Early Retirement - Financial Freedom (Investing, Tax Planning, Retirement Strategy, Personal Finance)

5 Easy Ways To Know If You Should Do Roth Conversions

July 29, 2024 • Ari Taublieb, CFP®, MBA • Episode 191

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Roth conversions can save hundreds of thousands in taxes when done well, but they don't always make sense for you.

This episode will give you the insight needed to determine if (and when) you should implement Roth Conversions.

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Ari Taublieb, CFP ®, MBA is the Vice President of Root Financial Partners and a Fiduciary Financial Planner specializing in helping clients retire early with confidence.

Speaker 1:

One of the most common questions when should I implement Roth conversions and when do they make sense for me? Because sometimes I can save my clients a whole lot of hassle by telling them not to do Roth conversions, and sometimes I can save them hundreds of thousands of dollars by asking them to do Roth conversions. So you're wondering does it make sense for me and, if so, to what extent should I implement them? That's what I'm going to be going over in today's episode. Thank you all who've been tuning into the show consistently. I'm continuing to try to make the episodes more impactful, with more stories and even more examples, and this is your show, not mine. So thank you, guys, as always. Now I'm going to start with a review of the week Now. This review is coming from what the Fud? Okay, now some of you are like hey, what were you about to say right there? Ok, this is not me, ok, so you can see it on my screen right here. Now. This is in response to a video I did recently about rental income, where I talked about the benefits of rental income but also the hassle of rental income, and they replied saying just had to tear off, meaning, a portion of their home and replace two roofs. I have 10 rental properties. This makes me question the hassle component. It also wiped out two years of profits from these properties. However, they have appreciated well over time. So when we sell is when we'll enjoy for retirement.

Speaker 1:

Why did I choose to highlight that comment? Well, the reason I want to highlight that comment is because it is not black and white investing, financial planning, tax guidance and I'm going to give you two examples today. The first one with real estate, which you're going hey, I tuned in to understand shiny rock conversions or not. I promise I'm going to connect all the dots for you. But regarding real estate, too many people go oh, but the tax benefits are so awesome and look at if this property appreciates and oh my gosh, look, I'm getting all this amazing rental income at the same time while it's going up in value. If all that's happening, I'm super happy for my clients, but sometimes that's happening while it's also incurring large costs like having to fix a roof. That's not really my main concern.

Speaker 1:

My main concern is when I have clients who go. I cannot wait to retire early. They do retire early Now. They have a new job. You know what that new job is. That new job is coordinator, where they are now trying to coordinate while traveling. Hey, did that roof get fixed? And I had the property manager. But then they quit and, yes, it's bringing in more income. And they're wondering do I need to do this for retirement? And guys, I have some people that I'm like yes, this rental property you have is so great, I want you to hold onto it. I know it's a hassle, but look, it's allowing you to retire early. And the client sometimes goes hey, you know, it's not that much work, it's really not that much effort, and I enjoy it. I actually give me something to do a little bit and fulfillment and retirement, and I kind of like it. I go well, then you've got it made. Other people go no, I just have the rental property, because up until this point I thought it was going to be my best investment, but it turns out I should maybe look elsewhere. Great, then maybe we look elsewhere, but I'm not married to one or the other.

Speaker 1:

You can see this person here. He's or she who's doing this, or they. You never know nowadays guys, okay, got to be politically correct here. And when I say that, just so y'all know, my cousin is a they, so they actually listen to the podcast and so I they know when I make those jokes they don't always love them as much as I do when I laugh and do them, but anyway, you guys get my point here. Okay, so you can see here the comment here, from what the FUD? Okay, when they said, hey, I've got to replace the two roofs? Well, that's just hassle, that's taking more headspace, that's them going. Oh, you know, yeah, I really know I don't love having this property and I've got to do the roof, and they don't love the management side. Some of you do love the management side, so, getting off on a little tangent here, but that's the rental income and I just want to highlight that comment. For any of you that have real estate or considering real estate, make sure you're identifying it in light of your whole financial plan.

Speaker 1:

Now back to the episode. So, regarding Roth conversions, I promise I'll give you two stories. The first story is in. A lot of you have heard this, but some of you I know have not, because you have referenced in the videos. Hey, do you mind sharing the Roth conversion story you say you're always talking about, and so I want to give it to you now.

