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That's FijiAirways.com. From here to happy. Flying direct with Fiji Airways. Had a question come up to me last week that I thought would be fun for me to tackle as the topic of today's show because it brings together a little bit of technical financial planning with some discussion of various scenarios and gives me a chance with a real world example to talk through a few strategies that I want you to be aware of.

Listener asks this, "I want to make sure that I'm not losing my mind. I know somebody who is 72 years old who has a traditional IRA who is thinking of converting some of that IRA to a Roth IRA. They call their advisor at Merrill Lynch today and he told them they would only pay taxes on the contributions and that the gains would roll over into a Roth IRA tax free.

This seems to me to be incorrect advice. Everything rolled over to the Roth, contributions and gains would be taxable as income. Any rollover amount would have to be above and beyond the required minimum distributions and then obviously any new gains would come out tax free. Is that right? I think this guy was a certified financial planner." So the scenario here to make it a little bit simpler is that you have a 72 year old person with a traditional IRA who is trying to figure out what are the rules of converting some to a Roth IRA.

Now let's start with why somebody would want or not want to do such a conversion. When you have a traditional IRA and that IRA could be accumulated either from a rollover from some sort of qualified pension plan such as a 401k or a 403b plan or it could simply have been accumulated over time with systematic yearly contributions.

But when you have a traditional IRA, one of the things that happens is about the age of 70 you start to have what are called required minimum distributions. Remember how the money gets into an IRA in the first place. The money gets in before taxes are paid. The US federal government wants to have taxes paid and so you have a choice.

You can either pay them now or pay them later. But you've got to pay them. Just remember, the government's going to get paid, pay now or pay later. Well a traditional IRA concept allows you to pay your taxes later. When you earn a dollar, you don't pay income taxes on that earning.

You just slide it right into the IRA and then it can accumulate over time and the tax is deferred until you take it out. Of course, the government wants to make sure they get their tax money and so they allow you to keep the money in there until about the age of 70 and at the age of about 70 then they say, "Okay, you've got to start taking money out of the account whether you need it or not." Many people are quite anxious to tap the funds in their retirement accounts but there are also many retirees who don't really need the money.

There could be various reasons for this. Frequently, perhaps a retiree has their house paid off and so their outlay of cash is lower, especially in those early years of retirement when medical expenses are also lower. Or perhaps their social security benefit ended up being higher than they thought or they may have other supplementary forms of pension income and they don't actually need the money from the traditional IRA.

And so this type of moderately wealthy to fairly wealthy retiree often finds it a little bit annoying to have to start adding extra income to their tax return every year. And at the age of about 70, then they have to start taking those distributions. Now there are a few ways to take those distributions out but the way that you should just think about required minimum distributions is simply there is a table that goes based upon the life expectancy and a percentage of somebody's life expectancy, a percentage of the years that they have remaining, however many years that is, that's what characterizes how the money comes out.

So some small percentage of the money is going to come out each and every year. And that's when the taxes are going to be picked up. So that's how a traditional IRA works. Now in this case, this particular person is thinking about converting money into a Roth IRA. So why would somebody want to have a Roth IRA?

Well, the major benefit, there are a few major benefits of a Roth IRA. First let me explain how it works and I'll talk about the benefit of a Roth IRA, specifically focused on retirement. Remember the government's going to get paid now or get paid later. In a Roth IRA, what you do is you pay the government their taxes first so that you don't have to pay them later.

So during your working years, you earn a dollar and you pay your tax rate on that dollar when you earn it. Let's say you paid 20 cents out of your dollar in taxes and you contribute 80 cents into the Roth IRA. The benefit of that, of course, is as that money grows, there are no year by year taxes.

And as long as you take that money out after the age of about 60 years old, then you can take it out tax free and all of the money comes out tax free. Now notice for a moment that there's not really any difference in taxes. You might think that a Roth IRA actually allows you to pay less money in taxes than a traditional IRA.

But if your tax bracket is the same during your working years as it is during your retirement years, that's not actually the case. You're going to pay the same amount in dollars or the same amount in percentage in taxes whether you put the money in a traditional IRA or a Roth IRA.

