Hello everybody, it's Sam from Financial Samurai. In this episode, I want to talk about the Roth IRA, the tax now Roth IRA, because the tax cuts that were passed due to the Tax Cut and Jobs Act of 2017 will expire on December 31st, 2025. If Congress does nothing, which nothing is what they tend to do, taxes will revert to their pre-2018 levels on January 1st, 2026.

This means tax rates will go up anywhere between 1% to 5%. And therefore, the logical conclusion and solution is to try and convert some of your tax deferred retirement money in your 401ks and traditional IRAs into a tax now Roth IRA. This way, you can potentially save on taxes during your retirement years.

So I think it's important to talk about this subject now because we have slightly less than three years to convert our tax deferred funds to tax now funds in a Roth IRA. And sometimes or oftentimes you don't want to convert too much because it might bring you to a higher tax rate.

So three years is a good amount of time to plan ahead. The question is, how much of your tax deferred retirement funds should you move? And at what marginal income tax bracket should you contribute or convert to a Roth IRA to minimize future retirement tax liability? Before I answer these questions, let me share my historical thoughts on the Roth IRA.

I've long been an opponent of the Roth IRA since I haven't been able to contribute since I turned 25 in 2002. The arbitrary income limits to be able to contribute shut me out, so I decided to reject the Roth IRA as well. So I was completely biased for over a decade.

Right now in 2023, you can contribute to a Roth IRA, which is 6500 max. If your income is under 153,000 as an individual single filer, or under 228,000 as a married filing jointly, you can contribute the maximum 6500 if you make under $138,000 as a single individual and under $218,000 as a married filing jointly.

There is basically a prorated amount you can contribute less and less as you get to the 153,000 and over for singles and 228,000 and over for married filing jointly. Now these income levels in 2023 seem pretty reasonable, but at the same time, it's also rather arbitrary. Why not double the amounts?

Shouldn't all American taxpaying citizens get to fund and take care of their retirement future? I think so. In addition, I was an opponent of doing a Roth IRA conversion. It just wasn't appealing to me after I left my day job in 2012, my overall income declined by 80% as a result.

And the last thing I wanted to do was pay more taxes when I had way less income. Instead, I just wanted to hold on to as much cash as possible because I was facing an uncertain future. Was this the right idea at 34 years old? Didn't feel right, but I had the severance package and I had some passive income.

And I also had hope that I could grow Financial Samurai and do other things to make supplemental retirement income. However, now that I'm 45 years old and I have two young children, I now believe contributing to a Roth IRA is a good way to tax efficiently diversify your retirement income sources.

Roth IRA withdrawals don't face required minimum distributions. Further Roth IRAs do not count as provisional income and therefore don't cause any of your social security to be taxed. Just know that for required minimum distributions on December 29th, 2022, President Biden signed into law the Consolidated Appropriation Act of 2023.

That includes the Secure Act 2.0, which basically increases RMD age to 73 in 2023 and to 75 in 2033. So this is good if you don't need the money because it enables you to pay less retirement taxes, but you've got to live that long. But if you die before the RMD and you never spend your retirement funds, well, then it goes to your heirs.

But that also shows that maybe you didn't properly consumption spend throughout your life and you spend too much time working and investing and stressing about the money. Those are just some things to think about as you plan for retirement. To decide on paying taxes upfront by contributing or converting assets into a tax now Roth IRA, we should make three assumptions.

One, Congress will let taxes return to previous levels on January 1st, 2026. Two, tax rates may go even higher than pre-2017 levels due to an even larger budget deficit. We've got to pay for all this pandemic spending, stimulus spending. Three, you believe your tax rates in retirement will be higher than your tax rates while working.

This is the most important variable. Do you believe you're going to pay more taxes when you're not working or more taxes when you're working? Now I know it's human nature to think we are smarter, better looking, more charismatic, charming than we really are. But the reality is we probably hover around the average plus or minus one standard deviation.

That's just what it is. Therefore, I just don't think the vast majority of Americans will be paying a higher tax rate in retirement than while working because most Americans won't be making more money in retirement than while working. If you do a gut check, this makes sense. It makes a lot of sense.

You're working, so you're making more money. What kind of person makes more money in retirement? Well, maybe a really lucky person who got a huge windfall or maybe someone who invested amazingly well, or we just have super high inflation, high risk-free rates, high dividend yields, high returns in retirement, and we're just crushing it.

But is that going to be reality? I just don't think so. Just look at what the median retirement balance is in America. It's about $100,000, right? And the median Social Security payment is around $22,000 to $24,000. So even if you withdraw $10,000 a year from your median retirement balance of $100,000, your total income, if you add on Social Security, is around $32,000 to $34,000.

