Why Roth Conversions?

Roth conversions involve moving money from pre-tax retirement accounts (e.g., 401(k) or IRA) to a Roth IRA. Pros of pre-tax accounts include immediate tax deductions, tax-deferred growth, and asset protection. However, cons include taxation upon withdrawal, uncertainty about future tax rates, and mandatory distributions.

Roth conversions offer benefits like tax-free withdrawals, no required minimum distributions, and flexibility in controlling taxable income. They can help mitigate future tax risks and Medicare surcharges. Beneficiaries also receive tax-free distributions. Timing conversions after market drops is advantageous. Balanced retirement planning typically involves a mix of pre-tax and Roth accounts to optimize tax efficiency and financial security.

Video Transcript

Why do we want to do Roth conversions? Pros and cons of having money in a pre -tax environment, so pre -tax 401k, pre -tax IRA, benefit is you get a tax deduction now. So a 401k for example, if you put 19 ,500 in, you get that tax deduction off of your income that year, which is a good thing.

Other benefit is a tax deferral growth. So the money goes in on a tax deduction. It all grows tax -free. You don’t pay capital gains taxes on any of the growth, but when it’s distributed, obviously you would pay income tax on that. And the third benefit would be asset protection.

So for if you’re a physician or a business owner and you ever get sued or in a lawsuit, in most states 401ks are asset protected, but we would obviously recommend to check with your attorney to verify the laws in your state specifically. So those are the pros.

These are the cons of having money in a pre -tax environment. The money is taxed at distribution. So get the deduction now. It grows when you’re in retirement or whenever you distribute the money, you pay the income rates, income marginal tax rates that are applicable at the time.

So looking historically, one thing that Democrats, Republicans agree on is that the low marginal tax rates should remain low. Right now the lowest tax rate is 10%. Most of our clients, if you’re watching this video, you’re not in the lowest tax bracket. What the government has disagreed on is what high marginal tax rate should be.

And right now we’re in a low tax environment. The highest marginal tax rate is 37%. But if we look at historical numbers, it’s been as high as 90% and could be anywhere between, it’s been as high as 70 to 90%.

Another thing to be aware of with the money being taxed at withdrawals, if, let’s say, for example, you’re in retirement and you have social security, maybe a pension and requirement on distributions, most situations, social security and pension are filling up the lower tax brackets and RMDs are getting distributed at the 22% or 24% tax bracket.

If a spouse were to pass away in retirement, that runway would get cut in half. Social security and pension are still filling up the low tax brackets, but RMDs would be distributed at a higher tax rate and in most cases would jump 10% to 12%. Another thing we want to be aware of in a downside of having money in a pre -tax environment is when it gets distributed in retirement, Medicare surcharges are based on taxable income.

So if you have the same example, pension, social security and everything has to be distributed on top of that is taxable. That would bump up your tax rates in retirement, which would then drive up your Medicare surcharges.

Third downside is the requirement on distribution. So anything in a pre -tax IRA 401K, it hasn’t been taxed yet, you get the tax deduction, but the government hasn’t gotten their share of it.

So the law currently is when you turn 72, the government says that you have to distribute a portion of the account. No matter if the market’s up or down, they say every year you have to distribute a portion of it, which in retirement if the market’s down and you have to liquidate 5% of the account, that could put some stress on the overall portfolio.

Another thing to be aware of in a downside of any pre -tax account is the Secure Act that was put in place at the end of 2019. It has eliminated the stretch IRA rule and now that money has to be distributed in a 10 -year window.

So if a beneficiary inherits an IRA, the old law said that they had their lifetime to distribute that account and with the Secure Act, they now have a 10 -year window. So if, let’s say, for example, you have one kid and they inherit a million -dollar IRA, over 10 years they have to liquidate that account.

So they would have to recognize 100 ,000 of income every single year and that would obviously bump up their tax rates that year. James, a great point on our concerns of pre -tax accounts. One of the arguments we see for pre -tax accounts is generally speaking, someone’s in a high income earning years and then when they forecast and retire, they have things like their house, things like their children, houses paid off, student loans are paid off, children are out of the house and they think, well, I’m not going to need this same income that I was earning to live a similar lifestyle.