Frequently, people think that a Roth is better because of that reason. It's not true. Again, for the sake of let's do a little bit of math, if you put the money in and you deposit 80 cents and then you fast forward say 30, 40 years over the investing timeline and then you calculate how much money you get out after taxes whether you paid them up front or in the back end, as long as you're in the same tax bracket, you'll pay the same amount in taxes, which is why when you're choosing between a traditional IRA and a Roth IRA, the number one factor you want to consider is usually, well, when am I going to pay money in a lower tax bracket?

Is it likely that I'm going to be in a higher tax bracket at retirement because my income is going to be higher or lower? And then choose accordingly. However, that's not the whole story. One of the benefits of a Roth IRA is there are no required minimum distributions during the lifetime of the account holder.

So you can reach the age of 70 or 71 or 72 or 80 or 90 and you can continue to keep those assets in the Roth IRA. You don't have to force them out of the Roth IRA into the world of taxes. For somebody who has other forms of income, this can be a very valuable benefit, especially if they have substantial amounts of money in the Roth IRA.

The longer you can defer taxes, the better. And this can be a really powerful tax planning tool, which is why it's reasonable for people to consider converting some of their traditional IRA assets into Roth IRA assets. And it's wise to do that before you have required minimum distributions because you can keep the money in the IRA longer, which allows it to grow more and to ultimately be worth more.

The longer you can keep the grubby little hands of the government goons who collect the taxes off of your money, the more you'll have. Just like with fees, the fewer fees you can have on money, all things else being equal, you'll have more money. And so tax efficiency is very important, very important when it comes to financial planning.

Now back to the original question. This particular client thought that they had been told by their financial planner that they could convert the money from a traditional IRA into a Roth IRA and that they would only pay taxes on the contributions of the account, that the gains would just roll over into the Roth IRA tax free.

Now of course that is erroneous. Now my guess is not that the CFP probably gave this particular person the right advice, but the individual client of the CFP probably just misheard and misunderstood. It's certainly possible that financial planners give bad advice. I've given my share of wrong advice. The rules and regulations change.

Things are very complex. It's hard to keep it all straight. Sometimes you just don't keep your head. It just doesn't work. So I've given my share of wrong advice and I think many of us would admit that we've done that. But more frequently it's that somebody who's not a professional hears what they think they hear and the professional said the right words but it didn't really connect with the meaning.

So let's talk about how a conversion would work before age 72 and after age 72. Now pretend that you are say 40 years old. So we don't have any dates. We're not worried about the 59.5 numbers. We're not worried about that 70.5 number or that about 60 and about 70.

We've just got these – you're a 40-year-old person and we're trying to figure out whether you should convert some of your money over. Now because you've put money into a traditional IRA, let's say you have $100,000 in your account, you have the option now with no income limits to convert any amount of it from traditional assets to Roth assets.

And when you do that conversion, basically what it means is you pick up some income. Now that example would be if you were going to convert $50,000 from your traditional IRA to your Roth IRA, you could move it over in the accounting with the brokerage firm that you have it and then your tax return this year would have an additional $50,000 of income on it that you would pay taxes on.

Why would somebody do it versus why would they not do that? Big reason to do it is to be able to move the asset into the Roth and to get some of the benefits of the Roth, the longer-term growth, the fewer – no required minimum distributions, which has some options in a moment that I'll talk about.

The big disadvantage of course is that you're going to go ahead and pay taxes. And so this would only be intelligent for you to do if you felt that your paying taxes today was on a lower amount of income than paying taxes in the future. You're paying at a lower rate.

So you want to be very careful in when you do this because it's silly to pay more money in taxes just to put the money into a Roth. However, this is a way that many people can use to get large amounts of money into a Roth. See, the rules for contributing to a Roth IRA have everything to do with how much money you're earning and high-income earners aren't able to contribute.

As I record this in 2017, the rule is that if you are single or head of household or married filing separately and you're earning more than $118,000 as your modified adjusted gross income, then you cannot contribute – you can't – excuse me, $133,000. See, what I talked about with making mistakes.

If your income is over $133,000 in 2017, you can't contribute to a Roth IRA. If you are married filing jointly and your household income, your modified adjusted gross income is over $196,000, then you can't contribute to a Roth IRA. So if your income is, either whether you're single or married, over $200,000, you can't contribute to a Roth IRA.

