Transcript:
Easan Arulanantham:
So I’m getting close to retirement. I’m interested in thinking about Roth conversion for my 401k. How does it work?
Tom Vaughan:
Okay, so Roth IRA conversions, one of my favorite subjects, one of the subjects that does come up again, a lot in our strategy sessions with clients, my guess mainly because we’ve probably been talking about a lot. And we really try to help people understand the ramifications of what’s going on with their retirement plan. So 401k, KS, and IRAs, 403, B’s 457 plans, all of these things that are out there that are set up to be these retirement plans are getting bigger and bigger. People are investing in the stock market stock markets, and well used to be pensions. Now pensions have disappeared, and we ended up with this money that you put in and then the company matches. And so we’re seeing these really large amounts of money in those 10. They’re called tax deferred into those tax deferred accounts. And it’s great, right, it’s better than than not having it. But you do have some significant problems coming your way, if you have a lot of money in tax deferred accounts. And so let me show an example here, of kind of how this works. All right. So this is a projected taxable income for a hypothetical client, who, as you can see here is about 66 years old, right now. And we’re looking out until age 95. So you got to pick some age to plan to, we usually pick an older age, just because that is the most difficult thing to do in financial planning. You know, if you don’t live that long in retirement, then the money isn’t stretched and stretched as much as it is if you live longer. So we usually do that. And what you’re seeing here in this kind of big purple blob is the projected income for that client. And those little lines that you see the blue, the green, the orange lines going across there, those are the tax brackets. And so there’s some interesting things when you look at this number one is you can see that the taxable income is kind of lower at the beginning, and all of a sudden, it jumps up at 72. Yeah, that’s because this person has a lot of money and retirement plans and tax deferred plans. And at 72, the government makes you stop, start taking money out. And that gets higher and higher every year as a percentage. And if your accounts are growing like they hopefully are, that just means you have to take out more and more and more taxable income. And you can see what’s happening there. It’s just growing and growing, it’s going up into higher tax brackets and what have you, too, so really, really important to understand your long term tax, taxable income projection. This is called tax planning. So you’re mostly familiar probably with tax preparation, you know, you fill out the forms, like we’re doing right now. You take it in, and you do it yourself. And that’s tax preparation, tax planning is totally different. This is not something that often is done by a lot of people, we do it a lot, where we try to project your taxes all the way out for the rest of your life. And then we can make some adjustments to that and see, okay, how much tax did we save for the whole lifetime. And it’s amazing how much money can be saved, I think, you know, on a regular basis. So that’s, that’s happening as far as that goes. And really, the big thing here is what we call the tax time bomb, right? So this is a situation where you know, that income is growing and growing and growing. And if you take a look, what happens is, at some point down the road at 80 to 8586, you’re pulling out so much money, that you’re actually having to pay more on Medicare, right? You’re not paying base Medicare, because you’re being forced into this higher, you know, bracket, because of the income from the minimum distributions. You’ve got a scenario where it maybe there was two of you, and you both built up your retirement plans, and one of you passes away. And now all of the retirement plans under one name. And that’s a really hard situation, because now you’re a single filer. And that means that you’re going to pay more tax on that same withdrawal, because the withdrawal is the same whether it’s two people or one. It’s the total value. And so if you combine them into one person, taxes go way up on that.
Easan Arulanantham:
Yeah, and you can see, like 66 to 71. That’s kind of their base level expenses. And so when it jumps to 72, you’re essentially doubling the income. And really, you don’t want to be taking income from your debt you don’t need right. You just want to be taking enough income that you can live your standard of living, because you want to pay extra taxes that you don’t need to pay taxes on.
Tom Vaughan:
Yeah, so one of the solutions, and there’s many little pieces that can be done here to try to whittle away at reducing taxable income in the future. Sure, but one of them is to convert some or all of these retirement plans into a Roth IRA. So just so you know, anybody can do a conversion, no matter how much money you make, anybody can convert any amount from an from a 401k, or IRA, all of those to a Roth IRA. Right? There’s no limits. And so the first question is, Should I do it? Right? Does it work? Is it better or worse? And the second question is, okay, then how much do I do each year. And so that’s what we do with this program is we solve for that. And so here’s a scenario where we are converting assets, and fitting it see that yellow line, there’s the 22% bracket, right. So we’ve determined that the optimal bracket for this particular hypothetical client is the 22%, bracket two and 24. And actually, your net worth went backwards, doing 22. Worked great, right. And so you can see now this green, you know, blob is the projected income. And you can see it goes right up to the 22% bracket, the way that works is let’s just say the 22% bracket and make up the numbers 200,000, you have 100,000 of income, you can divert another 100,000 A year and come right up to the top of that bracket. And you do that every year, we do this at the end of the year, most of the time, so we can see what incomes came in, we’re very active with this in this conversion concept. Lots of details here that we won’t get into because it just takes too long about paying the taxes and how you do that. And that can be kind of painful here too, is, you know, because we do these projections, and it looks good. And we’ll finish up and show you how good it looks in just a minute. But it’s very hard to pay the taxes.