And that falls within the 12% marginal federal income tax rate, which is low. And if you're making that money, do you think the government is really going to go after you? I don't think so. Politicians crave power more than anything else. So if politicians raise taxes on the middle class, they will lose the most number of votes.

And if you lose the most number of votes, you're not going to stay in power for very long. It's the same thing with Social Security. Cost of living adjustment went up huge, 8.6% in 2023. This was an opportunity to actually lower the COLA. And it's been an opportunity every single year since we realized the Social Security pension fund is underfunded by 22 to 25%.

But politicians aren't willing to raise that retirement age or reduce the Social Security benefits during retirement, because that would mean political suicide. They will not get reelected. Even President Biden, who is a Democrat, who is for bigger government, has said he will not raise taxes on any person or any household making less than $400,000 a year.

$400,000 a year is a top, I would say 3% income, because top 1% income is over $500,000 a year now. So he's unwilling to raise taxes on the top 3% income earners. Maybe it's top 2%. So what makes you think if you make $250,000, $200,000, $150,000, $100,000, or $50,000, you're going to pay more taxes in the future?

I don't think you will. Yes, we are at the historical lows of tax rates. We are. If you look since 1950, we haven't been lower. The problem is, once you give goodies, right, once you start giving people what they want, they are loathe to give up what they have.

And once politicians have power, they are loathe to give up that power as well. So we are actually in cahoots with the politicians. We want lower tax rates and the politicians want power. So the majority is going to vote to keep tax rates probably the same. So we need to figure out at what marginal federal income tax rate is it worth converting to a Roth IRA or contributing.

And my answer is this. At a 24% rate, it's a wash, break even. As a single individual, that means you're making between $95,376 to $182,100. For married filing jointly, that means you're making between $190,751 to $364,200. So in other words, if you start converting at a 24% marginal federal income tax rate to a Roth IRA, when you retire, I think it's going to be a wash.

These income levels are the protected class. They're protected because this is mass affluent class, including middle class for some people who live in more expensive countries. And politicians don't want to raise your taxes. So this leaves us with the 22%, 12%, and 10% marginal federal income tax rates. At these rates, I think you can convert.

You'll probably end up okay. Even if you don't end up okay, the most you'll probably pay more in taxes is maybe 1% or 2%. So let's just do some quick math on the 24% marginal federal income tax profile, where it's a wash. So let's say you're an individual making the bottom of the range of the 24% marginal income tax bracket, $95,736.

As a worker, you're paying that 24% marginal income tax rate on $1. But to generate that same amount of income in retirement would require amassing about $2.4 million at a 4% rate of return. Now remember, the median retirement balance is only $100,000. So we're talking about you accumulating 24 times the medium.

It's possible, but again, we got to be a little bit realistic. Even with $25,000 a year in Social Security, which is, you know, today's dollars probably what you would earn if you were making that kind of income for 35 years. You'd still need about $1.9 million in retirement to generate $70,736 a year at a 4% rate of return.

I got $70,736 by subtracting $25,000 a year in Social Security by that income of $95,736. $1.9 million is a lot of money for someone who's been averaging $96,000 for 35 years. But it's doable. I just don't think the majority of people who make that kind of money will accumulate that much in retirement.

Just look at the data. Therefore, most retirees making that $96,000 level will likely earn less. And if they earn less, they will likely pay a lower marginal federal income tax rate. Maybe 12%, maybe 10%. Because here's another thing, the standard deduction, the standard deduction is used whether you're 25 and making money or 70 making Social Security money.

In 2023, the standard deduction for an individual is $13,850. And their standard deduction for married couples filing jointly is $27,700. In 20 years, at a 3% annual increase, the single taxpayer standard deduction will rise to $25,000. And the married couple standard deduction will rise to $50,000. So in other words, you could make $25,000 a year in Social Security as an individual and pay zero taxes because of your standard deduction.

So my argument is that not only will you likely be making less money in retirement, you also have standard deduction you can take to lower your income even further, which lowers your retirement taxable income even further. We've already agreed the government isn't going to crush the middle class taxpayer who's paying a 10, 12, or 24% marginal income tax rate by jacking tax rates higher.

The government is going to go for the top income earners, the top 1%, maybe the top 0.1% for sure, right? The deca millionaires, the centa millionaires and the billionaires. So wouldn't that mean they should start converting more of their tax deferred funds into a rough IRA? I don't think so.

