Are Roth Conversions Viable? A Case Study

Episode 140 June 01, 2024 00:22:11
Are Roth Conversions Viable? A Case Study
Annuity Straight Talk
Are Roth Conversions Viable? A Case Study

Jun 01 2024 | 00:22:11


Show Notes

Episode 140: Are Roth Conversions Viable? A Case Study

In this episode of the Annuity Straight Talk podcast, Bryan Anderson explores the real costs and benefits of Roth IRA conversions through a detailed case study. Discover whether this popular retirement strategy makes sense for you, learn about potential pitfalls, and get answers to common questions. Perfect for anyone looking to optimize their retirement planning. Tune in to clear up confusion and make informed decisions about your financial future!

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Episode Transcript

[00:00:00] Speaker A: Hello and welcome to the Annuity Straight Talk podcast, episode number 104. My name is Brian Anderson, founder and creator of, answering all your questions about retirement planning and how annuities fit into that. For some of you, not everybody likes to use them. Clearing up confusion. Gonna go back to some seemingly mundane topics for the professional listener because I seem to guess when I started this podcast, it was, hey, I'll answer all the questions and people will get a lot of the questions answered. And now that there's so many of them, I don't blame anybody for missing maybe something that was critical for them or one of their questions. We're gonna try to repeat some of the things, but doing it in a different way so it's more engaging because new information has come to light. So right now I'm following up on a newsletter I wrote five years ago. Please like subscribe or comment on any of your favorite podcast platforms or on YouTube. If you want to talk to me about your situation, whether it's this topic or anything else, schedule a call. Click on the top right corner of any page on enter your name, email phone pick your time zone. Pick the time. One quick note is like, that'll do the calculation for you. I am on mountain Time, but you don't have to figure it out. Just put your time zone in and it's going to come onto my calendar as the mountain time zone. All right, but that's how you get ahold of me. So the newsletter I wrote more than five years ago is the reality of Roth conversions. And I've been getting this question a lot. So share my screen. I've got a spreadsheet and I'll put the newsletter on to start. But in the newsletter that the past newsletter is linked right up at the top. So I'm going to start up here and go, I'm trying to be more patient this week because people say, you talk so fast. And usually by the time I create all of this and get to that point, I want to get it done. And this is, to me, the easy part. Reality Roth conversions. I wrote that because I think far too many people consider it to be a viable strategy in retirement. In most cases, it does not make sense. I'm going to explain why this the case I'm going to cover today is obviously on the line, and it's going to come down to personal decision, and that's fine. But there's a lot of scare tactics surrounding increased tax rates, and that's a common pitch for investment advisors, insurance guys, oh, you got to do this because tax rates are going to go up. I'm not into scare tactics, but they're just trying to get an appointment, and then they're going to use your fear to say, hey, put all your money under my management or buy this product. And so really I'm mostly getting people who are coming because someone did that to them, either for taxes or market risk or any of the major concerns in retirement. And then my goal is to provide valuable information or value to anyone who asked for my help. So answering this question may definitively clear up confusion for a lot of people in retirement, every case is wildly different. So this is generally in the past newsletter, I ran through a few examples that cover about 90 95% of all scenarios. I'm not going to redo those right now. You can go read it. For this week's case study, this couple responded to a newspaper ad promoting bonuses on index annuities. It was like, hey, you can get a 13% bonus and all the money you put in. And they're also trying to de risk a little bit of portfolio. Hey, that sounds good. We'll go talk to them. I'm not sure if it's promoted or if it's was uncovered. I think it was uncovered that one of their primary concerns is converting IRA assets to Roth so that they can get to a tax free status. They've got a healthy amount of IRA assets in their late sixties. They haven't collected Social Security. Once they do, then all their income needs will be met. So they don't really need the money from their iras. They're in a fortunate position and. But that doesn't stop anyone from trying to be efficient and minimizing taxes, if at all possible, when they do take RMD. So in three, four, or five years, they're going to be end up paying, paying, or taking funds out that they don't necessarily need and paying taxes they don't really want to pay. So everybody needs to understand this is general exercise and not tax advice for anyone. If you're going to do a plan like this, it's going to have to be signed off on by your CPA. I can assure you, however, for purposes of this, I'm qualified enough to do some simple math and think through complex problems and help these guys figure it out. I'm going to make several assumptions, but there's. Because there are certain variables that need to be fixed. I'm going to disclose it where I, wherever possible, or where necessary. I really want a