But you might like to have money in those Roth amounts. Well, because of the ability to do a conversion, you can take money from your 401(k) or an IRA or traditional IRA, any kind of – you can take money from an IRA, which – the source of which could have been a 401(k) or a 403(b) or it could have just been accumulated little by little over time, and you can convert that into a Roth.

And so if you have a high household income in excess of, say, $200,000, this would be the way that you would get money into a Roth IRA, which can be very helpful for the reasons that I described. Now, you have to pay taxes on the full amount. You don't get to just roll the contributions in and have the gains flow in without taxes.

No, you pay taxes on the full amount. So if you're converting $50,000 of a $100,000 account over, then you're going to pay taxes on the full $50,000. But the question is this, what happens if you are 72 years old and now you're subject to required minimum distributions? Well, if the IRA is requiring you to do required minimum distributions, the answer is it depends.

Assume for a moment that our 72-year-old is earning income. Well, in this case, it's fairly simple. Why is this important? Because in order for you to contribute to a Roth IRA, you have to be earning wages. You have to be earning wages. The amount of the wages matters, depending on your filing status, single versus married, but you have to be earning wages.

So if our 72-year-old retiree still has some wages, maybe they're working part-time somewhere or they have a business out of which they take some wages. Notice I'm saying wages, not profits. There's a distinction. Wages. If they're earning some wages from somewhere, then they could contribute to a Roth IRA.

Here's how that would work. Example. If somebody is earning income, they have the opportunity to make contributions to the retirement accounts depending on their age. Generally, if somebody is under the age of 50, then that number is limited at $5,500 in 2017 for their annual contribution to a retirement account.

If they're older than 50, they have a special $1,000 catch-up contribution. So our 72-year-old could contribute $6,500 into a retirement account or specifically into a Roth retirement account. After the age of 70 and a half, you can no longer make any regular contributions to a traditional IRA. So you can't make regular contributions to a traditional IRA after the age of 70 and a half, but you can still contribute to a Roth IRA.

So the simplest scenario for our retiree, our 72-year-old retiree, is if they have some wages to just simply go ahead and make a contribution to the Roth IRA. Assume for a moment that our 72-year-old is married, filing jointly, and our 72-year-old has at least $13,000 of wages. Well, in this case, they could make a $6,500 contribution to Roth IRA for the husband and $6,500 contribution for Roth IRA to the wife, totaling $13,000.

If their required minimum distributions from the traditional IRA were $13,000, then this would work very, very well. They had a $13,000 required minimum distribution from the traditional IRA. That means they're going to receive $13,000 of income from the traditional IRA. They're going to record that $13,000 of income on their tax return and pay taxes on it, but then they're going to make a separate $13,000 contribution to a Roth IRA, and now they're funding the Roth IRA.

Now, why would they want to do that? We'll talk in a moment that the most powerful reason is so that they can start to build a stretch IRA. But for right now, recognize that this allows them to buy more tax deferral on these Roth IRA contributions. And this can be helpful because they can put the money in at 72 and 73 and continue putting in, and they never have to take the money out of the Roth IRA.

The trick here is that they have to have wages, and if they don't have wages, then they can't make that contribution to the Roth IRA. In order to contribute money to a Roth IRA, you have to have wages and then fit in under the earning amounts. Now what I found out in the discussion over this question was that this particular retiree that had our questions here, this particular retiree doesn't have any wages, and so that messes up this plan.

Basically what it means is there's not going to be a tax-efficient way for them to move the money from a traditional IRA into a Roth IRA. They can't make contributions to a Roth IRA if they don't have an appropriate level of wages, and that's the problem here. Now what could they do in order to get the money into a Roth IRA?

Well they can't do anything with their required minimum distributions. They have to take the required minimum distributions out and pay the tax on them now. They could convert money from a traditional IRA into a Roth IRA, but that's now going to be a separate calculation from the required minimum distributions.

They would have to go ahead and pay the tax on the required minimum distributions and then separately make a conversion of the traditional IRA assets into the Roth IRA assets and pay the tax on that. And now we start to pick up a significant amount of tax. Is that in their best interest to do?

Well it's hard to say. Probably not from a tax perspective. Probably not. And the reason would be because you're picking up the income, and the whole goal is we're trying to keep the money in the account for tax efficiency, but now you're picking up more income quickly and you're just paying a whole bunch of tax now instead of stretching the tax efficiency out for the future.

