Hello everybody, it's Sam from Financial Samurai, and in this episode, I want to talk about the Roth IRA conversion and why doing one is probably a waste of time and money for most of us. Now, if the House Ways and Means Committee has its way, there's a chance, a good chance, doing a Roth IRA conversion will be no more in 22 and beyond.

And frankly, I'm pretty agnostic to ending our ability to convert our traditional IRAs to Roth IRAs. I've really had this kind of weird love-hate relationship with Roth IRAs since I started Financial Samurai in 2009 because I couldn't contribute to a Roth IRA about the second year after I started work.

And so therefore, I felt kind of salty thinking, "Well, why do other people get to contribute to a Roth IRA and I can't?" And it's the same thing with traditional IRAs. Once you make above a certain amount for a traditional IRA, you just can't contribute. So I really forgot about contributing to a traditional and to a Roth IRA for a long time.

But I slowly changed my mind and my way of thinking once I became a father in 2017 because I think about my kid's future and I think about how much more expensive things will be 10, 20, 30 years from now, right? Housing, food prices, tuition, healthcare, cars, everything. Everything is going to be much more expensive.

So we need to continuously invest so we can beat inflation or at least keep up with inflation. Therefore, I put my kids to work, doing menial tasks, making a little bit of money. But thanks to the standard deduction, they don't have to pay taxes on their income. And given our forward thinking, I'm getting them to invest in their custodial Roth IRAs.

So they get to contribute to a Roth IRA tax-free, which is very different from the way normal people contribute to a Roth IRA. It's with after-tax money and then it gets to grow and compound tax-free and it's tax-free when you pull it out. But for kids who are earning less than the standard deduction, which is $12,550, or not just kids, anybody, it's a good idea to contribute to a Roth IRA because it's tax-free in, tax-free growth and tax-free out.

It's a win-win-win. But I didn't realize all the benefits and this way of thinking because in 1998, when a Roth IRA was first introduced as a savings and retirement vehicle, I was a junior in college. I was a junior in college looking for a job and the last thing on my mind was trying to save for retirement because I didn't have much money.

I just needed to find a job. But now we know. Ah, so right now there's like no excuse not to contribute to a Roth IRA if you're in a very low income tax bracket. But what if you are in a moderate to higher income tax bracket? So once you make over $76,000 or more, you can't contribute to a traditional IRA.

And once you make more than $140,000, you can't contribute to a Roth IRA either. So what is a person to do? Should you really do a Roth IRA conversion and pay taxes up front? I think the answer is probably not unless you are in the 0% tax bracket, 10%, 12%, 24%.

And after that, I just think it's a wash or you're going to be losing money. And here's why. First of all, tax rates are unlikely to go up for the middle class because the politicians we have depend on the middle class for votes and to stay in power. Now the median household income is about $69,000 and a common definition of middle class is plus or minus 50% on the median.

So we can talk about a middle class income going up to about $105,000 nationwide. However, half the population lives on the more expensive coasts. For example, for a family of four in San Francisco, you can be considered low income if you have a $117,000 income or less. Therefore, you can argue that a middle class income for a household of four or five can go up to about $300,000.

And that might sound like a lot to some folks who live in low cost of living areas. But the reality is the nation is not even in terms of cost of living. And I think it's very consistent because President Biden has said he would not raise taxes on anybody making less than $400,000.

So $400,000 for an individual he clarified and $450,000 for a couple, which doesn't make sense because 400,000 plus 400,000 equals 800,000 and not 450,000. But this is a very traditional way of thinking the government has where one spouse or partner stays at home. The traditional IRA and Roth IRA are retirement vehicles for the middle class.

And if middle class tax rates aren't going up, then it doesn't really matter if you do a traditional or you convert to a Roth IRA because the math dictates so. Let's say you're 40 years old and make $65,000 a year, you're a single person. This income level puts you in the 22% marginal federal income tax bracket.

If you invest $6,000 in a traditional IRA, and it grows at 8% a year for 20 years, you'll end up with $27,965. And when you withdraw the money, you decide to withdraw all of it and pay the same 22% marginal federal income tax. Therefore, you end up with $21,813.