lot of questions on this because this is going to be an individual deal. If I get enough questions, I'm going to come back next week or in two weeks and I'll do a follow up to ask frequently asked questions. So please go ahead and send over any concerns comments. If you're on the email list, you get this on Saturday morning and you can just reply to the email and say, hey, I've always wondered this or that because I thought about adding to this like a list of Roth IRA facts, conversion facts and all that stuff, but then it would just get too long and I really just want to run through this one. When you look into the future for Roth conversions, it's helpful to get an idea of kind of what your boundaries are for doing that. But it's a whole different deal in practice. It changes on an annual basis depending on a lot of factors, investment returns, changes in tax rates, discretionary spending needs as well, and that you can put a 1012 15 year plan into place. But I guarantee you it's going to change from year to year. And those changes could have a significant impact on the outcome of this. So we're going to fix this in place and understand that I'm not recommending they do this, I'm just testing different ways of doing it. So here's their details. 2.1 million in total IRA assets between both people. For simplicity purposes, I'm going to consider it one account. In practice, this will be different for them because they've. There's six months separate them and part of the. So they're going to take RMD's at different in different years and also some of the IRA. Half of it's in one, half of it's in the other. It's a little different than that, but so we're going to make it easy. We're just going to consider it one account, okay? The husband and wife are 68 and 69 years old respectively. I'm going to assume they'll both take RMD's at the same time, kind of the same as, like the assets are split between the two of them. RMD's are going to come at a different, in a different year for each of these guys, but we're going to assume it's the same six months separate them. Actual numbers will be a bit different, but this is going to be close. Currently they have a $60,000 annual income and they haven't taken Social Security yet, which will more than cover that gap and leave some surplus income as well. With the numbers that I quoted in this spreadsheet. I assume them taking Social Security now, but they're probably going to wait till 70. That was their plan at this point, because there's only a year and a half from now. It doesn't make a whole lot of difference. I'm going to run both scenarios for them. If they want to go deeper, then we'll probably look at both and see if there is a meaningful difference. I'm guessing that it's within a few thousand bucks, probably of the total. I used a 6% static investment return for the IRA and the Roth IRA that it's being converted into. So we can calculate the totals of those accounts. Variable rates of return. If you're market based, assets higher or lower are going to change those numbers considerably. That's another reason why the conversions need to need to be adjusted annually, and not to mention changes in marginal tax rates and all that stuff. That's something I just took the liberty of, like, let's put a growth rate on it. It's going to make sense, but it's not at all realistic to be that way. So part of their question is whether they add an annuity. I'm not really going to touch that here, but I consider long term 6% between an annuity, a myga, or an indexed annuity. They don't need an income annuity. Whatever they choose to use 6% of reasonable conservative return for a blended portfolio with equities and annuity them about this. I assume that their personal income as a married couple filing joint taxes will top out at the 12%. We'll top out the 12% tax bracket. So any conversions that they do are going to happen at the 22% or 24% federal bracket. Anything more is unacceptable to these guys. After 24, they bump it up into 32. They don't want to do that. And it's probably a terrible idea, honestly, because what we'll find out is if you're jumping into a higher tax bracket just to convert, then it's a waste of money. And it's also one more little thing here that everybody should realize, doesn't matter what guys, what state these guys are in, probably a different state than you. State taxes have to be added to it on a case by case basis. I can certainly do that, but we're leaving it out. We're just analyzing the federal taxes, which is the lion's share of the hit they're going to take. So in the newsletter, I call it one of the biggest problems. It's actually the biggest issue. Issue with Roth. Roth conversion is general, is that you need to have money available to pay the taxes. If you do it with non qualified cash, then you're decreasing your liquid cash that's at your disposal, because it's just sending it off to the government. And if you don't have that, you're going to have to do additional IRA distributions. Either one of is a significant cost and probably the determining factor on whether a conversion is a good idea. If you have to take excess withdrawals from an IRA, it effectively reduces the amount you're actually getting into the Roth. And all you're doing with that is accelerating the rate at which you pay taxes. So figuring out how to do this was kind of one of the complicated parts. But I did get it. And the newsletter. I guess everybody that's watching this or listening knows you're on the podcast. You're going to get the most detail, but a good visual aid and just run through it quickly. You can read the newsletter and the graphics are going to be helpful. So if all personal income tops out the 12% bracket, then this couple can. Could convert an additional 101,299 in the 22% bracket and 173,450 in the 24% bracket, with more than 274,000 available to be converted at an acceptable tax rate. We first got to figure out how to pay the taxes. They already did a Roth conversion this year, so that's off the books. We're not going to start until the second year, and I guess I'll go to the spreadsheet now. So, first of all, there's. So is there Social Security? So we add that in there. Okay. And then over here on the conversion side, I'm not going to give too much of it away at the beginning. So, 2.1 million in the IRA, 101,000 available in the 22% bracket. 