Okay, so look, 37% is the top marginal income tax rate for individuals making over $578,125 in 2023. That's a top 1% income for sure, because the threshold is about $500,000. Now if I look at what tax rates were, what they were pre the Tax Cut and Jobs Act passage, at over $500,000, the marginal income tax rate was 39.6%.

So it was 2.6% higher. Okay, that's relatively significant. And if you can make over, let's say $578,000 a year in retirement, well, yes, you'll be paying more than 2.6% in taxes. But in order to make $578,000 a year or more in retirement, you need to have capital of at least $14.4 million at a 4% rate of return.

Now how many people have that? Well, less than 1% because the top 1% net worth figure is about $12 million right now in 2023. Might be less since 2022 was a bear market. So if you are a top 1% income earning person, you appreciate the lower tax rates now.

But are you really going to be enthused about paying 37% upfront to convert your tax deferred money to a Roth IRA? I don't think so. I think instead what you'll do is you'll keep hope alive that tax rates won't go up or won't go up as much. Or what you might do is move to a lower income tax state when you retire because the optimal time to do a Roth IRA conversion is after you retire or in a lower tax bracket, but before claiming Social Security benefits, right?

So if you retire at 50, 55, 60, 61, and then you drop to the lowest marginal income tax bracket, yeah, start converting. That makes a lot of sense. I just think that if you're making that kind of money, there are too many ways for you to shelter your taxable income and your assets from the government.

You can set up a graft, you can set up revocable trusts, irrevocable trusts, and so forth. You can move to different states, you can move out of the country, you can renounce your citizenship. There's just all these different things you can do. So to pay taxes upfront when the government is so spendy and so inefficient with our dollars feels like giving up a war, frankly, because we all have the responsibility to minimize our tax liability in the most legal way possible.

And paying that much upfront, ooh, that just seems too painful to me. So in conclusion, I count on politicians to keep tax rates low because I count on politicians to want to remain in power. I assign only a 20% probability that tax rates are going up in 2026 and beyond for sub $250,000 income earners.

For those households making over $400,000, perhaps the probability is over 60%. But who knows who's going to win the presidency and who knows how the makeup of Congress will be. If you find yourself ever in the 10% or 12% marginal income tax bracket, I think you should convert as much as possible to a Roth IRA.

Definitely contribute as much as you can afford. If you find yourself in the 0% marginal income tax bracket because your earned income is below the standard deduction amount, then definitely try to max out your Roth IRA contributions. And in this situation, it's mostly probably because you're a student or you're just underemployed.

But it's hard, right? Because you're not making that much money. And then to ask to put away more money for your future. It's a little tough. But that's where we parents who understand the Roth IRA and care about taxes can come in and help our young children or adult children plan for their future.

I wished I was able to contribute to a Roth IRA when I was growing up, but it only just began when I was growing up. And so many of us didn't know much about it. And then by the time I turned 25, well, I couldn't contribute anymore. And so I just forgot about it.

But I don't forget about it now because I have two kids. And I find it actually really exciting and somewhat of a challenge to try to grow their Roth IRA portfolio large enough so that by the time they graduate high school or college, they can hit the ground running and not feel so constrained by life's many inflationary expenses.

A diversification of retirement income sources is a good one. Whether we pay taxes now or in the end, it's simply unavoidable. We just have to decide what we think future tax rates will be. And just like inflation. Yeah, it's a 40 plus year downward trend. We've had a couple years of anomaly spikes, right?

2022 and 2023. But I think that trend is going to go back down. So we could have several years of anomaly spikes of higher taxes, but then the people are going to get angry and they're going to vote the politicians out. And then we're going to revert back to the long term trend since the 1950s of lower tax rates for longer.

That's my opinion. I'd love to hear yours. If you want to run some smart scenarios about when to do a Roth IRA conversion for your retirement, check out new retirement at financialsamurai.com/nr. I spoke to the founder, Steve Chen, and he said one of the most popular tools they have is the Roth Conversion Explorer.

It enables you to test out your Roth IRA conversion plan under various tax and wealth scenarios. This is what we all want. So I do recommend you sign up and check it out. Then you can get a better idea of exactly what your tax liability will be in the future.

Thanks so much everyone for listening. I'm not a tax professional, but I'm a tax enthusiast who studies tax law every single year because it's our largest ongoing liability that we cannot escape. So if you enjoy this podcast, others will too. Please share it with a friend or a loved one.

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There are a lot of things that I don't think about that you share based on your experience. And many of these insights are so wonderful. You know, we're talking about retirement planning in your mid sixties and seventies, and I'm only 45. So I don't know what I don't know.

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