Now let's say on the other hand, you contribute to a Roth IRA, you have to pay 22% tax on that 6,000 upfront, leaving you with $4,680. If it grows at the same 8% a year for 20 years at age 60, you can withdraw tax free $21,813. In other words, the results are the same.

So if the math is the same, because the tax rates are the same, input output the same, then it really doesn't matter. So in that regard, you're wasting time trying to do a Roth IRA conversion. The other really important point is that your income will likely be lower in retirement than while working.

This makes logical sense. In retirement, you're not working, you're relaxing, you're living off your savings and investments and Social Security and maybe a pension. Generally, that is much less than your highest income earning years or your average income earning years. Therefore, if you're making less in retirement, which most of us do, since we're not working, we're probably going to be in a lower marginal income tax rate.

Further, your Social Security income actually isn't fully taxed. Did you know that? I didn't really know that until recently. The portion of your Social Security benefits subject to taxation varies with income levels. So you'll be taxed on up to 50% of your benefits if your income is $25,000 to $34,000 for an individual or $32,000 to $44,000 for a married couple.

You'll be taxed up to 85% of your benefits if your income is more than $34,000 for an individual or $44,000 per couple. So in other words, not 100% of your Social Security benefits will ever be taxed. Pretty good. Now let's say you are a top 1% or you're going to end up being a top 1%.

Now Roth IRAs are more valuable for those in the top 1% net worths or top 1% incomes in retirement because it could be used for tax planning for those dealing with a larger estate because their heirs can draw the money tax free. So let's say you're a lucky individual working 100 hours a week.

You never see your kids, don't see your friends, gain a lot of weight, but you're making $700,000 a year. You're living large, right? You're in the top 1% and you're concerned about paying 39.6% marginal federal income tax rate in retirement versus what you're paying now, which is 37%. So you decide to do a Roth IRA conversion and you pay 37% rate upfront.

That's crazy. That is crazy. But you do it anyway, even though you were only in the 22% marginal income tax bracket years ago when you were contributing to your traditional IRA. So therefore you're locking in a 15% loss with the potential for only saving 2.6% in federal income taxes in the future.

Does that make sense? I don't think that makes sense, but you're really, really bullish on your future. So what happens 20 years from now? 20 years from now, you amass a fortune of let's say $15 million. And out of the 15 million, 5 million is in a Roth IRA conversion.

5 million is in your after tax brokerage accounts because you need that passive income. 3 million is in your primary residence and 2 million is in rental properties. So okay, you're in the top 1% net worth, which currently has a cutoff of about $10 million at the minimum. So it's already hard enough to generate a top 1% income.

It's another thing to consistently save and invest 50% of your after tax earnings for that long. Most people don't. We've all heard plenty of stories of people making a lot of money, way more than $700,000 a year and ending up broke. So these are two unlikely things that are going to happen, right?

Huge income, huge savings. But regardless, you did it. You are just the man or the woman with the financial plan and everything is going fantastically well. So in those 20 years, you were actually living off "only" $200,000 a year, right? Because after taxes and saving 50% of your after tax income, you only got about $250,000 left out of your $700,000.

So let's say you're in retirement, life is short, so you decide to bump up your target spend from $200,000 a year to $300,000 a year. I don't think it's feasible to comfortably spend that much more money, 50% more money when you're used to spending a certain amount for two decades.

But let's just continuously be conservative with this example. Now after withdrawing 2.4% from your $5 million Roth IRA conversion, you get your total income up to about $336,000. That's pretty good. But the marginal federal income tax rate at $336,000 is 35%, which is still lower than your 39.6% when you did the Roth IRA conversion.

So once again, you lose. Now obviously tax rates could be higher, but we just made an argument that up to about $300,000, inflation adjusted, politicians aren't going to raise taxes on people making that much because that is considered middle class for some people in the country. You would probably have to start withdrawing closer to 4% from your Roth IRA or $200,000 to add on to the passive income your dividend stocks and your rental properties are generating to get to $400,000 plus to potentially pay more in taxes and retirement than while you're working, potentially.

