Roth Conversions: Building Long-Term Tax Flexibility and Control

Maximizing Tax Efficiency through Roth Conversions

In this episode of the Retire Early Retire Now podcast, host Hunter Kelly, owner of Palm Valley Wealth Management, discusses the nuances of Roth conversions as an advanced tax planning tool. The episode covers the importance of timing and strategy in minimizing lifetime tax liabilities, particularly for high-income earners. Key points include understanding the process of converting pre-tax retirement funds to Roth accounts, evaluating tax brackets, and navigating potential pitfalls. Hunter also addresses how Roth conversions can be integrated with other tax strategies and estate planning for optimal financial flexibility. Practical tips for implementation and the role of financial professionals in this process are highlighted.

00:00 Introduction to Roth Conversions
03:26 Why Consider Roth Conversions?
05:56 Key Factors and Considerations
09:59 Roth Conversion Scenarios and Strategies
20:07 Potential Drawbacks and Pitfalls
23:02 Practical Tips for Implementation
24:42 Palm Valley Wealth Management Approach
27:48 Conclusion and Next Steps

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Transcript

0:00

And welcome to the retire early retire now podcast. I'm your host hunter Kelly owner of Palm valley wealth management. And today we will be talking about Roth conversions and how they can give you longterm tax flexibility, um, as a advanced tax planning tool, or Chaterjee. Um, and so we talked a little bit about these last week, um, and, and some previous podcast episodes as well, but wanted to dive back into these because, uh, generally most people are considering these Roth conversions right about now. Um, so make sure you one. You check with your custodian to make sure that if you're considering tax. Or Roth conversions. Uh, you know exactly the date. that you need to submit that request or that paperwork and how that's done. Um, because the last thing you want to do is try to get that paperwork in and then it's too late. Uh, and then you miss the cutoff for 20, 24. So, uh, make sure that you're looking at that, and I know we're coming in to the end of the year pretty quickly. But this can be a great strategy to give you tax flexibility and control. Uh, throughout the rest of your life and hopefully. Uh, also save you quite a bit on your lifetime tax liability. We talk about that a lot, especially for high income earners. This will be your largest expense over your life. Um, so do what you can do the research work with professionals. Um, to minimize this so that you can keep it in your pocket. And do the things that you want to do with it, whether that be, spend it, give it to your kids, give it to other family members. Uh, charity, whatever that may be, you have ultimate control over it. Ultimate flexibility. And that's kind of what this podcast is about today. But before we jump in. Just as a reminder, I'm starting to record these and put these on YouTube. So go into YouTube and, and, uh, give me a like, subscribe to my channel. Um, and, uh, and share this with a friend, uh, again, uh, anything to save taxes or plan for taxes can be very helpful to most people. Um, so if you think someone is, uh, could benefit from this topic, go ahead and share that with your friend. And, uh, that would be greatly appreciated, but let's hop into a Roth conversions and how they're used as a tool. So. Hopefully by the end of this episode. Uh, you'll understand what a Roth conversion is, why it might make sense for your situation. and how it fits into your broader financial plan. Um, and then lastly, navigate any pitfalls or. Um, gotchas that, that come along with Roth conversions. because there are a few, but if you navigate them properly, uh, they should be no problem at all. So let's hop into what a Roth conversion is, uh, converting pre-taxed retirement funds. So that can be traditional IRAs. Uh, pretax, 401ks, rollovers, things of that nature. To a Roth account. So you're basically transferring that money from that pre-tax account. To the Roth account, paying taxes on that. And then, um, that money will be at your tax dollars. It will grow tax free. And as long as it's say, qualifying distribution later on down the road, Uh, it will be tax-free. So that will obviously be a benefit later on not on the road and could potentially, if you time, these properly could potentially save you in taxes as well. And so why would we want to consider Roth conversions? will aching. do a couple of different things. One, it can create tax diversity. Uh, in the types of money that you have and types of assets that you have. So we talk about. Uh, the three buckets, Chaterjee a lot on this podcast. Now I'm and this is one way to kind of build that, that third bucket, right? So you have your, your after tax dollars, your brokerage accounts, things of that nature, you have your pre-tax dollars from 401ks, traditional IRAs, SEP IRAs, whatever that may be for you. Um, and then you have your Roth money as well. And so utilizing that three bucket approach, um, can give you some more tax flexibility. And tax diversity. Uh, as you move forward. And so, uh, two ways to do that would be either to contribute to your Roth IRA or Roth 401ks, or, um, do it through Roth conversions. And so depending on your situation, Uh, one could be more appropriate than the other or both. It just depends on your situation. So, um, The second thing why you would want to consider it? Uh, obviously I've mentioned this before, but, uh, tax flexibility, future flexibility. Once those funds are in Roth, uh, future qualified withdrawals are generally tax-free. So. This could be your large purchase account later on retirement. It could be a legacy play where now. you have kind of taken on that tax burden and your kids and your heirs. will not have to pay taxes on that money. Uh, it could be used for longterm care purposes. Whatever that may be for your specific situation. Um, but it can give you that flexibility. You could supplement income. and keep you at a lower tax rate, maybe avoiding Medicare surcharges, things of that nature. Right. Um, and then the last thing. Uh, for a lot of high-income earners. Uh, it will minimize your required minimum distributions later on down the road. So, uh, again, it'll help you control your taxable income in retirement, and that's the biggest thing. Or the biggest Uh, perk that I see. Four. Most clients that I work with is overtime. We will end up minimizing these RMDs, which will minimize. Their taxes over their lifetime, and sometimes it can save them. Hundreds of thousands of dollars in taxes depending on their situation. Right. So. Uh, these are a couple of reasons, three reasons why we would want to consider. Rothman versions of what Roth conversions are. And so the next thing we want to think about is key factors and con. That we need to consider before converting. So what do we want to think about before we make the decision to convert our pre-tax dollars to rot dollars? So, uh, obviously tax rates are something that you want to consider. So what are your current tax rates and what are your future tax rates going to be? Um, so assess your current, uh, marginal tax bracket. So are you in the 22% bracket? 