🔗 Access the retirement planning software → https://foundryfinancial.typeform.com/rightcapital?utm_source=youtube&utm_medium=longform&utm_campaign=should-i-do-a-roth-conversion-desc&utm_content=descriptionRoth conversions can save some retirees over a million dollars in taxes. But for others, they may not make sense at all.The problem is that most people are getting shouted at from both sides with no real framework for figuring out which camp they fall into.In this video, we walk through an actual case study using the same planning software our firm uses internally, so you can see the real numbers, not just the theory.You'll see exactly what happens to a couple's tax bill when they do nothing versus when they strategically convert during the low-income window between retirement and Social Security. The difference is striking.We also break down the 7 key factors that determine whether a Roth conversion makes sense for your situation, including things most people overlook.At the end, we show you how to access the same software used in this video so you can model your own scenario.Roth conversions are not a one-size-fits-all strategy. But with the right analysis, they can be one of the most powerful tax tools in your retirement plan.
[00:00:00] Hey, welcome to another episode of Retirement Made Simple. I'm your host, Kevin Lum. I'm a certified financial planner based in Los Angeles, and this podcast is dedicated to helping a million people retire without worry. As a quick reminder, every episode here comes straight from our YouTube channel. So this is just the audio, so you can listen while you're walking, driving, or living your life. Let's dive in.
[00:00:26] Okay. Roth conversions can save you an enormous amount of money in taxes over the lifetime of your portfolio. It's not uncommon to see a savings of over a million dollars. As you know, on YouTube, there are a lot of people screaming at you, you should do a Roth conversion, you shouldn't do a Roth conversion, but few people know how to decide if they should do one, if it makes sense for their situation. And fewer people know how to calculate the potential tax savings or have the proper tools.
[00:00:55] So in this video, I'm going to walk you through an actual case study to show you the impact of a Roth conversion. And then I'm going to give you access to the same software that I use to model it. And it's the same software we use in our firm. And finally, I'm going to give you a framework to help you decide whether a Roth conversion makes sense for you and what the critical factors you should consider as you make this decision.
[00:01:20] Before we get into the case study, let's start with what a Roth conversion actually is. Now, I know many of you already know this, but a Roth conversion is when you take money from a tax-deferred account and you move it into a tax-free account. Taking money from your traditional IRA or your 401k and putting it into a Roth IRA.
[00:01:40] For most retirees, the bulk of their wealth sits in a tax-deferred account, meaning you received a tax break when you put the money in, but it's been growing for the past 20 or 30 years. And now when you take that money out, you have to pay tax on every dollar in that account. And that can create a massive tax problem, particularly later in retirement. Why? Because as I said, those accounts have continued to grow.
[00:02:05] And at some point, the government is going to force you to take the dreaded required minimum distribution. And every dollar you pull out is taxed as ordinary income, just as if it was a paycheck. And the big issue is, is that those withdrawals often push you into a higher income level, which can cause your Social Security to be taxed. And in some cases, it can trigger higher Medicare premiums, often much higher.
[00:02:31] Not to mention, it can push you into a higher tax bracket, often the highest tax bracket of your life later in retirement. Exactly at the moment when you want to be paying less in taxes, not more. So you have really two options. Option A, withdraw money from your tax-deferred account strategically and just spend it. For some people, that's the right move. But for other people, the better option is doing a Roth conversion.
[00:02:56] Take the money out of the 401k or the traditional IRA and move it into a Roth IRA. That's a Roth conversion. Now here's the trade-off. When you convert, you pay tax today. So if you take $50,000 out of the tax-deferred account and you move it into a Roth, you pull $50,000 out of your 401k and move it into a Roth this year, you will pay tax on $50,000 of extra income.
[00:03:22] But in exchange, you get tax-free growth for the next 30 or 40 years. And the money inside the Roth is not subject to the required minimum distribution. And this can end up saving you a fortune in taxes over the long run. And part of this calculation requires using a very fuzzy crystal ball. Because one of the questions you need to ask is, will future tax rates be higher or lower than the current tax rate?
[00:03:50] Forget about your particular situation and whether you're going to move up or down into a particular tax bracket. But will the tax brackets change over time? And many people, particularly Ed Slott, talk about the ticking time bond because we have a national debt that is skyrocketing. And a lot of people like Ed Slott believe rates are going to have to increase rather than fall over the next 30 years to help take care of that debt. Now that's a judgment call you have to make.
[00:04:18] Because to be honest, throughout most of my lifetime, I've been hearing the national debt is going to cause taxes to go up. But actually, tax rates have come down a bit over the past 30 years. You're paying less in taxes today than you were 30 years ago. And so part of the calculation is this question. Do you think future tax rates are going to be higher than the tax rates today? So that's part of the calculation, right? What is your future tax rate going to be? And then just what are tax rates in general going to be in the future?
