Transcript:
Easan Arulanantham:
“When converting a traditional IRA to a Roth IRA, why don’t I use some of the funds in my traditional IRA to pay the taxes that will incur when during that conversion?”
Tom Vaughan:
Yeah, okay. That’s a really good question and… one of the difficulties of doing a conversion is that to really make it work, you need to have the money from outside the IRA. So give me an example, let’s just say that I want to move $100,000 of my IRA and convert it into Roth IRA. I’d want to do that because now the Roth IRA can go tax free for the rest of my life, and when I pass away, my beneficiaries can get tax free growth for 10 years, additionally. And so that’s a huge deal. That’s why I moved my accounts to Roth accounts. And you can do the math. There’s all kinds of things to figure that out. But move $100,000, let’s just say for example, you got $25,000 of taxes you have to pay, because you move that. If you reach into your IRA, and pull out that $25,000 in tax to pay it, well first of all you’re going to take out more than 25, because that’s also a taxable event. So maybe I have to pull out 40, to net 25. So now, I have just taken $100,000, and moved it, but I lost $40,000 of assets inside of my IRA. …I’m making these numbers up, but that would be 40% of the move from one to another. So that $40,000 is no longer growing tax deferred, and in my IRA for the rest of my life. It is gone, it’s out. And if you do the math, it doesn’t work. If you do the math, if you take the money to pay the taxes out of the IRA, to do the conversion, it does not work.
You’re better off just leaving the $100,000 in the IRA. …That’s one of the difficulties, though, of doing these conversions: you actually have to have the money outside of your IRAs. And so you know, often people do have money, but it’s like, you know, emergency money and things like that, that you wouldn’t want to just get rid of to make the conversion. So the most successful scenarios that we have in terms of in-conversion, are people that have a pretty good balance. They have good IRA amounts. They have good home equity, that’s great. And then they have money in taxable accounts and trusts and individual accounts: TOD, Transfer On Death accounts. They’re all taxable. That’s where they can go in and take some of that. So they can take that $25,000 out of there. Some of it might be capital gains, but that’s lower. Some of it might not. Sometimes I can get that $25,000 out with very little tax. And so that works when you do the math, but you have to have that outside bucket of money. And this is one of the reasons I encourage people to really, really focus on what where all of their money is within their retirement.
It’s incredibly important when we work on somebody, the healthiest financial situations we deal with, have money inside retirement plans and outside retirement plans: both. And so if you’re not retired yet, or even if you are, you still want to try to accumulate some assets outside your retirement plan. So it’s just so much easier. Now, not everybody can do that, and I understand. And we have some strategies to try to work around that. But an ideal scenario, especially if you’re younger, and heading towards retirement, is make sure you’re putting some money in non-retirement things too. You know, …you want to get your full match at your 401k, if you’ve got it, or those types of things. There’s a bunch of really smart things, but have some money in some kind of liquid assets. They could be in the stock market, it doesn’t matter. As long as it’s not fully taxable, to get out at ordinary income rates. And so placing everything you have inside these retirement plans, I think is a mistake, at least in an ideal scenario.