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

The Complete Guide To Implementing Roth Conversions: Tax Strategy

August 26, 2024 • Ari Taublieb, CFP®, MBA • Episode 194

Share episode

Roth conversions can add millions of dollars to your retirement, but too many make mistakes and implement them at the wrong time, not at all, or in excess.

Understand the role of when conversions make sense and when they don't. That's what this episode is all about.

Begin optimizing what you've worked so hard for and implement conversions when applicable. 

Create Your Custom Early Retirement Strategy Here

Get access to the same software I use for my clients and join the Early Retirement Academy here

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:

My hope is this is the only episode you ever have to listen to. If you want to implement a Roth conversion, you will know if you should implement one, if you should not implement one, when it makes sense, when it doesn't all that good stuff. Now I'm going to start with a story and this is a real story, before I get into some specifics. An example, a review of the week, all of that good stuff. So a client came to me and they're a current client now. But when they came to me, they said Ari, my tax preparer sucks. That was the word they used. Okay, I said a little bit of a weird word, but okay, why do they suck? They go. Well, they didn't even tell me that tax brackets are about to change and if I do a Roth conversion, it's going to actually save me more on taxes now versus later. I said, okay, what else they go? They didn't tell me, if I inherit some of this money from my dad, that there's a schedule and I can optimize the way I pull income based on my income every year and all this stuff, I go cool, what else they go? They also didn't even tell me that, based on my current tax bracket, I'm in if, when I retire, I might be able to sell some of the stocks I've purchased and pay 0% in taxes. And I said, okay, they're never going to do any of that stuff. And they're like you agree they suck. I go no, what you're asking for is different from what we do. So what they do they're a tax preparer, their jobs to repair your taxes and go John Jane, you know, if I do a good job for you, would you pay me again next year? And it is a valuable job. They actually love us tax preparers. We do tax planning, which is all of the forward looking aspect of tax planning. So how do we minimize your lifetime tax liability, not just a single year?

Speaker 1:

So I know a lot of you are just listening on the podcast app, but if you're actually watching this on YouTube, I'm pulling up a checklist just so you can see the difference, but I'll explain it, which down here in the corner you can see it says tax prep services. They are going to prepare your return. Now, that's what I just shared from this person who came to me and they were upset. They're like why isn't my tax preparer doing the stuff you're talking about? Well, they're never going to. They probably have 400 clients and they're just so swamped they're trying to just file returns and they're probably playing catch up most of the time.

Speaker 1:

We wanna be proactive so as things are changing, we can adapt. So what you can see on my screen here, this is what we're doing, and, transparently, this is the main reason people are working with us, because it's yep, I need help with all the conversions and the harvesting and charitable giving and planning for Irma and estate planning and healthcare subsidy planning and real estate and what if I inherit a lot of money and equity compensation and for my personal business and provisional income and all of this stuff that you're seeing here. This is what a tax planner does. So tax preparers love us because we give them all the information they need to prepare their return, and we love them because they file it and so just want to make sure that you guys understand and maybe even stop beating up your preparer. Now some of you are like, look, I am my own preparer. So others of you are like, nope, yep, this was helpful because I was kind of hoping my preparer would do that and I now understand why they are not doing that. So, with that being said, that's a quick, dopey story, but what I want to now go through is when does it make sense to do conversions? Give you all the insight you're looking for. I will start doing so by showing you two reviews of the week.

Speaker 1:

So, if you don't already know, my name is Ari Taublieb. I'm a certified financial planner, I'm the host of the Early Retirement Podcast and I'm the vice president here at Root. Now, before I get into the fun, if you want to work with us and our team, there are two ways. The first way some of you go look, I don't have $2 million yet, I will one day. Or I just want to be my own advisor. Well, if you want to run your own projections and determine when you need to do conversions and go into all the weeds for what we're going to be discussing today, or you just want to optimize your financial strategy for a few hundred bucks.