[00:04:45] And like I said, it requires using a very clouded crystal ball. If I had to take a bet, I would guess that tax rates are going to have to increase in the future because our national debt is accelerating at an insane pace. And just the cost to service the debt is becoming a major drag on the federal budget. So that's the first thing you need to think about. What's your future tax rate going to be? And then what are tax rates going to be in general? The second question is, what's your asset allocation?
[00:05:14] If all of your money is in treasuries growing at 3% or 4% a year, a conversion is going to be less powerful. There's simply less future growth to shelter. But if you hold a balanced equity portfolio that's growing 7%, 8%, 9%, 10%, 11% a year, and it's doubling every 7% to 10 years, that Roth conversion becomes far more valuable over the life of your retirement. And so the second question you need to ask yourself is, how are my assets invested?
[00:05:43] Number three, how long does the money have to grow? If you're 80 years old and you have a typical life expectancy, a conversion might not make sense unless it's going to go to an error that's in an incredibly high tax bracket. But if you are 62, you have a much longer time period for that money to grow, and that might change the calculation on that Roth conversion. So number three, how long do you expect that this money will be able to grow? Is it going to be 20 years, 30 years, 40 years?
[00:06:11] The longer that the money has to compound, the more powerful the Roth conversion will become. Number four, are you leaving money to charity? If a chunk of your 401k or your IRA is headed to charity, converting that money makes less sense. Charities don't pay tax on what they receive anyway. So if your goal is to give most of your assets at the end of your life, the charity, Roth conversions are going to be less powerful.
[00:06:39] Number five, will the conversion trigger a stealth tax? And this is important. Every dollar you convert counts as income that year. So will it cause your Social Security to be taxed? Will it raise your Medicare premiums? Will it kill your ACA subsidies? This is a big issue for many early retirees, right? If they do a Roth conversion, they could lose a significant subsidy on their health care.
[00:07:04] Now that doesn't mean it's not worth losing that subsidy, but you need a careful analysis weighing the long-term benefits against the near-term cost. For many people, converting early helps you avoid a stealth tax later in your retirement. For others, it can trigger taxes today that simply aren't worth paying.
[00:07:25] And so you need to do a careful analysis of your situation, which is why in just a minute, I'm going to walk you through a scenario because everyone yelling on YouTube about doing a Roth conversion or not doing a Roth conversion is talking generally. And you need to know and understand your numbers for your situation. Number six, can you pay the tax from another bucket? Do you have cash in a taxable brokerage account or in a bank account to cover the cost of a conversion?
[00:07:52] Because if you can pay from outside the IRA, it lets the full amount be converted and grow tax-free and it maximizes the benefit. Let me give you a quick example. Let's say you have to pay 30% tax on your conversion. I'm just using this for easy math. If you convert $100,000 today, you're going to owe $30,000 in taxes. You can either pay for that from within the conversion, which means $30,000 of the $100,000 goes to pay taxes and $70,000 is converted into the Roth.
[00:08:21] But that means you have less money in the Roth to compound over the next decades. On the other hand, if you have $30,000 sitting in your bank and you can pay for the tax bill with that money, the full $100,000 that you converted will be able to go into the Roth IRA and compound over the next decades. And so one of the questions you need to ask yourself is, do I have money to pay for the conversion from the outside?
[00:08:44] Often the Roth conversion can be even more powerful, but the math on that question is a bit tricky because you could invest the money in the bank account or the taxable brokerage. But often the math on that equation is a bit tricky. And beyond the scope of this video. Number seven, if you are going to leave money to heirs, what is the heirs tax rate going to be? If you have kids that are going to inherit your money someday and they're both doctors and they're in the 32% tax bracket and you can convert at 22%, a conversion probably makes sense.
[00:09:14] On the other hand, if your kids are maybe in the 10% or 12% tax bracket or whoever's going to inherit your money is in the 10% or 12% tax bracket and you're going to have to pay 22% to convert the money, then it probably isn't going to be as powerful. It doesn't mean you shouldn't do it, but it means you should take that into account. Often it's called the terminal tax rate. And you'll see here in a minute how we take that into account when we are calculating a Roth conversion.
[00:09:40] With that framework in mind, I'm going to switch to my other screen and we're going to look at a tax situation for Phil and Claire Dunphy. So here we have the software that we use internally at our firm and we have Phil and Claire. They have a net worth of $1.5 million. And so we can go over here and look to see what that is comprised of. They have about $50,000 in the bank. And then they have investments making up about $1.5 million. $500,000 is in Phil's 401k. $400,000 is in Claire's 401k.
