.820 | that sometimes it's nice, if you can,

00:46:49.320 | to pick a threshold that is not a Medicare IRMA threshold.

00:46:53.720 | Because if we're picking a tax bracket threshold

00:46:56.620 | and you end up, oops, I went $1,000 over,

00:46:59.920 | not that big of a deal.

00:47:00.920 | It means $1,000 got taxed at a couple higher percent.

00:47:03.620 | Not-- who cares?

00:47:04.620 | But accidentally going $1 over an IRMA threshold

00:47:07.720 | really is not ideal.

00:47:09.220 | So IRMA thresholds are less forgiving.

00:47:11.120 | So that in itself is a reason to pick a different threshold.

00:47:15.820 | Because then if you mess up by a little bit,

00:47:17.620 | which does happen, because when we're doing the conversion,

00:47:20.420 | we're not usually doing it December 31st.

00:47:22.220 | We're usually doing it at some point

00:47:23.520 | somewhat earlier in the year.

00:47:24.920 | So we don't know exactly, precisely, all of the inputs.

00:47:28.820 | So it can be hard to nail it exactly.

00:47:30.520 | So picking tax brackets rather than IRMA brackets

00:47:33.720 | often makes sense just because it's more forgiving.

00:47:44.920 | If it makes sense to do a conversion from IRA to Roth,

00:47:47.720 | is the goal to reduce the IRA to zero

00:47:50.220 | or to some other value target?

00:47:52.920 | No.

00:47:53.920 | There is no rule of thumb.

00:47:55.920 | Sorry.

00:47:58.220 | Sometimes we want to be reducing the IRA to zero.

00:48:02.520 | That's almost exclusively in cases

00:48:05.120 | where there is a big taxable account.

00:48:08.020 | Because if we're reducing the IRA to zero,

00:48:10.020 | we're getting to the point where we're probably

00:48:12.020 | making that future tax rate pretty darn low.

00:48:15.120 | And the only reason that we would

00:48:17.220 | have kept converting all the way to that point,

00:48:19.220 | probably paying taxes at a higher rate

00:48:21.020 | than whatever we're anticipating that future tax rate to be,

00:48:23.820 | the only reason we would be doing

00:48:25.220 | that is because we're just trying

00:48:26.820 | to get maximum value out of these taxable account dollars

00:48:29.520 | by just using them to pay this tax.

00:48:31.020 | So some cases, yep, it makes sense

00:48:33.620 | to go all the way to zero.

00:48:34.720 | But that would specifically be if we're really

00:48:36.620 | trying to maximize that, get the value out

00:48:38.520 | of the taxable account sort of thing.

00:48:40.320 | Most of the time, we're not going

00:48:42.020 | to be converting the IRAs all the way to zero.

00:48:44.520 | We're usually going to be picking

00:48:45.920 | some particular threshold, hitting

00:48:47.820 | that threshold every year.

00:48:49.320 | And then often what ends up happening is Social Security

00:48:51.520 | kicks in, and then RMDs kick in shortly thereafter.

00:48:53.820 | And there's just no more space for conversions at that point.

00:48:56.620 | So that's typically how it goes.

00:48:59.220 | Should you do the conversion all in one year or over time?

00:49:01.620 | Generally over time.

00:49:02.520 | Again, it usually makes sense to break it up

00:49:04.520 | to keep your taxable income relatively lower

00:49:06.920 | than doing one big chunk and paying a huge tax

00:49:09.220 | bite all at once.

00:49:10.020 | If you do a conversion on January 1,

00:49:14.820 | when do you have to pay the tax?

00:49:16.620 | So if you have taxes withheld, the advantage of that

00:49:22.920 | is that whenever you do the conversion, any withholding,

00:49:26.820 | just as a rule, whether it's withholding from wages

00:49:28.920 | or withholding from a conversion or anything,

00:49:30.720 | withholding is always treated as having been paid on time.

00:49:33.920 | Whereas if you're paying taxes separately,

00:49:37.420 | making estimated tax payments, there

00:49:39.220 | are specific deadlines for that.

00:49:41.020 | So if you choose to have taxes withheld,

00:49:45.520 | no matter when you do the conversion, you're good.

00:49:49.220 | But again, we don't usually want to have taxes withheld.

00:49:51.720 | Because that means we're using the IRA money.

00:49:53.620 | And most of the time, we want to be using, if we have it,

00:49:56.520 | taxable account money to pay the tax.

00:49:58.420 | And so in that case, we're going to be making an estimated tax

00:50:01.120 | payment.

00:50:01.820 | And estimated tax payments, there's

00:50:03.920 | four over the course of the year.

00:50:05.320 | But they're not quarterly.

00:50:06.520 | They don't happen every three months.

00:50:07.920 | If you think it's every three months,

00:50:08.920 | you're going to get one of them late.

00:50:10.420 | So you just make estimated tax payments on time,

00:50:14.420 | is basically how it works.

00:50:15.520 | Just look up the regular rules for estimated tax payments.

00:50:17.520 | And it looks like we've got 20 seconds left.

00:50:19.620 | Let's see what this is.

00:50:20.520 | Oof, that's not a 20 second one.

00:50:24.820 | [LAUGHTER]

00:50:28.320 | Oh, OK.

00:50:28.820 | I'm 62 with a number of dormant old 401(k)s kicking around

00:50:31.720 | from past employers.

00:50:33.020 | Convert or no?

00:50:35.120 | Well, so likely, it makes sense to be moving those,

00:50:39.920 | just for simplicity's sake, all into one account,

00:50:42.420 | whether that's into an IRA or into your current 401(k).

00:50:47.120 | That's usually what makes sense.

00:50:48.420 | That's separate from the conversion idea.

00:50:52.020 | This factor, having a whole bunch of different 401(k)s,

00:50:54.920 | not really a factor in the Roth conversion analysis, right?

00:50:57.420 | All the things we talked about--

00:50:58.720 | current tax rate, future tax rate--

00:51:00.520 | they're based on dollar amounts rather than number of accounts.

00:51:04.220 | So all the same stuff we said, it's the same,

00:51:07.320 | even if you have a bunch of old 401(k)s.

00:51:09.020 | But if you do have a bunch of old 401(k)s,

00:51:10.520 | it's probably time to do something about that.

00:51:12.420 | So I think that's it, right?

00:51:14.920 | We're over time by a minute and a half now.

00:51:17.920 | you

00:51:19.980 | you

Bogleheads® Conference 2024 Roth Conversion Deep Dive with Mike Piper

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