So that is correct. However, if we have, for example, we’ve seen clients retired right now, they have Social Security for both spouses, they have a pension and they have RMDs, if everything is in a pre -tax environment, even if they don’t need the money, they’re still going to be paying taxes at the higher bracket because of the forced income that’s coming out.

So at a minimum, even if you’re a high income earner, we recommend to have qualified money at a minimum split two -thirds and one -third between a pre -tax and a Roth IRA to avoid a lot of these risks that Jameson brought up. Being that money is here to support your life by design and being that money should free up time, autonomy, and give you peace of mind.

Having more than a third of the Roth we found has brought a lot of peace of mind for a lot of clients because a Roth IRA gives us a lot of benefits. It’s not just a tax calculation. Are we in a lower or higher bracket an hour later? It’s about the control, the autonomy, and taking care of some of the guarantees in the future as well.

Right off the bat, the pros of a pre -tax account, only one of those turns into a con for a Roth. You lose the tax deduction. For example, if you put in the 19 .5 into a Roth 401k or the 6000 into a Roth IRA, that wouldn’t be tax deductible. 19 .5, you may miss on a $6 ,000 or $7 ,000 tax deduction that year.

Still tax deferred. The money goes in on the after tax basis. It’s tax deferred. It’s asset protected. Again, consult with your attorney, but most states will honor that. It takes care of all four of these concerns.

Once the money’s in a Roth, if you convert into a Roth or contribute into a Roth 401k, after five years, a converted Roth, the contributions or the basis is available without penalty regardless of your age. The growth if untapped until 59 .5 once that five -year rule has been satisfied is all tax -free.

Who cares what tax rates are in the future if you have a Roth? Roth comes out tax -free. This avoids the risk that a political environment may lead to a higher tax bracket in the future. This removes the risk of the widow penalty or the widow squeeze, the tax runway getting cut in half.

Medicare surcharge is a Roth distribution does not get calculated into your adjusted gross income in retirement. You can stay in a much lower Medicare bracket with analyzes for a lot of clients. We’ll save upwards of $250 ,000 just in Medicare cost alone over a 30 -year retirement if they have the proper amount of Roth allocation.

The biggest reason we like the Roth though is there’s no requirement of distribution. The market’s up. We can decide to take the money if the market’s down. We’re not forced to take it out of the loss. We can control when, if, how much we take. We can control if we need money for a nursing home and that spikes our tax bracket.

Well, it would not spike it if you’re distributing from a Roth IRA, which is all tax -free. It really helps us avoid those highest tax brackets. We really want to find the equilibrium between getting a tax deduction now, but really being tax -efficient for the future and navigating these hidden rules and regulations that the IRS will capture millions of dollars from in the future for those that don’t plan properly.

Beneficiary has also received this completely tax -free as well. They have to take it out in the 10 -year window, but it does come out completely tax -free. Roth conversions, we typically recommend to do if you’re in a 24% or lower marginal tax bracket and then regardless of what your tax bracket is, if we see a 10% or more drop in any asset class, we can decide what asset class we’re converting from pre -tax to Roth.

For example, if you convert $100 ,000 over, that means $100 ,000 is going to add it on to your adjusted gross income that year. You’ll pay taxes on that once. The money then grows tax -free and gets distributed tax -free, so you’re paying a tax bill now to avoid what we think will be a much higher tax bill in the future.

Doing that when the market’s on sale, meaning when the market drops, is a great idea to think of a Black Friday sale if you’re going to buy a TV and you can get it for half off. You might as well wait till Black Friday, similar in the stock market to Roth conversions.

We want to ideally implement after we see a market drop because then all the appreciation gets treated as tax -free for the rest of your life. As always, please reach out to us if you have any questions on Roth conversions and we look forward to implementing this strategy this year and moving forward.

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