Speaker 1:

You can see I have an academy. It's not one-on-one guidance where you're talking to me. Now you do have me with custom videos helping out, but that is why I do that option. If you're going, no, I want to work with you and your team one-on-one. That's where you can apply to work with us. Right now there is that $2 million minimum, and then right now I know there's a delay in just booking. So some of you are like I'm trying to book but it looks like it's five months out. I go right now we're working on adding new team members, but I personally refuse to bring on more clients and have them get average service until we actually have the capacity to serve you in the way you deserve to be served. So we are taking on new clients a limited number every single month so you can go ahead and look in the links for all that good stuff. Now that's the logistic stuff I have to get out of the way.

Speaker 1:

Important stuff that I'm excited to talk about right now is look at this. So this is the first comment and I'll read it. I know a lot of you are listening on the podcast app right now. It shows me all of the stats. So I mean not all of the stats I don't know where any of you guys live or anything like that but it shows me a lot in terms of who's listening audio to video. About 40% of you guys, so approximately right now it's wild to even say, but the podcast is about 55,000 downloads every month and so 40% of you are just listening. The remainder are on video. So because of that, I want to speak to both of you, and I personally listen to a lot of podcasts and it's annoying when they don't explain things clearly. And I'm driving so I totally get it, so you can see here.

Speaker 1:

This comes from boating Charlie one, and boating Charlie one commented on a video I did where I said are you 60 with all pre-tax assets? How do you minimize taxes? Essentially do Roth conversions. And he said hey, this was great, but it doesn't take into account the lost income from the money you took out for the conversion to pay the taxes. Now, if some of you are listening going, hey, what the heck is a conversion? I'm going to give it to you in just a second, so just bear with me for two more. One more minute, not two. Those tax dollars you decided to pay today could have kept growing tax-free in the pre-tax account and made a lot more money to pay the future taxes with. Can you figure out how much tax will be paid each year? You did the conversion and use the standard growth you would have gotten if I left in the pre-tax account. I feel it'd be substantial.

Speaker 1:

I know what all of you are thinking right now. What the heck did? He just say Okay, let me give it to you in English. This is like when you go to the doctor and I did this personally. I went to the doctor months ago. I said, hey, doc, that was great, sounded great, I think you felt like you did a good job there. No idea what you just said. So, like, give it to me now.

Speaker 1:

What they're saying very simply is if you do a Roth conversion, let's assume you go. Yeah, first of all, when should I even do a conversion? We're going to talk about that. But let's assume you're familiar with what a conversion is. When you move your money from an IRA to a Roth IRA, you're doing that to say I'm happy to pay a little taxes today so I don't pay a lot in the future. That's all it is. It's very simple.

Speaker 1:

So what this person is saying they're saying hey, this was a good analysis. But what I want more insight on is if I want to move $10,000 from my IRA to my Roth IRA, you're telling me I have to pay $2,000 in taxes to do that, to make the move. So I give the government $2,000 and they'll move $10,000 for me into this Roth IRA. So I've got 10, I'm paying 2,000 to move it. So now 8,000 only gets moved over. So what this person is saying is they're saying, hey, is this analysis taking into account that $2,000 that would have just kept growing? What if I did not pay the 2,000 and I let 10,000 keep growing? If I let 10,000 keep growing, wouldn't that be better than letting 8,000 keep growing? And so what I'm going to go through for this person is help them understand how to think through this, because they're not wrong, they just need to understand the analysis. So, first, what we're going to do, I know a lot of you are once again on the podcast app.

Speaker 1:

If you're on YouTube watching this, look at what's on my screen right here. Okay, this is the coolest gift I know. I'm trying to talk in the audio here. It is a cauliflower shirt. Okay, this was given to me by a listener. This is because you guys are awesome. The cauliflower shirt. What the heck does this mean? So, so I like to explain things in English, because when I go to anyone and they use fancy words, I'm like, hey, are you just stroking your ego right now? Like what's going on? Like I just need to understand this. So the way I explain conversions is like eating cauliflower.

Speaker 1:

I am asking my client. I will say do you want to eat only cauliflower when you are 75? And they're like no, I like steak and I like pasta and I like other things. I go, cool me too. Well, you're gonna have 80% cauliflower for the rest of your life, from 75 on. If we're not strategic here, they're like what? I go? Yep, because you saved and invested so well into your 401k.