Speaker 1:

So a client came to me and he said Ari, I'm going to get killed in taxes. I need your help. I said okay, what would you like to do? And they're like I think you're supposed to tell me that. I go, you're right, that is what I'm supposed to do, but I want you to tell me what you're looking for and for. And they're like well, I'm looking to like not pay more taxes than I need to, like, isn't that why I'm paying you? I go yes, and you are going to get killed in taxes because you have these required minimum distributions. And they're like when are those going to start? I go for you 73. They go. I think that's wrong. I go what do you mean? They go well, I heard someone else say 75. I go yep, for some people it's 75. And for some people it's 73. And they go are you just making this up? I'm like no, this is my actual client, okay, so if they're listening right now, they're like yes, I did ask these questions.

Speaker 1:

So then I said you should do some of these planning considerations, like a Roth conversion, tax gain, harvesting things like this. You should do this sooner than later. And they're like why? And I said well, the brackets are going to change and so if we wait too long, we're not getting as much bang for our buck, meaning we could do a Roth conversion pay a little bit in taxes versus paying a lot in the future and you will save more money. And they're like okay, I got that and I go okay, so here's what I want you to do. Okay, I'm going to build this whole analysis and I'm going to give it to you and I want you to tell me what it says. Okay, they're a little confused at this point.

Speaker 1:

I said flip to the last page. They go, it's like 40 pages. I go. I know I do it to humor myself. I've done a lot of conversions and I just, you know, sometimes want to have my own fun. They're like okay, that's a little weird, but go to the flip to the last page. And I go thank you, what does it say? Getting killed in taxes? I go Nope, that's not what I said. They go Huh, I go. I said you are going to get annihilated in taxes, not killed. They're like Huh, I go. I said you should also do it sooner than later because the brackets they're going to change. You get more bang for your buck. They're like hey, would you stop beating around the bush? What's the deal here? They're very transparent.

Speaker 1:

People like me and I said I want you to go take a cruise with your mom, who you told me is not in good health, and I want you to love doing it. If I thought you were in a position where you would either have to go back to work or run the risk of running out of money, I would not tell you to do that. I need you to do it. You are retiring so early at 55. We have plenty of time to do significant Roth conversions and you are not going to look back wishing you spent more time doing Roth conversions. You are going to wish you took that trip with your mom Now. Please go do it or I'm going to be pissed. That's what I told them.

Speaker 1:

They went oh so this isn't like a financial answer. And then, like you, just kind of do that, I go. No, it's a lot deeper than that. So tax planning is not okay. What bracket are we in and do we fill that up? Yeah, that's a big piece of it, but that's not the only reason why.

Speaker 1:

That's the first story. The second story is a client that came to me and they go. Ari, you're going to be so impressed. I already did Roth conversion. I go cool, what'd you do? They go. I did this and this and this, I go.

Speaker 1:

Okay, my analysis shows right here I wish you did nothing, they go. Why nothing? I go? Because you are converting too much. It would be better that you did nothing at all. They're like I don't understand. I've got these distributions and this and this and I go.

Speaker 1:

How much does your neighbor wanna spend? Like, what the heck does that have to do with any of this? I go just. You talk about your neighbor a lot in our meetings and how you like to spend more than them, which is not good or bad. I'm a spender as well. I'm just want to hear from you they go well, they spend about half. I go well. Their required distributions are going to be a lot higher than yours, and so I don't believe in comparing anyone's success plan to another plan.

Speaker 1:

That's not what I'm saying. What I'm saying is you want to spend way more, and because you want to spend more, that's good. You're going to enjoy more of these efforts because you shared with me early on. That's important to you, but your distributions will not be as high. You are not going to be forced to take out as much money because you are spending more of your money. They are not.

Speaker 1:

So I do not want you to implement Roth conversions. You are implementing them because it's a fancy technique that you saw on YouTube and you wanted to go along with it. And they're like, yeah, you kind of called me out there and I did not like hearing that, but I see your point, which was them saying that's accurate. So the point here is Roth conversions is something you want to consider doing. It's not something you want to do.