173, 450 in the 24% bracket. What happens is we can calculate. So in the tax column, I just added 22% of 101 and 24% of 173 to figure out that the taxes annually for that will be $63,914 is what it's going to cost them on an annual basis. Now they've got about 23,000 of additional income that they're income gap plus the surplus of Social Security. Wipe it away, send your cash. Plus an extra $40,000 distribution from the IRA. So instead of 274, they got 234,199 coming into the Roth and the very first year. And it stays relatively similar in the following years, the two years now when they get RMD's. So, as the IRA is drawing down in column j. The Roth IRA is increasing in value, both growing at 6%. Okay. They're going from taxable to tax free. This is not to say this is how they will do it. This is just the maximum conversion strategy they could employ and how they can afford it and pay for it without, you know, really because they're using Social Security money and part of the IRA to pay the taxes. So here's the factors for RMD or RMD calculations. So at age 73, you divide the total IRA by 26.5. Look these up online. RMD tables, 2024, 2025. They're going to change a little bit every year. Divide 1,000,449 by 26.5, and you get 54,000 because that's going to be paid in the highest tax rate because it's the last money coming out that's just going to be wiped out. You're pulling it from the IRA and it's going straight to the feds. Okay, done in. At which point, because of that plus Social Security, they would have additional investment, additional cash available that they could reinvest. But because it's outside the IRA, I'm only considering IRA assets for the purpose of this calculation. So we continue to do that over, and they end up converting the last $187,000 in year eleven. So then they're 79 and 80 years old and they're done, and it's all in a roth. Never have to worry about it again. All right. Over those eleven years. Ten years, actually, because we didn't do it the first year. Total taxes due of 618,000 either out of pocket or out of IRA. And the Roth at a 6% growth rate, with conversions adding to the balance every year, plus a 6% growth rate. And so I did annual returns. That's also going to be different if it's monthly or whatever, real basic, just to get the idea. So you got 3 million. So you go from 2.1 million fully taxable to 3,041,000 tax free after eleven years. So then I look at it, it's like, okay, that's what it's going to cost. I haven't talked to them. They haven't seen the sheet. I think they've seen the newsletter. I sent that to them when I got it written. I've updated a little bit, so if they're listening, they can go look at that again. It's got a few other things in it. And I'll probably add a couple more things before this actually goes out to the email list. So then you look at that and say, well, let's look at the $600,000. Seems to be a huge hit. So they could draw it out and do less conversion over a longer period of time. But the only difference is it's going to be less at 24%. There's only 2% difference. So you're just extending the amount of the length of time to get to that 600 or so thousand. It's going to cost you. And it might turn out to only cost 590 if you did it over 15 years, say, still, it's pretty expensive. It is not cheap to convert to a Roth, no matter how you do it. Steep price of admission. You need to figure out if it's really what you want to do. So obviously say, well, what if they didn't convert to the IRA? They don't need the money, they don't have to touch it. They've got a surplus from Social Security, assuming they take it early. Now, if they wait till 70, they might draw a little from the IRA just to supplement income. But they wouldn't have to take an RMD until it's using the same factors. They'd have 96,000 they'd have to take in the fifth year or in the fourth, 4th, 5th year. That's why there might be small differences in how the numbers actually work. Pay the taxes, reinvest 75,000 same the following years, and what you get is you would have paid 177,000 in taxes over the same eleven year period, and you've got 2,000,813 in the IRA. But if you look at the reinvested amount, 736, 762, the two together is $3.5 million. So really what this, what the idea comes down to is, for at least four or five years, this really straps them from an additional cash standpoint. And so instead of having additional cash and flexibility, they're choosing to accelerate tax payments to the government and be on the line with discretionary spending. Now, they're a sharp, successful couple. They're not going to have a problem doing that. But you have to decide which is most important to you. Let me get back to the newsletter. You've seen the numbers. So this assumes the maximum conversion. They might do less, but it's going to cost roughly