We’d like Tom’s Thoughts on Whether we Should Convert our IRAs to Roth IRAs.
Transcript:
Katie Nealis:
At the start off with the first question here. Thank you, Tom. Well, the first question that we have in the question bank is, should I be converting my IRAs to Roth IRA?
Tom Vaughan:
Okay, yes, this is, this is one that I put in the bank first, because it’s probably the most commonly asked question right now, they change the tax laws, and multiple times, and every time it kind of leans more and more towards looking at a Roth IRA. So just very quickly, let me kind of talk about the difference. So you might have a traditional 401k, or our traditional IRA. And in those cases, whatever assets that you have in there grows tax deferred. And then once you get, you know, to retirement age, you might start withdrawing on those, and then it’s taxable, when you take it out.
When you get past 72 years old, they make you start taking out a certain amount, and then that amount continues to go up and up over the years. And so if you have a Roth IRA, or even a Roth 401k, that grows tax free, and so you don’t have to worry about, you know, paying taxes when you pull it out, and they don’t make you take money out past age 72. So kind of gives you some flexibility. With that. Big difference. Of course, when you put money into a 401k or an IRA, you get a write off. And if you put money into a Roth IRA or a Roth 401k, you do not get a write off. So those you know, those are the competing pieces, I would say honestly, in all of the tax laws that are out there, the Roth concept is one of the most powerful I’ve ever seen. And it really has the capability of doing, you know, some great things.
But the question was about conversion, you are allowed to convert money, at any point with any income and any amount, from your IRA to your Roth IRA, you can convert from your 401k usually have to be separated from service in order to do that. So it just may be after retirement. But I’m going to share my screen here and just give you a little example, that I think you might find interesting. So hopefully, you can see this well enough, I’ll try to describe this. This is a program called write capital. And what I’ve done is I’ve made up a sample plan. So Joe, and Jane sample. And what I’m going to do is kind of show them in this case you how to, you know, look at the Roth conversion concept and see if it makes any sense for them. So I’ll describe what this chart is here, these little lines that are here are tax brackets, you know, the 10%, bracket, the 12%, the 22%. And so that’s basically you’ll see how important that is just in a moment. Now this green blob here is a projection for how much income that will have on their tax return each year for the rest of their lives. So Joe and Jane sample have 750,000 each in an IRA, and about a million dollars outside of IRA. So I know everybody’s got a different dollar amount. And you can still take a look at this, you know whether you have more or less, but the concepts will still be fairly, fairly similar. Now, there are some key criteria to make a Roth conversion work. Number one is you have to pay the taxes with money outside of the IRA. So if I take $10,000, and I move it from an IRA to a Roth IRA, and let’s just say my taxes are 2500, I need to take that 2500 out of kind of my other monies, my taxable money, I can’t take it out of that conversion, it won’t work. So that’s one criteria, that actually cuts a lot of people off from doing the conversion. But Joe and Joe and Jane here, they have some money outside their IRA. So you know, they fit that criteria.
So then the next thing that we’re going to be looking at is trying to figure out what bracket to use, how much to convert and doesn’t work at all. So but we’re going to start with what’s called the wealth withdrawal sequence. And this is very fascinating. So what it has here is called pro rata. Okay, so what pro rata means is that Joe and Jane hit retirement, and they need income. And so they have, say, 10% in one account, and they take 10% income out of that account, they have 15%, in another account, they take 15% out of that account. This is not a concept I see very often, but what they’re doing in this program is using this pro rata as kind of a base for you to take a look. And then as we make adjustments, you can see how it changes. And what we really want to focus on is how much more or less we have based on different things that happen as I change these parameters down below. So very quickly, we’ll look at the standard distribution methodology, which would be to take you know, and Joe and Jane’s case to take their incomes first from their taxable accounts, and then tax deferred accounts and tax free accounts, which would mainly be Ross.
In that sequence, well, you can see here that adds $650,000 more to their net worth, which is great. That’s, you know, really a big deal actually, just by having that sequence now. Just to kind of emphasize how important this is, I’m going to go down here and do the wrong sequence. So you’ll see this go $750,000 less. And so what this sequence is that they’re going to go to their IRAs first, and use those and then eventually get to their taxable accounts. And if they have any, they would use their tax free. I see this sequence all the time. And what people tell me is, Hey, I saved in my IRAs, or 401, K’s or what have you, those are my retirement accounts, I’m now retired, I’m going to take money out of those retirement accounts. Well, unfortunately, in this particular case, if you do that, they’ll actually end up with $1.4 million, less than net worth. So let’s go back to the standard. And we’ll leave that as our as our, you know, base case now. So remember, the 650,002. Now, we’re gonna go down here and just take a quick look at converting IRA. So this little slider allows me to try different levels. So what I did here first was I said, All right, if we have any room inside the 10% tax bracket in any one year, we want to convert and fill in that bracket. Well, it didn’t do anything, mainly because they already have the 10% bracket, that’s this line here at the bottom filled. Alright, so then we go to the next 112 percent now says 12, slash 15. Because the the current tax brackets sunset and disappearing in 2025. And unless Congress continues them, they’ll actually go back to 15%, where they were before. So we’re assuming that they don’t, you know, go back, I mean, assuming that they don’t get keep at 12%, it actually goes back to 15.
Now, we can see that there’s an increase 918 instead of 650,000. So converting at the 12%. And you can kind of see here, where it filled in, see that that little blue part, it filled in the 12%. And that’s why those lines are important. Alright, couple more here. 22%, wow, big difference. 1,000,004 increase, right 24% actually goes backwards. See, that’s what that just told me was that the optimum bracket for Joe and Jane to Phil is 22%. And what’s really, really wild here, if you look closely at age 85, if we make the conversions, there’ll be done converting at about age 82. And they’ll have zero income, taxable income at age 85, which is completely different standard of living, versus if they don’t make the conversions, they end up with $278,000 worth of taxable income, which is really, you know, kind of a big, big piece here, too. So, the other big criteria just to cover is that people see it, they like it, they want more money. But when it comes time to actually paying the taxes, it can be really painful. Because if you look here at the first year, they would have had $47,562 worth of taxable income, but they’re filling in the 22% bracket, which is 172,000, that’s a lot of money to pull out of your pocket to pay taxes.
So you have to be committed to make this work, but it can be life changing. And it also makes a big difference to beneficiaries. If you look here, in their current case, they don’t have any tax free assets. So everything that would be inherited would be in these tax deferred or tax, you know, taxable accounts. And the tax deferred section here has to be taken out over 10 year period. So the kids are if that’s who it is, would be paying taxes versus over here. We’ve got 100% tax free income tax free estate, which is really, you know, an unbelievable situation to leave your kids. They still have to take it out over 10 years. But anyway, that’s that’s how that works. So hopefully that helps explain a little bit. You know, how