Speaker 1:

Let's assume you're 55. Right now You've got a million dollars and it doubles in 10 years, conservatively. Now you have 2 million at 65. Now you have 2 million at 65. Now you have 4 million at 75. What happens is you're you have to take out, starting at 3.8% of your pre-tax balance at 75. So for most of you some of you at 73, it's based on your age, but most of you will be 75. As of current law, this can always change. So you have $4 million at 75, just a hypothetical and you're going to be forced to start by taking out 3.8% of that $4 million, which is $152,000. Now you probably also have social security turned on at that point, so maybe that's another 50,000. So now you've probably got 202,000 coming in, but you also have dividends and interest and maybe rental income and maybe a pension.

Speaker 1:

So maybe like 400,000 is coming in the door and my clients will stop me and go look, all right, I don't know if you're listening, I don't need $400,000. I go, I'm listening, and the government does not care, and I don't want you to get killed on taxes. And so we need to be strategic here so you don't only have to eat vegetables in retirement, like, okay, I kind of get it now. So what I'll ask my clients to do is to temporarily not forever temporarily pay a little bit in taxes today, eat a little bit of cauliflower to avoid having to eat a lot in the future. That's the whole premise of why we do this. So they go yep, I'm on board, I get it. I said cool.

Speaker 1:

So here's what I want you to think about when you're thinking about did you do a conversion or should you not? A lot of you guys have head trash around hey, should I do this, should I not? My neighbor says do it. I don't know if I should. I'm gonna give you examples, but I'm gonna walk you through the five things real quick so that you do not have to worry about this. If you have worried, if you do not have a healthy pre-tax account, I want you to ignore and not worry about this stuff ever.

Speaker 1:

So if you have a business that you just sold for $10 million, I have a client. They were doing really well, they were making about $250,000 a year. Then their business just went to the sky and they sold it for about $6.5 million and they're like oh, we got to do a conversion, right? I go no, that's all after-tax money you have, so you don't have to worry about that. So if you have a business or you have healthy brokerage assets, a 401k, that that is where an RMD required minimum distribution would come into play on something like an IRA or a 401k. On anything else like a brokerage account or a Roth IRA, don't worry about it. So some of you should consider doing conversions, even if you have a small amount in your 401k, because you might have $300,000 with $5 million from a business you sold, but the $300,000 will just keep growing. A business you sold, but the 300,000 will just keep growing and then eventually it's 2 million and you're going to have to take distributions.

Speaker 1:

So in all of that like, why are we even talking about this? Everything you delay and then you get hit on later is hit at your highest marginal bracket. So I have clients spending 50%, like literally they're paying 50% taxes on what they've worked so hard for, which is insane. So the point here is if you are going to be in a higher tax bracket in the future. So if you're like here I am, right now I'm making 250,000 a year, I'm in this current bracket. But in the future, once I have excuse me once I've required distributions, once I have social security, once my pension's turned on all these things moving on, once that happens, I'm going to be in an even higher bracket.

Speaker 1:

Well, maybe you should do a conversion to pay a little bit today to avoid a lot in the future. If you're like look, right now I'm 55, I'm working, or I'm 50 or I'm 45, whatever, I'm enjoying my life. Things are going well. I don't know exactly when I want to stop working. Well, there might be a day that you're like I want to stop and you're 57. Well, if you're 57, you might be able to go. Well, I don't have social security. I don't have any. I have a brokerage account I call it the superhero account to help you bridge the gap until 59 and a half, and I can live off of that. Well, you can live off of that and you can implement Roth conversions really intentionally pay maybe 10%, 12%, 15% taxes to avoid paying 25, 30, 35, 40% taxes. That's a big difference. That's millions of dollars that we're talking about, that you will be saving in taxes.

Speaker 1:

That's why this is so important and why I get so emotional about this stuff, because some clients go well, if I just would have done conversions, I could have retired five years earlier. I go yeah, that's the power of good planning. It's not me just saying this to save you on taxes for the sake of it. This is me saying look, if you're smart about money, you might not have to work as long. That's a pretty special thing to think about. That's why I love this stuff. So I'm not being mad at you guys. I'm just saying some of you guys go yeah, I think this maybe could help. I go no, it's not a maybe, that this for some of you, if you do it and I've had people come and go yeah, I did a conversion and I'm like I wish you did nothing. They're like why I go?