So there's not really any easy solution or tax efficient way for them to get the money into a Roth IRA. Now you would have to sit down and think about your plans. And let me talk about the inheritance of the IRAs here and what's so powerful about having an IRA as an asset.

IRA assets and Roth IRA assets are wonderful assets to have into old age, into retirement, and at death. They're really wonderful assets to own. Some of the benefits of Roth IRAs and traditional IRAs is they're very protected money from the claims of creditors, which is very valuable. They are assets that you can own excellent investments in.

They're very inexpensive to own. You can hold an IRA just about anywhere without – it's a lot cheaper than say managing a trust that's going to hold assets. So they're very, very inexpensive. And these assets are nonprobate assets. So they're assets that you can adjust the beneficiaries of in a very easy and flexible way.

You don't have to go and update your will when you want to change the beneficiary of the asset. You can just simply change it at the website. If you have a million dollars in an IRA or $100,000 in an IRA and you want to leave it to the grandkids, just tell the grandkids, "Listen, I change the IRA beneficiary every single day." Right online, I change the beneficiary.

So whoever calls me the most and whoever I like the most, that's who I put that day or some version of that joke. The point is it's very simple and easy for you to change the beneficiary of the IRA asset. You don't have to go and file new paperwork with an attorney and update your will, get it notarized and signed.

You just sign a few papers. So an IRA is a very flexible asset. So is a Roth IRA, same thing, very flexible assets. They have beneficiary designations. One of the benefits though of an IRA and a Roth IRA is they can be inherited by people and your, what do they call it, inheritees, the person that inherits the account has the ability to also continue with some of the tax benefits.

And this is what we call colloquially a stretch IRA. Now there's no such thing legally as a so-called stretch IRA. What a stretch IRA is, it's just a word that we use to describe the rule of or describe the practice of trying to defer contributions, sorry, trying to defer distributions from the account to a future time so that we can continue to maintain the tax efficiency.

So let's say that I am an 80-year-old person and I have a 40-year-old child. Well my 40-year-old child, if I leave them as the beneficiary of my IRA, they can take that, they can receive that IRA and of course they can take the money out right away. But let's say it's a traditional IRA.

Well in that case they're going to take the money out and they're going to pay the taxes. If it's a Roth IRA, they're going to take the money out and the money's going to come to them income tax free. That's very valuable. But what if they don't need the money?

Well under the IRS rules, they can take the money out over a much longer schedule. There are required minimum distributions for somebody who inherits an IRA account. If my 40-year-old child inherits my IRA, they're going to be required to take distributions from that account, whether it's a Roth IRA or whether it's a traditional IRA.

And they're going to be required to take it out whether they need it or not. The government doesn't allow the assets to stay in the IRA into perpetuity. But they can take it out using a chart, a calculation chart that goes over their life expectancy. They use what the IRS calls their single life expectancy table, which means that if somebody is very young, they possibly have many years at which they can keep the money in the account and only take out small amounts.

This allows an IRA or a Roth IRA to accumulate over time more and more and more while still staying free of taxes. Really valuable. The challenge of course is winding up at death with assets in the account. And this is where a Roth IRA really shines. Remember that at the age of 70 and a half, about 70, you're going to be taking distributions from a traditional IRA every year of your life.

Now if you die early, great, you get to leave behind a big IRA. But if you die late, you're going to have taken a lot of money out of the account whether you need it or not. Not so with a Roth IRA. With that Roth IRA, you can keep the money in there.

And in fact, if you have wages, as long as you have wages, you can continue making contributions to the account. So if you're working into your old age, like I recommend at 70 and 75 and 80 and 85 and 90 and 95, and you're still working and earning wages as you probably should be and probably will want to be, in that situation you can still fund that Roth IRA and you never have to take the money out.

You die at age 100, you can leave that behind to your spouse or you can leave that behind to your children. Or you could leave it behind to your grandchildren. Now you just imagine for a moment, if you had a nice, fat Roth IRA at retirement age, and whether you could contribute or not, you just left it alone and it continued growing for 30 years from 60 to 90 or from 65 to 95 or 70 to 100.

Let me give you an idea of the numbers that would be involved. Let's say that you had a $500,000 – that would be a lot. Let's say we had a $100,000 Roth IRA at the age of 60. So let's put this in. Hold on, clear the register. This as our present value starting at the age of 60.