Speaker 1:

So what are the five things that you should look at? Well, the first thing you should look at and I've got my list here. So if you're listening on the podcast app, keep listening. If you are on the YouTube channel watching this video, you can see that my head is looking at my different points here. So, in case you're wondering, why is he looking at outer space, I'm not. I just wrote down my five situations where this does make sense. So, before I go through the five, what on earth am I even talking about right now? Some of you are like, oh, I already get all this Roth conversions. I've been listening for a long time, totally sold on when it makes sense, when it doesn't just want more clarity. Some of you are like I don't know what you're talking about right now. So for those that already do know it, great, you can skip the next 15, 30 minutes if you will, but a Roth conversion is where you go.

Speaker 1:

I want to intentionally pay a little bit in taxes to avoid paying a lot in the future, and it might make sense for me to take advantage of these brackets Maybe it's very low brackets because you're retiring early so that in the future you're not forced to take out so much money when you have social security and you've got required distributions and you have a pension and you inherited this account from your mom or your dad, and now all of us or you're they, you know, you never know and now you have to actually take more money than you'll ever need, and that is why we do tax planning. So the point here is if you do this well, you could save hundreds of thousands of dollars or avoid unnecessarily pay more than you need to. So the first reason when it comes to Roth conversions, the first thing I want you to look at is is this a macro or micro conversation. In the micro you might go oh, the tax brackets show this and it looks like I should convert and it's optimal like this. But it turns out you really are looking forward to some massive travel in retirement and you're going to be spending a whole lot more in your first 10, 15 years from, let's call it, 60 to 75, then maybe you're gonna taper that down. Well, if you're gonna taper that down, the truth is you might be spending way less. So you don't wanna make these projections based on what you're gonna spend the rest of your life.

Speaker 1:

So, quite simply, if you're looking at the macro side of things, we wanna go okay, great, what do we wanna accomplish in life? And some of you are like that sounds a little woo-woo for me. What does that have to do with tax planning? I go. I like to start there. How much would you love to spend? How much would you love to give? What is the point of why you made all this money? Great, once you identify that, now my whole thing is I want you to optimize your taxes, but too many, ari. What if I don't do these conversions? Excuse me, ari? What if I don't travel and I do these conversions. Instead, I'm going to optimize my taxes. I go. If you really want to be the best optimizer, go work for 40 more years and your withdrawal rate will be like really low and you won't ever run the risk of running out. They're like that doesn't allow me to travel, I go.

Speaker 1:

I know the goal in life is not to optimize just for the sake of optimizing. It's optimized after you've determined everything you want to do in your life. So the point here is, quite simply, if you're wondering what should I do? Well, are you going to be in a higher tax bracket later, yes or no? That is going to give you a lot of insight. For example, let's assume you retire right now and you're 55 and you're in the 12% bracket. Should you pay taxes at 12% to avoid paying taxes when you might be in 32%? You probably should. Let's assume, though, right now you are in the 20, let's just say, 28% bracket, and now you're wondering you know, what should I do? Should I do the taxes? Should I not pay the taxes? Well, if in the future, when you're bringing in other income and you've got a brokerage account and you might be in the 22% bracket, maybe you shouldn't do that, maybe it wouldn't make most sense. So when I'm saying 28, I'm not literally picking a federal bracket, I'm just what if, between federal and state, you're in that bracket? Just hypothetical.

Speaker 1:

So that's number one. Number two required distributions. Your spending might go up, but your required distributions might go up faster. So, for example, let's assume you have a million dollars and every let's just say, eight years it doubles, because if you look at the rule of 72 and you invest really well, that's not unrealistic. So you have a million dollars to age 60. Now you're 68 with $2 million. Okay, now you're 76 with $4 million.

Speaker 1:

$4 million, if I just take out my very basic calculator here and I take out a required distribution of $4 million, that is $152,000, which means you are going to be forced to take out $152,000, adjusted for inflation. Okay, and you might have a social security and let call that sixty thousand dollars between both of you, probably larger than that. Well, now we're at 210 000. Now let's assume there's an inherited account that you have to take distributions from. Well, maybe we're at 250 or 300 000. So the question is, do you need 250 or 300 000 to do everything you want to do? I asked that to my client and they said no, you're not listening to me, ari, I don't need $250,000. I go, I know that, and the government does not care, and they're going to force you to take out more than you will ever want because they want their share. And so, if you know, you are going to be in a tax bracket where it's going to be pushing you to pay more than you want to at what we call the not so fun rate.