Speaker 1:

Well, based on where you are and your spending and tax brackets and what you want to do. You'll be better off to do nothing at all and you're actually, by doing conversions, forcing me to have to maybe tell you you have to go back and work longer, and I've had those instances. So you want to be careful when you're doing this. But the first question is will I be in a higher tax bracket in the future and do you have a healthy pre-tax account? If so, boom. Those two questions. You're probably going to want to consider conversions at some point. Number two required minimum distributions. What this means is you're going to be forced to spend a good amount of money at 75.

Speaker 1:

Some of you are like look, what if I do a tremendous amount of luxury travel and all this awesome stuff from I don't know 60 to 68, and then I don't want to spend as much from there because I did the majority of my travel. Well, if you did that and you spent a lot of money, I'm like, great, I'd rather you spend more money and do less conversions. A I'm like great, I'd rather you spend more money and do less conversions. A lot of you are gonna be guilty of letting the tax tail wag the life dog. That's where you go. Oh my God, I wanna do all these conversions.

Speaker 1:

I had a client come to me and they said this they're like help me optimize my conversions. I'm like okay, I don't want you to do any. They're like, but you said I was gonna get killed. I go yep, you really should do it. They're like then, why zero? I go well for your situation. You told me your mom's not in good health and I'd rather you spend more on this big cruise ship. You said you wanted to take with her and next year we can do some of these conversions. And then you told me, personally, you don't wanna do international travel. So because you're doing domestic, because you're doing domestic, I want you to do this level of conversion and travel to this degree. And they're like oh so, don't just like, not do conversions. I go no, don't just.

Speaker 1:

Some people come and they're like I just need to save on taxes, no matter what. I'm like great work 40 more years and move to Florida, like. So some clients are like look, I take that personally offensive. I live in Florida. Okay, I like Florida, let's be clear. Okay, I like their tax code a lot. But my point here is don't just move to Florida for the taxes. Now some clients are like, look, and this is my third point here Pretty good transition. Okay, guys, three and a half years into podcasting and I'm finally learning how to do this a little bit. So planning to change states was my third point here.

Speaker 1:

Some of you are like, look, I don't know where I'm going to live in retirement, but maybe I moved to Florida or Texas because of the tax or whatever and I'll go. Great, let me show you the magnitude before you make the decision. And they go wow, that's a big difference. That's $700,000 over the course of my lifetime. I go yeah, I mean, you'd still be okay if you didn't do that, but it's a big difference. And one client said it's a big enough difference for me. I want to spend more and I don't love being here. And they were in Oregon. So they moved to Florida. Great, good for them. Now they're spending way more and they're really happy.

Speaker 1:

I have other clients. I showed a similar analysis too and I said what if you moved? It would be the difference of about $400,000. And they said would I still be okay? And I said, yes, there'd be a difference of $400,000, but yep, you would be okay.

Speaker 1:

They said well, then I'm not gonna move because my friends and family are here and yeah, I know I could save more on taxes, but I don't wanna live there. So for a lot of you you're like I don't care where I live, I just wanna be. Well, great, start doing some analysis. Others of you are like no, I would like being where I am, it's just. If it's a no brainer, I wanna consider it at least as an option and I like showing clients that as an option. So if you're planning to change states this is gonna get into what we're discussing and you wanna do a Roth conversion, well, if you're gonna do a conversion, maybe wait until you're in that state with a lower tax burden so that you get to save more on taxes. If you're here in California and you do a conversion at the 12% rate just federally, should I say 12% you have to pay another 6%, likely in California taxes. So that's an 18% tax on the conversion versus in Florida or Texas. It's just the 12%. So that 6% tax savings. It's significant. So something to consider. 12%, so that 6% tax savings, it's significant. So something to consider.