Okay, you got 35 years from 60 to 95. Life expectancies are going up, you're a healthy person, rich people live longer. You got 35 years. Let's say that you keep that money invested in equities and you are able to earn a 9% investment return and you don't put any more money into it.

After 35 years, your $100,000 IRA – there must be a problem. Hold on. That can't be right. $100,000, present value. 35 years, 9% rate of return, no payments. Future value after 35 years, $2 million. $2 million in that Roth IRA. Is that right? Can that be right? Make sure I don't mess everything up when I'm doing live math.

Let's see here. $2 million. I've got to check myself. I have to work it backwards and make sure I didn't mess anything up. 35 years, annualized interest. Yeah, I'm right. $100,000 at the age of 60 invested for 35 years at 9% interest equals $2 million in a Roth IRA at the age of 100.

I just felt really high and I don't think I'm making a dumb error somewhere. Talk about a dumb error, I'll tell on myself. I gave a recent speech and at that recent speech, I was talking about percentages. I did the math and I forgot to change my final decimals to percentages in my presentation.

I put the numbers in and I said that 0.24% of an audience does such and such or 0.57% does such and such. Then I went back and afterwards, somebody said, "Didn't you mean you forgot to multiply by 100?" I had completely messed up my numbers in my presentation. It's recorded on video, very embarrassing.

We all make math mistakes. Just imagine this Roth IRA that's left alone and this Roth IRA grows over time. You leave that as an asset to your grandchild. Let me give you an idea here of how much money that could be. If you die and leave your $2 million at your death, you leave your $2 million Roth IRA asset to your 20-year-old grandchild, your 20-year-old grandchild would have to start taking out required minimum distributions.

But it's not all that much. If we did the math real quick on the single life expectancy for a beneficiary who's 20 years old, their life expectancy would be 63 years. The way it would work is they would take the $2 million balance of the account and you would divide that in by 63 and you would get your required minimum distribution in the first year is $31,746.

Your grandchild would receive that money income tax-free. Remember it's a Roth IRA asset and so that money would come to them income tax-free. You put $100,000 into the account, you left it alone, it was never taxed, you leave it, your grandchild starts to receive that money income tax-free. Then they would have basically 63 years over the course of their life expectancy during which they could take distributions.

Now there would be a bit of a scale here that I can't do for you live to show you exactly how much of an amount this would be just based upon required minimum distributions. But let's just talk about what it would be, how much your annual payments would be if we were going to take level payments and deplete the account over time.

So let's say that our 20-year-old, our goal is to take payments out over 63 years of their life expectancy which takes them to 83. So we've got a $2 million, clear the register, $2 million starting balance. So that's our present value. Our starting balance for them is $2 million.

We've got a 63-year time horizon in which we're going to take distributions. We're going to keep it at that 9% investment interest rate or that investment return, 9% investment return. We're assuming you keep the money well invested at equities and we're able to earn 9% net of fees. We don't have to worry about taxes here, net of fees.

And our closing value, our future value is going to be zero on this account. What would be the payments out of this account? Well, in that situation, if we were able to earn that amount of income, hold on, that cannot be right. Man, I double-checked it again and it works.

Man, I just double-checked it again. I get so scared when I say these numbers because they sound unbelievable and yet they are technically accurate under the assumptions that I said. Old grandchild taking money out over 63 years, if they just took out a level payment over 63 years, starting with $2 million, earning 9% annually on the money, that would be an annual flow into their pocket of $180,793.

$180,793. I checked it three times. That's the power of assets sheltered from tax. Now, go ahead and get your financial calculator and you run any scenario that you want. But when you're talking about a very, very simple and powerful way to leave money behind for heirs, Roth IRA is a wonderful way to do that.

And remember those required minimum distributions, they're adjusted based upon the value of the account at the end of the year, which means that when the account value goes down, then they naturally wind up taking less. When the account value goes up, they take out more. And that money's coming in tax-free.

So just imagine yourself. You at 60 years old accumulate $100,000 in a Roth IRA. You leave it alone for 35 years until you die. And then your grandchild inherits it and takes it out over the course of a little over 60 years. If that money can be intelligently invested, we're talking huge amounts of money received income tax-free.