Speaker 1:

You want to consider Roth conversions Doesn't mean you want to consider it today, but it means you want to consider it generally, when your income begins to decrease or if retirement is right on the horizon. There. Number three state tax brackets. Are you planning to move? So when a client comes to me and goes, you know, ari, I don't know, but I want to optimize my taxes and I'm here in California, just like you. You know what it's like. We're getting killed. I go, this is true. They go.

Speaker 1:

Well, I'm thinking about moving to Florida. I go great, here's the tax impact. And normally they go. That's significant, that's like hundreds of thousands of dollars. I would save by no and I'll go. Well, then maybe you shouldn't do it, but you showed me all the tax savings. I go correct.

Speaker 1:

That is one consideration. That is not the reason to move to another state. I want you to consider going. Wait a second, what if I move to Florida? What if I move to North Carolina? What if I move to Nebraska? What is essentially the cost of living, meaning how much would it cost me to literally live there? And then what is the cost of enjoyment? And some people go well, it doesn't matter. Look how much I'm saving, okay, great. Other people go no, I don't care what I'd be saving. I don't have family or friends there and it's not in your family, so I don't want to do that. So don't do it for the sake of doing it.

Speaker 1:

But just for an example here, if you're moving from California to Texas just an example. Okay, I know a lot of people are doing this you might go wow, I'm going to be in a much lower tax bracket because I don't have to worry about those state taxes and so maybe I should be doing, you know, less conversions, because you know right now I'm in a high tax bracket state and I'm going to be, in the future, a lower tax bracket state. Great, that makes a lot of sense. Some people do the opposite. Let Some people do the opposite. Let's assume you're in Texas and it goes to California. Well, right now you might be going. Oh right, let's just assume you're in the 12% federal bracket and right now you're in Texas and you are paying 0% state. In the future, you're gonna be paying 6% state taxes.

Speaker 1:

Some of you are like why would you do that? Well, some people wanna move back to California. So now what you're looking at is a total of 12 plus the six. That's 18. But wait a second, what about level two to this re? Well, level two is tax brackets are changing. So 12 today, the 12 tax bracket, is going to become the 15 tax bracket after the current state of tax brackets get. Essentially, it's called sun setting and now all of a sudden we have higher tax brackets. So so some of you are like yeah, but if the brackets change, shouldn't that change conversions? I should do and I go yes, so traditionally, you're in the 12% bracket. That's going to move to 15. So some of you are like oh, maybe I shouldn't do the conversions, but you are in 12% in California plus 6% state. You're at 18. 18 is still higher than 15. And some of you are like what's the big deal here. 1%, 2%, 3%, I go. This is often the difference of legitimately hundreds of thousands, if not millions, of dollars, which I've shown on many occasions on my YouTube channel, where I show you exactly what this looks like in terms of the conversion impact it would have on a plan.

Speaker 1:

Number four is charitable giving. Many of you have heard of qualified charitable distributions QCDs but you are eligible to do qualified charitable distributions once you are 70 and a half, and what that means is you can directly give money from an IRA to a charity. And some of you are like why would I ever do that? I don't want to pay taxes and then pay the charity. You do not have to. That's what this whole thing is about. Pay the charity you do not have to. That's what this whole thing is about.

Speaker 1:

Qualified charitable distributions lets you move money from your IRA into a Roth. Excuse me, look at me, I'm already getting excited about Roth conversion. I'm so IRA to Roth, I'm stuck in my headset there. Ira it lets you move money from your IRA to your charity of your choice and you do not have to sell and pay taxes to give it to the charity. You get to move money directly from your IRA to a charity. Some of you are like why would you do that? Well, you don't have to.

Speaker 1:

Let's assume you are given a charity $5,000 a year. If you just gave them $5,000 a year, that'd be very kind of you. But you're not getting, essentially, a tax benefit for it. These are after-tax dollars. What if you could give from pre-tax dollars dollars that you got a deduction for up front in your 401k? You then move to an IRA, didn't pay any taxes, and then if you were to take it out and live on it, you'd have to pay taxes. But you don't have to because it's all coming from your IRA directly to a charity and once you hit this age they let you skip that step where you can just move the money directly. That's going to lower your required distribution. So that's number four. And then number five, which in my opinion is the biggest one, is legacy.