[00:10:10] They have $500,000 in a taxable brokerage account. They have a balance of $500,000, but the cost basis is $250,000. And then they also have Phil's Roth. So that's a quick overview of their investment situation. Phil's Social Security at his full retirement age is going to be $3,200 a month. Claire's Social Security at her full retirement age is going to be $2,800 a month.
[00:10:35] Their retirement expenses is about $7,000 a month net of taxes, plus another $1,000 a month in healthcare expenses, Medicare and all the other healthcare expenses that you'll have in retirement. And then we've also included some long-term care expenses later in the plan. So that's a high-level overview of the plan. Phil is 61. Claire is 55. Claire plans at a retirement age 60. Phil is going to retire at age 62. So now we can go over the tax tab.
[00:11:02] Before I do, I should just mention this is a great plan. They're in great shape. They have 100% probability of success. So let's go over to the tax tab. So we go click here. And first, I want to look at the tax estimate. So this is what it looks like if Phil and Claire don't do anything. They don't do any Roth conversions. Once they retire, their tax rate or their tax bill is basically going to collapse. Because when you first retire, often you have no income coming in. If you remember, Phil and Claire have a lot of money in their bank account and their taxable
[00:11:31] brokerage that they can live off of and really keep their income fairly low over the next few years. And this is what a lot of retirees do. They're like, this is amazing. I don't have to pay any tax. And so they haven't done any conversions. But if you watch what happens, basically their tax bill goes to zero and they're feeling great about themselves. And then they hit age 75. And all of a sudden, that tax bill begins to climb. And that effective tax rate begins to go to 10% and then 12% and 13%.
[00:11:58] And then what happens here is Phil's a bit older. So Phil passes first. And all of a sudden, Claire is put into the highest tax bracket of their life later in retirement. So here we have the tax estimate. And this is if Phil and Claire don't do any Roth conversions. And this is very similar to what I see with a lot of retirees. You're working, you're in maybe the 20% tax bracket, and then you quit working. And basically your tax bill falls off the cliff, which everyone loves.
[00:12:25] It feels great not to pay any money in taxes because the income has stopped. They've got about $50,000 in the bank and $500,000 in the taxable brokerage. And so they're going to be able to pull out a lot of money to live on completely tax free. So you watch their tax bill basically by their mid-70s goes completely to zero. And they're feeling really great about the retirement plan. But then you watch what happens. All of a sudden, that tax bill begins to creep up.
[00:12:51] And their effective tax rate goes to 10% and then 12% and then 13%. Because what's happening is the required minimum distribution is pushing them into a higher tax bracket. And then what you see right here is that Phil passes. Remember, he's a couple of years older and now Claire is a single filer. And what happens is now she's in the highest tax bracket of her life. So this is if they don't do any Roth conversions. So let's come over to the tax strategy tab. And so we can see an overview of their situation.
[00:13:20] We haven't done anything yet. We haven't done any Roth conversions. And so we can come down here and we can say, okay, Phil and Claire have a couple of kids. They're both doing pretty well. They have a terminal tax rate of say 24%. So the kids are in the 24% tax bracket. So if they were to inherit these IRAs, they're going to have to pay tax over a 10-year period, at least the 24% tax bracket. And what often ends up happening is the kids are making a couple hundred thousand dollars a year.
[00:13:47] And now they've inherited a million dollars that has to be taken out over 10 years. And so they're taking out $100,000 a year. And so now they're not paying tax of the year. They're paying tax on $300,000 a year, which causes them to potentially be in an even higher tax bracket. But we're going to set the estimated terminal tax rate at 24%. Okay, so now we come up to fill the tax bracket. And Phil and Claire have been watching YouTube videos about how they should do a Roth conversion. And they're like, we're going to do a Roth conversion. Let's be aggressive. Let's get it over with.
[00:14:15] So they put it up to the 24% tax bracket. And so we go up here and we look, their tax-adjusted ending assets is $285,000 less. So they end up paying a million dollars less in taxes, which is great. But at the end of the plan, there's actually less money because they paid a high tax bill, which reduced the future growth, which actually causes them to have less in tax-adjusted ending assets.
[00:14:41] So in this case, going to the 24% tax bracket, maybe that was a bit too aggressive. So now we can come down and say, well, what if they did the 22% tax bracket? Now they have $500,000, a half million dollars more in tax-adjusted ending assets. They save $1.6 million in taxes and they have $500,000 more. That looks better. But let's say, what if maybe they did the 10% tax bracket? So they'll look at 10%, $900,000 more and about $400,000 less in taxes.
[00:15:09] So a little more tax-adjusted ending assets, but they're going to pay more in tax. What if we did 12%? Let's try 12%. And what you see is that they pay a million and a half less in taxes and that they have $2 million more in their tax-adjusted wealth. So we can come over here and look at the details. So while they're still working, they're going to convert just a little bit. So they're going to go up to the top of the 12% while they're still working. And then once they retire, they've got that window where they have no income, which most people just say, this is great.