Speaker 1:

Number four is charitable giving, which is essentially if you're going to be doing charitable giving anyways. What you can do is you can move money from your IRA to a charity of your choice and that fulfills your required distribution, which allows you to do charitable giving and minimize your RMD. You can also potentially do a donor advised fund. This is a more a little fancy tactic but for a lot of you it's applicable where, if you're doing charitable giving or considering it, you can set up your own foundation. It does not cost $12 million. Generally. It makes sense if you're doing charitable giving in excess of 10,000 a year, generally not all the time. But what you can do is you can essentially give to your own foundation. So I would give to the Taublee Foundation. That's my last name, taublee okay. I've gotten Tabooli and Teletubby and you name it okay. So what I can do is give $50,000 to the Taublee Foundation. Now the Taublee Foundation can give money to any charity and I get a big deduction in the year that I do that. So let's assume I bought Apple stock for $10,000 and it grows to 50,000, awesome, versus me going and selling that and paying taxes and giving to the charity every year where they actually get less money because once again I had to pay taxes. Well, I can just give that appreciated stock position to the Taublee Foundation, in that one year I get a huge deduction and I pair it with the year where I get a big conversion which allows me to minimize more of my taxes, save taxes over the course of my lifetime. So that's, on the charitable front, the number five.

Speaker 1:

The last point here on once again, does a conversion maybe even make sense is legacy planning. Some of you are like look, if something happens to me, all this is going to my wife and then she's going to have to inherit this and pay a crazy amount of taxes. Others of you go I don't have specific heirs and because of that don't really care what happens. I mean I want to choose where it goes, but that's not a big concern to me. And if you don't have strong legacy goals, roth conversions should not be as applicable to you. If you're like, no, I don't want my spouse and children to get burdened with a huge tax burden. And you know, if I've got five million bucks and now my kids are making a healthy income and they have to pay taxes based on their current rate and you know they're crushing it as a doctor, well, that could happen and I've seen that case as well. So if you're listening to all of this stuff going, look, none of this applies to me. I'm not worried about required distributions, I'm not going to be moving states, I don't do any charitable giving, I'm not worried about my tax bill and I have no legacy planning goals. Then don't do a conversion If you're like. No one of these, if not all of these apply to me. Well, this could make sense.

Speaker 1:

So let's go to my examples now and get you the hard data. So, in terms of my example, I have a few here. So let's assume the question that was brought to me once again was essentially, how do I know how much conversions I should implement? So an example here. I've got it on my screen here and I'm going to read it out for you. But if you're on YouTube, once again, you see me looking over here. I've built out my example. So let's assume you do a $10,000 Roth conversion at 20%. Okay, that's a $2,000 tax bill. So you pay 2000 in taxes. 8,000 goes to the Roth IRA. If that 8,000 doubles, you now have 16,000, eight times two, and now it's growing for you and it's all tax-free, beautiful, beautiful. So all I did.

Speaker 1:

I said hey, client, based on your current tax bracket, let's assume you're 55. You retired early. You have very little income, maybe some coming from dividends and interest, but in this example, no rental income, no Social Security, nothing crazy like that. I want you to pay 10% in taxes. And they're like what the heck? What's going on? I go, just kidding, I was trying to keep it fun here. I want you to pay 20% in taxes. And they're like why are you making me do this? And I'm like well, I want you to pay 20% in taxes today because 20% of 10,000 is a very small amount. That's only 2000. Imagine 20% of a hundred thousand. Well, they're like I don't want to spend 20,000. I go, I know that's what I'm trying to avoid. So by us paying a little bit today and it grows, you're saving a lot in taxes. If you want to quantify it for yourself while you're listening to this, go into the academy and play around with the conversion tool and you will see it for yourself.

Speaker 1:

Now, when I'm doing this, what the question was original question was hey, what if I didn't pay that $2,000 in taxes and I just let my $10,000 keep growing and I avoided any of this stuff you're talking about. Well, let's talk about it. Let's assume that 10,000 kept growing and it doubled and now it's $20,000. Okay, so in the first example you have 10,000, you pay 2K in taxes. 8,000 goes to your Roth, grows tax-free, doubles to 16K. In this new example, you don't do anything. I just said completely avoid it and you do no conversion and you let your $10,000 grow to $20,000. Well, what is 20% of $20,000? That is $4,000 people. What does that mean? Well, in my first example you have a Roth conversion where you pay the 2K I know I'm explaining it again and again, but it's want to harp it down here. You pay the 2000 and now you have 8,000, that8,000. That doubles.