Now, is this a perfect solution for all scenarios? No, of course not. One of the disadvantages, for example, with just doing this in a simple Roth IRA is you have no control over the money. You can't force your 20-year-old grandchild to not take all the money out in the first year and go and buy a bunch of fun stuff.

You can't force them to—you can't exert control over it. You would have to write a trust and leave this as an asset of the trust, which has its own benefits and disadvantages in it. But this is simple. This is easy. And it continues to get huge benefits for your grandchild.

For example, one of the things that people would want—that people want with their children and their grandchildren, they want asset protection. Roth IRA, basically ironclad, governed by state law, but basically most states have put in place protections for it, protections from the claim of creditors. Now, the big concern is what about in the case of divorce?

Well, an IRA asset that is received as a gift from a grandfather, whether you're in a community property state or a non-community property state, is generally considered to be individual property. It's not generally considered to be a marital asset. It's protected. So there are tremendous benefits to this, and it's simple.

You can open a Roth IRA with just about anybody. So I hope these ideas give you an idea of how valuable a Roth IRA is. Of course, you're subject to potential danger of changing tax laws. Can the IRS and can the U.S. federal government change their tax laws? Absolutely.

Will they? Absolutely. What will they change it to? Who knows? I don't know. But it's a powerful, powerful, simple tool. Now back to the original question. Unfortunately, for this retiree, they can't really efficiently get the money from their traditional IRA into a Roth IRA because they don't have wages.

They don't have wages. They can't do a Roth. Yes, they could convert it, and that's worth considering for the reasons that I described. But they should acknowledge the fact that it's not necessarily tax-efficient to do that. It may be useful, but it's not necessarily tax-efficient. What I would do if I woke up or if I were giving advice to this particular 72-year-old person, I wouldn't recommend that they convert the money necessarily.

What I would probably do is I would have them just take those required minimum distributions, and if they're going to go for the kids or for the grandkids, just write checks to the kids or the grandkids, or figure out a way to make sure the kids and the grandkids get income, have their own wages, and then go ahead and make a Roth IRA contribution for them.

If this 72-year-old has a 10-year-old grandchild, and if that 10-year-old grandchild can earn $5,000 of wages, the grandparent here can make a gift to the grandchild of $5,000, and the grandchild can make a $5,000 contribution to their Roth IRA while also having $5,000 that they can spend. Because they earned $5,000 and they received $5,000 from the grandparent, $5,000 of that total of 10 is in the Roth IRA, and then $5,000 is spendable income.

That would be very powerful. Now, the grandchild, if they can leave it alone, can also have the money grow over time. It can grow tax-protected for a very long period of time, but also the grandchild has the benefit, and I believe it's a benefit, of being able to withdraw the money, because of course with a Roth IRA, you can always withdraw your contribution to the account without penalty.

If they contributed $5,000 to the account, and the account has grown in value from $5,000 to $5,500, they can always make that $5,000 withdrawal from the account. So as long as the grandchild, as long as somebody can earn wages, we have opportunities. Hope you enjoy thinking those scenarios through.

IRAs and Roth IRAs are powerful tools. They're really, really powerful. They're very, very useful in the hands of a competent financial planner, aka you. I want you to use these tools and look at them and think about how they can be used to their maximum advantage. And this particular benefit of a traditional IRA and a Roth IRA, to be able to take the money out over an extended period of time, and thus protect the money from taxes, is valuable.

Remember, you have this benefit in both traditional IRAs and Roth IRAs, as the tax law currently stands. The recent tax proposal had some proposed changes, but to my knowledge, as things go at the moment, those proposals to change the stretch IRA rules are not included in the current debates over tax law changes.

But they both have those benefits. It's just a lot harder to arrive at death with a nice fat IRA than it is with a nice fat Roth IRA. I hope this is useful for you. If it's not useful for you, talk with your parents. Talk with a friend. Try to help someone else with these ideas.

These ideas are available to the common man. You don't have to go and spend thousands of dollars on fancy documents. You do have to sit down and look at your situation and understand it. And that's your job and my job, to sit down and look at our situations and look at other people's situations and try to help people to do smart stuff with their money.

If we can do that, my hope is we'll keep a lot more of it. This show is part of the Radical Life Media network of podcasts and resources. Find out more at RadicalLifeMedia.com. Hey, Cricut customers. Max with ads is included with your Cricut $60 unlimited plan at no additional cost.

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