[00:15:39] I'm not paying any taxes, but they're going to use that golden window before social security kicks in and before RMDs kick in to really begin to do Roth conversions to use that window effectively. So they're going to convert $130,000 a year. And so you can see they've got this taxable account balance and they're beginning to spend that down to pay for their lifestyle and also to pay for Roth conversions. And so then we can come here and look at the tax details and we can see here, they're able
[00:16:07] to keep themselves in the 12% tax bracket throughout most of the retirements. We can come down here and look. And in fact, eventually it drops off and goes completely to zero. And at some point they'll never pay another penny in taxes for the rest of their lives. On the other hand, if they had not done a Roth conversion, we would have seen exactly the opposite. So let's go to zero. Let's come over here to the tax details. You can see they're still working. They have 93,000 in income and then their income goes to zero and the tax bill goes to zero. And they're feeling like they are winning the tax game.
[00:16:35] And then what is all of a sudden at age 75, it jumps up to the 22% tax bracket and just continues climbing and climbing. And their tax bill continues to climb as they begin to age. And for some people, they end up paying more money at the end of the retirement plan than they did while they were working. In fact, that's the case here, right? When they were right here, they're paying $100,000 a year in taxes. And when they were working, they're paying like $12,000, $11,000 a year in federal taxes.
[00:17:01] And in many times, you'll end up paying more in taxes later in retirement than they were when they're working. So you see here at age, let's see, let's go to 85 because some people will say, oh, don't plan too far in advance. I'm not going to live that long. Okay. So let's look at age 85, right? At age 85, $50,000 a year in taxes. And they were paying $11,000 a year in taxes when they were working in federal tax. And so what Phil and Claire were able to do was effectively use the tax brackets to their advantage, right? They retired early.
[00:17:31] Social security was going to be pushed off a few years in advance. Phil ended up deciding to claim at age 70. Claire decided to reclaim at age 67. So they've got no social security coming in and they use those incredibly low income years to convert moving money out of their 401k into the Roth and using their taxable brokerage and their bank account to fund their living expenses and to cover the conversions and taxes. And by doing that, they were able to save a million dollars in taxes over the course of their life.
[00:17:59] Now, a couple of things could have impacted this plan rather dramatically. And if Phil and Claire had passed early, if they'd passed at age 80 or 85, you would have seen a much smaller impact with that Roth conversion. Also, it's important to point out without doing a Roth conversion, yes, they could be paying more money in taxes later in their life. But you have to remember that inflation comes into play. And so $100,000 30 years from now isn't quite the same as $100,000 today.
[00:18:27] So as I've said in this video, Roth conversions are very specific to your situation, your plan. How long do you think you're going to live? How aggressively are you going to invest your assets? When are you going to claim social security? What other sources of income do you have coming in? If you've got a big pension, there's going to be less room to convert effectively. If you don't have a lot of money in a taxable brokerage account or a bank account like Phil and Claire had, it's going to have less of an impact.
[00:18:54] So Roth conversions can generate dramatic tax savings for a lot of people in retirement. But smart analysis and smart planning is absolutely required to see whether it pays off in your situation. And for some of you, a Roth conversion simply won't make sense. But you still may want to strategically use the tax brackets to your advantage, withdrawing from your tax-deferred account up to a certain tax level early in retirement, potentially before
[00:19:22] your social security kicks in, because if you wait until social security starts and RMDs force you to withdraw more, you can end up causing more of your social security benefit to be taxed and shrink the money you have to live on. So what questions do you have about Roth conversions? Let me know in the comments. And then I'm going to link in the description to the software that I used. You can use it free for 30 days. We used to give unlimited use of it. And then the company that we white label their software, they started telling us way too many
[00:19:51] people are creating accounts and we had to rein it in. In fact, I have to pay for every account that someone uses. And so that's why I've limited the amount of time that people can use it. And then I'll put a QR code here if you would rather use that. So there's a link in the description where you can use the QR code. Now, quick disclaimer, I'm not creating a financial plan for you. You are using these tools on your own. It took me years to learn them fully. And there are a ton of variables that I haven't covered. I'm going to be making some more videos where I'm going to talk about some of the other knobs
[00:20:19] that you could twist that can also make an impact on your long-term tax bill. But hopefully this gets your mind spinning and gets the wheels turning thinking about Roth conversions and how it might make sense in your retirement plan. Hey, thanks for listening. If you enjoyed this content, if you'd do me a favor and just leave a review on whatever podcast app you're using, Apple or Google or Spotify. And also you can find us on YouTube. Just search Foundry Financial or Retirement Made Simple. You should be able to find us by searching both.
[00:20:47] And then you can find our website at foundryfinancial.org. Thanks for listening.