Speaker 1:

Let's assume all of the monies are in your name and you are the primary breadwinner and you've got the healthy IRA. Well, if you pass away, well, now your spouse is going to inherit this and they have to begin taking distributions. I've done a whole separate episode on how to think through that type of planning considerations. But this is not just your tax, this is not just your spouse's tax, this is not just your child's tax. This is, you know, great-grandchildren potentially paying taxes on these dollars. So I want to make sure that you're intentionally thinking through this.

Speaker 1:

Now, when we're talking about tax planning and all the planning here, I always leave with this kind of last story here. Now, the reason I like to tell this story it's not going to be applicable to a lot of you, but some of you. It's going to make you think a little differently, because when you do a Roth conversion, you are intentionally saying, yes, I'm happy to pay taxes today a little bit, sometimes more than a little bit, to avoid paying a whole bunch later. Now I want you to at least consider not saying you have to do this. But let's assume there's a child you have and, god forbid, something happens to you. And now they inherit these dollars and they're in a really healthy tax bracket because they are now a physician and they are just crushing it with healthy income.

Speaker 1:

Well, I've seen situations and I've talked about it where children go I'm not gonna be a physician anymore. That's too much work. Look at, my dad just gave me all this money and so because of that and my dad worked so hard for this I no longer am going to be a doctor because I don't want my dad to have to have paid so much taxes on what he worked so hard for and I'm no longer going to be a physician. So I went to my client at the time and I said do you realize what your child's doing? They're like no. So we talked about the whole situation. The child's like Ari, you're missing the boat here. I know I could make more money by being a physician and inheriting these dollars from my father, but in this case you don't recognize that.

Speaker 1:

My father is the first generation, worked very hard for these assets and it crushes me to see everything he's worked so hard for get taxed at 50 plus percent. And I go. I don't blame you, I don't blame you at all, I just was not. I needed to ask better questions. They go, thank you, and after long, educated, long conversations, they are not going to quit becoming a physician, but they considered for a moment going wow, financially I know it doesn't optimally make sense, but you know, I just don't want my father to be crushed in taxes which really means I'm crushed in taxes based on what he worked so hard for. So some of you are like, hey, what's the point of the story? Well, the point of the story is you don't want to invest so well that your children no longer need to work hard or don't take a job that they otherwise should have, because they feel bad, that they're essentially getting taxed on what you work so hard for. A little crazy, and I don't see it that often, but there's been a few odd situations where, because you invested so well, your children altered their future, and that whole concept has always blown my mind.

Speaker 1:

So, roth conversions, tax planning, withdrawal strategies all of these different concepts this is what we help clients to do. If you're looking for this type of holistic guidance, I encourage you to reach out. At the moment, we do have a $2 million minimum, not because we're mean, but because we want to make sure, when you come on board, you are getting unbelievable service, and we can only service so many people. There's a reason I don't want to hire 400 new advisors that are giving everyone average service, and the reason for that is I care that you come on board and get unbelievable service. That's what I care about. Now, if you're going, you know what? I don't have 2 million yet, but I will one day. But I still want help and I still need some guidance.

Speaker 1:

I recommend checking out my Early Retirement Academy, which allows you to play around with your own projections, these whole tax planning strategies and tools. It lets you do all of that good, fun stuff, but with a whole lot more. So, of course, I'm with you along the way with videos to show you how to implement everything the way it should be implemented, so you're not just out there going, hey, what buttons do I click? So I'm with you the whole time. And, guys, that is it for this episode. If this was helpful, please like it and comment if you learned anything about tax planning today. Thanks, guys.

Speaker 1:

Thank you for listening to another episode of the Early Retirement Show. If you have a question that you want answered in a future episode, you can always go to my website, earlyretirementpodcastcom. That's earlyretirementpodcastcom, and you can go ahead and submit a question that I'll look to answer in a future episode. Thank you all for listening. Please do rate it, review it and share it with someone who you think would benefit from this information. If there's anyone out there that you know, I certainly appreciate it and I will see you all each week. Hey guys, it's me again. Please be smart about this. Nothing in this podcast should be construed as financial, tax or legal advice. Consult with your tax preparer or financial advisor before taking any action. This podcast is for informational purposes only.