Speaker 1:

$16,000 is tax-free, never pay taxes, ever again. If that $16,000 keeps growing and growing and growing, you never pay taxes. Versus example one your $10,000 grows to $20,000. You've now got $20,000 and now you pay $4,000 in taxes. So you pay $4,000 in taxes because at some point you have to. And let's assume it's the same 20% tax bracket you're in. Well, now you have $16,000 because you just paid 4,000 taxes. So the only difference here there's no difference in terms of what you're ending up with If tax brackets were to stay the same forever, and that's why I use this example.

Speaker 1:

If tax brackets stay the same forever, there's no difference Whether you pay 2,000 now or 4,000 later. You both have $16,000 at the end. The difference is the first person has it all tax-free. Now they have $16,000. That once it grows to a million, they never pay taxes ever again. The other person, when that $16,000 keeps growing, well, they're going to have to pay taxes on that when they eventually take it out. So this is quite simply the benefit of a conversion is yeah, you happily paid $2,000 in taxes today to never pay ever again, versus other person who's going to have to pay 4,000. And then, as that grows, and now they have a million bucks, well, now, if they're taking 20% of a million bucks, that's 200,000 taxes. So this is what the benefit of conversions can look like. So what does this mean for you? Well, tax brackets are not going to be neutral. I'm just giving this example for simplicity for the person that asked the question. Tax brackets are not going to be neutral.

Speaker 1:

Right now, you're a human, you're not a robot. You're probably making a healthy income, and so you're probably making north of $300,000, $400,000, or $200,000, whatever it is You're probably paying, let's just say, combined 30% taxes Don't know exactly, but 30%. Well, right now you probably should not do a conversion. Why would you pay taxes at 30% to avoid paying taxes at 15%? That doesn't make any sense. But if you're right now in a healthy tax bracket and you're thinking maybe I retire next year, you retire next year and your income's low, and let's assume, for hypothetical situation, you're 62. And you're going to be retired at let's just say, excuse me, you're retired, you're going to turn on social security at 67. That gives us five years to implement strategic Roth conversions before social security gets turned on. Because once that's turned on we don't have as much room to fill up brackets.

Speaker 1:

And I once did this for all of this for a client. They're like this is what I want my tax person to do. I go, that's not what they do, they're just going to prepare your return. What we're going to do is everything you're hearing right now. So the point is all of the conversions, what you should do. The reason there's no, you know a lot of you guys have seen this. But this jar you can see right here, it says anti-cookie cutter jar. Okay, because I don't. There's no cookie cutter answer to fill up this exact bracket. And do this because you know what.

Speaker 1:

I might go to you and say, yep, we should do conversions, but you want to spend more the first few years of retirement. So do less conversions and spend more. Engage how much you'd love to spend in retirement. Well, I just told them not to do a conversion. I just told them to spend more and enjoy their life more. And they're not going to be. I promise you, at 80, going, ari, why didn't you tell me I did a greater conversion? They're going to be going. I'm so glad I took those extra trips and I loved it. Now I don't want them to get killed on taxes so I might go next year. You're not taking as many trips next year. We're doing this conversion and here's why they're like OK, I'm cool with that.

Speaker 1:

So this is the type of analysis you want to know. Ok, great, if you retire at 55 and you don't know income gets turned on, no distributions for 20 years you might need to do a little bit of conversions every year. If you're going, look, I've got five years or two years before social security gets turned on or my pension starts. You might need to start doing a lot of conversions. It should be dependent on your strategy. So hopefully this was helpful. If you want to run any of these projections on your own, that's why I have the Academy you can go in there and do it and I help you do it. If you're like, no, this is too much, I want to work with you guys and your team. That is why we exist and I encourage you to reach out.

Speaker 1:

So if any of this episode was helpful, enlightening, anything like that, I invite you to share it with friends. That's how the show continues to grow. I invite you to leave a review. I love seeing the reviews, all of the comments. This is what I love. So that's it for today's episode. I know a little bit of a longer one, but hopefully helpful.

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.