the same over time. So here's the takeaway from all of this. If you're interested. In order to effectively convert assets to tax free, you have to minimize taxes wherever possible. That's obvious. If you're jumping into a higher tax bracket to convert, then it is a waste of time. And money. I talked to another couple earlier this week. They were jumping out of the 12% bracket where they had. They still had plenty of room and we're willing to go into the 22% bracket to convert over a five year period. But they have 1314 years till rmbs are required. We run this calculation from them and show what it would take if they were patient and maybe converted 30 or 40,000 a year for 1213 years, it's going to be a lot more tax effective. They're going to save 10% on the tax bill. That would make a dramatic difference the other way. So if you're jumping into new tax break, it's a waste of money. If you're converting in a similar bracket, it's a wash and you're just making a bet on where taxes are headed. Also, some people, as these guys do have a chunk of non qualified investments that are in appreciated stocks. Highly appreciated stocks, really great for inheritance. And if those drop in value where they're below their basis, they could sell rebuy and they're going to have tax losses they can harvest to offset. So I think for these guys, that would make it a lot more tax effective because you're not actually going out of pocket, you're getting a tax credit for the losses you took. Where these guys, I don't know how highly appreciated their stocks are. They might be a long ways away from being able to loss harvest, but some other people can consider that as well. Under underscores the reason why things could change from year to year. Okay, if tax rates change, market takes a hit, you want to reposition those assets, sell them, take the losses, buy them again at the same value. You're not going to really lose anything there, but you get reportable losses that you can offset your taxes with. Legacy wishes are a core motivation for some who consider converting assets to tax free Roth is far better than an IRA as a wealth transfer tool because they both have to be distributed within ten years. But the IRA is obviously taxable and the Roth is tax free. The Roth may not be the best for maximizing accumulation each over the time period. May or may not. So you have to decide kind of if it's a legacy deal, you have to decide. You want to make it easy on yourself or make it easy on your heirs. Because if you go into a Roth conversion strategy over a certain period of years, you're talking about annual calculations, budgeting, accounting, all the things have to be considered. It's a lot of work. Can be a lot of work. No benefit with CAS. Like I said before, very steep price of admission for a Roth IRA conversion. Each person is going to differ in regards to who they think should bear that cost of admission to it. So my guess is that this couple, if they're listening and talking, or anyone in the same situation, would be well suited to adopt a more moderate conversion strategy. They're going to end up with RMD's and even maybe part of their Social Security in the 22% bracket. So probably best to top it out there if they still want to do it. If they have any tax losses they could take in any given year, they can go over and above that to accelerate it depending on how they got to write off. But I think it's critical. I think it's very important to maintain a good solid base of cash for flexibility, for emergency planning. And this taking the majority of the cash they would have available, that's a dicey position. Now they have places where they can go get it, but not without paying taxes. It's almost never a good idea to go all or nothing on one strategy. Combination of the two and something in the middle makes sense to me. But I said it's going to change every single year. They got to see it on paper. They got to see how it might look if they did it that way, and then dial it back up or down every year depending on the other experiences with the other economic factors in their life. So I might have left a few things out and every situation is going to be different. Did my best to cover it all. That's why I want your questions. How does it relate to you? What are the rules? All the different things you guys could think of? If I get enough questions, I'm just going to go back at this, maybe refine the sheet a little bit. We'll do a question and answer because this is a hot topic. Big marketing pitch for a lot of people. It's been episode 140, a case study on a Roth conversion. My name is Brian Anderson. Appreciate you joining me. If you want to schedule a call to talk about this for you, top right corner, any page on dot schedule a call. I appreciate you joining me. I will see you next week for episode 141. Have a great day. Goodbye. [00:21:14] Speaker B: You have been listening to annuity stray talk. The preceding information is for informational and educational purposes only and does not represent tax, legal, or investment advice. The views expressed by guests on this program are their own and do not necessarily reflect the views of annuity spray talk or no information presented today should be acted upon without meeting with a qualified and licensed professional. It is important that you read all insurance contract disclosures carefully before making a purchase decision. Guarantees are based on the financial strength and claims paying ability of the insurance company. [00:22:01] Speaker A: Our channel.

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