Easan Arulanantham:
Yeah, that’s it’s so bad. And you know, when you, you, maybe you prefer $100,000, and you have to pay additional $30,000 of taxes at the end of the year that you weren’t expecting. It’s just not a fun experience. And sometimes, you know, people don’t convert, you know, all the way to the bracket, but you can still convert some, you know, you can convert what’s in your comfortable level. And that helps you in the long run. So you don’t always have to be optimal. You just want to be you know, in a good place that you’re comfortable. And you’re picking some stuff. So make yourself a little bit better.
Tom Vaughan:
Yeah, move in the right direction. Yeah, I agree with that. And we can kind of compare the two incomes here on this slide. So you can see the green and see how that goes up. But look at what happens to the green behind there. The taxable income goes to zero at about age 83. That’s zero taxable income. That’s phenomenal, right? What a great solution versus this ongoing increasing purple blob, that’s creating a higher and higher potential Medicare costs and those types of things to that person that has that green one has lowest Medicare costs, for example, because they have zero taxable income. This doesn’t happen for everybody. It’s a hypothetical situation. But this is really critical stuff to understand, to have a really, I think, powerful retirement. And then it goes beyond that too. You can kind of see, just to show you kind of the purple blob at age 85 taxable income with no conversion $248,420. So that’s what’s ending up on their tax return that year. If they converted everything at 22% bracket, the green blob, just like we showed at age 85, they got zero taxable income. That looks good. Right?
Easan Arulanantham:
Yeah. And the idea is, you’re still having that same standard of living, but now you’re not paying taxes on that Senator living, right, that’s really important. You. Now you have so much more flexibility, say one year, you know, I’ve decided I really want this car, but I need extra $100,000 of money. And if I only have an IRA, to take it out from I have to pay taxes on that. So I have to take a little bit more money to cover those taxes. But if I have only a Roth IRA, I can take that money out tax free, and I don’t have to worry about it going on my income. Same.
Tom Vaughan:
Yeah, that’s a nice car, though. I could do that. So yeah, exactly. Right. I mean, you take that out of your IRA, you have to take 130,000 out to buy $100,000 car, you know, and so that’s a hard thing to do take out of your Roth IRA, you take out 100,000, then you can go buy your car. Yeah. So here’s the total for taxes, right. And so this is what we’re trying to do long term tax planning, you’re trying to make that second bar there as small as possible. So, you know, with no conversion, that person lives to 95 is gonna pay a million and a half dollars in tax, in total federal taxes paid with a conversion, a 22% bracket, all the way through taxes with dropped 826,000 and change. So, you know, that’s significantly better, right? And that, that adds up to a higher net worth in a better standard of living. All of these things happen. So this is a big, big area. All right. And then the last is just kind of comparing the estates. So the first one that’s just above our heads here. That one was no conversions. So there’s no tax free assets in that 0%, right. It’s all taxable assets and these tax deferred assets in the other estate here, and now that everything’s been converted the green circle over there, it’s 100%, tax free. Now, this is not a state taxes, this is income tax. And so what this means to your beneficiaries is that if they inherit the circle above us here, they’re going to have to take those tax deferred assets, and cash them out over a 10 year period, and pay the taxes on them. And you know, so for example, if I look at my kids, when I pass away, they could be in their peak earning years, and they could have a lot of extra income just being shoved on top of their income from this IRAs that they inherited from. If they inherit, say, a Roth IRA, instead, same dollar amount, they can let it grow for 10 years. This is why I converted all of my accounts to Roth IRAs already. And I had a conversation with my kids about making sure you keep those for that 10 year period, because that grows tax free for 10 years, and then they can cash it out at the end is so much more powerful.
Easan Arulanantham:
Yeah. And so when someone passes away, taxable, and their tax free accounts at that date of death, are pretty much the same, because taxable is stepped up to fair market value.
Tom Vaughan:
Yeah. And so the real potential for a Roth account is that you have the extra 10 years, you’re forced to take the distribution out at 10 years. But you can grow it for another 10 years and say, maybe you get 7% return, your account doubles in that 10 years, essentially. So, but if you had that in taxable money, you have to pay gains on that whatever doubling is, but you wouldn’t have to do that for tax free. And that’s where the power comes in, is it really helps your beneficiaries have this tax free asset that’s growing for them? Yeah, it’s, it’s, it’s definitely worth looking at. We talk about it all the time. You can’t learn enough about it. There are a lot of details. It’s certainly something we’ll talk to all of our clients about, you know, as far as that goes, you know that where it applies and sometimes it doesn’t work as well as as we think or what have you. But it really is an amazing thing as far as that goes.