Now again, to have all that, to generate all that income, you need to have a net worth of about $15 million and we know that less than 1% of people have a net worth of more than $10 million. So to get to $15 million, it's definitely less than 1%.

Getting to $15 million is unlikely to happen for more than 99% of the population. Inflation adjusted again. So let's please be realistic with your expectations. If you're doing a Roth IRA conversion because you believe you're going to pay higher taxes in retirement than while working, it's illogical. It's unlikely.

It could happen. It could happen. You could certainly win the lottery, invest in some massive multi-bagger that goes public. It could happen. It happens all the time with less than 1% of the population, but you've just got to be realistic with the numbers. For a quick calculation, take whatever you're making right now and divide it by 3% and 4%.

The result is your likely liquid net worth target necessary to be able to generate a similar level of income in retirement. If you have a similar level of income in retirement, your tax bill likely won't increase. So instead, divide your current income by 2% to get to a liquid net worth target that may cause for your tax rate to increase in retirement.

The other thing with doing a Roth IRA conversion is this. Once you do it, it's like surrendering to the government. Sure, you'll get the tax-free benefits upon withdrawal, but even that is not a certainty. The government could always pass new legislation, right? And all of us have the ability to adjust our income and therefore our tax rates in retirement.

We could move to more tax-efficient states. We could rebalance our portfolios to non-dividend paying investments. We could donate more of our wealth to charity while living, gift more of our wealth to our children and other individuals. We can invest in non-income producing investments like venture capital, start a business with lots of deductions, and we can withdraw at different rates.

There's no rule that says once you hit age 59 and a half and over, you have to withdraw 100% from your 401(k), Roth IRA, traditional IRA, and so forth. You can keep that there. You can just dribble it out if you want and you can play with the numbers based on your needs and desires.

So I think more of us should keep that call option, keep that flexibility. Now in terms of the best time to do a Roth IRA conversion, I got to thinking about my own scenario. For me, that year was 2013. It was my lowest income earning year because the first full year I didn't have a job.

I stopped receiving a steady paycheck in June 2012. Unfortunately or fortunately, even as an unemployed person, I was still in the 28% marginal federal income tax bracket, which is $87,000 to $183,000 for individuals because tax rates were higher back then. Further, I was earning passive income, some online income, and had deferred investment income as part of my severance package coming in for the next four years.

So the last thing I want to do as an unemployed person who just saw over 60, 70% of his income go away is to pay six figures in taxes to do a Roth IRA conversion. Therefore I decided to just roll over my 401(k) into a traditional IRA and just keep what I had.

You'll probably feel the same way in terms of desiring to hold on to as much wealth as possible if you ever lose your job. Or it's not as easy as you think once you're in a very low income tax bracket after being in a high income tax bracket or a higher income tax bracket for many, many years.

So the best time to do a Roth IRA conversion is when you are unemployed with little to no other income sources. At a 0%, 10%, or 12% marginal income tax bracket, it's probably a no-brainer to do a Roth IRA conversion. But even paying 10% to 12% of your traditional IRA in taxes is going to hurt.

So I'm not sure you'll want to do it even though it's probably the right move. So in conclusion, I say if you are currently in the 24% tax bracket or lower, you have a positive probability that doing a Roth IRA conversion will save you taxes in the long run.

If you are in the 32%, 35%, 37%, and future 39.6% tax rate, I would say don't bother. If you can contribute to a Roth IRA when you're coming up, you know, you're in college, first years of work, go do it. Diversify your retirement income streams. But after you've surpassed those income limits, I would just stick to your 401(k) traditional IRA and just save aggressively in your after-tax investment accounts.

And at the end of the day, if you end up paying more in taxes than you could have in retirement, then just feel grateful you did so well because paying more taxes means that you ended up making more money. So thanks so much everyone for listening. And if you are vehemently against what I just said, and if you strongly believe that a Roth IRA conversion makes sense, I'd love to hear from you.

I want to hear both sides of the story because this is real life and this is real money and we have a deadline potentially of 2022. And if you enjoyed this podcast, I'd love a positive review. I read all the comments and I appreciate them so much. Cheers.