24% bracket, 35% bracket. Where are you? Uh, in your income bracket? Uh, or your highest income bracket. Um, and then where do you think you're going to be in the future? Whether that be, uh, before retirement age, after retirement age. Uh, do you have a large sum of income coming in for a few years? And then it dramatically drops. Um, because of retirement or you selling a business or uh, going PRN, whatever that may be. Um, what does now look like and what does the future look like? Right. And then what do you expect those new rates to be? And then obviously you want to take into account any legislative changes. So any tax changes, uh, coming from Congress, things of that nature. Um, but generally your own situation is probably going to change that more dramatically. So timeline. Uh, and retirement goals is the next thing you want to consider. So the longer, the time horizon that you have to need these funds, the more powerful this strategy will be. So for my early retires retirees, um, Say 55 or younger. Uh, this strategy would be, uh, the best for, right, because they have a long time. they can kind of let this money grow right. Um, so if you are retiring at 65 or 70, something like that, Yes, you still should consider this, but your objective and the amount of growth that you should expect. Um, From this type of strategy would be minimized relative to someone that is retired at 50 and has 20, 30 years to kind of let this Um, grow in. And read the benefits of right. So for early retirees Roth conversions. Can be kind of a multi-year strategy. So it's something that we're going to look at and analyze every year. Um, and then the, one of the purposes of doing that. Uh, could be a legacy play. Um, And kind of the other things that we talked about here, that we'll all kind of dwell on here in just a second. The next thing you want to consider is your cashflow for tax conversions. So pain, uh, The taxes due for my non-retirement account. Um, is ideal. This will help you maximize it. So if you're going to convert$50,000, um, then you would want to, uh, take. Money from either savings. Or an after-tax account and pay those taxes that are due on the 50,000 that you convert it. So let's say you're a. Marginal tax bracket is 22%. And you, uh, convert$50,000. Obviously you're going to oh, About$12,000 in taxes on that conversion. So how do you want to pay that? Right? And so the options are, you can withhold, or you can, um, pay that from out of pocket. Obviously you want to keep the most money. Uh, invest it over a long period of time. That's going to work out. Best mathematically. Um, but if you don't have the liquidity to pay for those taxes up front, one, you wanna kind of rerun that cost benefit analysis there. Um, but too, if it still works out in your favor, Um, you can withhold from that account. Uh, that you're converting from and pay those taxes then. Um, the next thing you want to consider. Um, is some, some Roth conversion scenarios. So. When is a good time to do the Roth conversion. Uh, when does it make sense? And so what are some strategies involved with that? And so the first thing. Uh, that we look at is bracket management, right? So where's your marginal tax bracket? Where, how far are we from that next bracket up? Um, so a lot of times we will convert. Um, to fill up to that next bracket. Uh, before you kind of hit, let's say you're at the 22%. And you have$20,000 to go. Sometimes we may, uh, convert that$20,000 to keep you in that 22% tax bracket. Right. Um, coordinating with other income sources. So, uh, we want to take into account bonuses, rental income, capital gains, things of that nature. So all of these things that we want to consider. Um, and generally when we run these scenarios, a lot of times it'll look like. A bell curve for how fruitful they are. Right. So, um, you convert a little bit, you're going to see a little bit of, uh, maybe tax savings or longterm growth, add it to your net worth over time. And as you convert more, you'll see more and more benefit. And then eventually, uh, you'll start converting quote unquote too much. And then the taxes that you have to pay up front. Uh, we'll start to negate some of that, that benefit of doing the conversion. So generally it looks like a bell curve, so we want to find that sweet spot. And that's something that we'll analyze, um, on a yearly basis based off your income. Um, Um, based off tax rates, things of that nature to make sure that we're kind of maximizing that, um, each year it's not a set and forget type of deal. Uh, the other thing you want to consider, obviously, early retirement window, for those who retire in their fifties. Um, you won't necessarily take social security for. Potentially 10, 15, 20 years of any now early retire. When you want to take. And so, um, the biggest thing that this is going to allow you to do. Is due a long conversion ladder. So you can actually convert a little bit less and keep that tax rate. Um, much lower. Um, and then this will minimize your RMDs later on down the road. And then obviously give you uh, quite a bit. Um, in Roth money moving forward. So whether you want to use that for your retirement or passing out to your heirs or whatever that may be right. And that's kind of what I want to transition to now. The other thing that you want to consider is your estate planning angle. Right? So, um, If you are kind of, of just a typical retirement age, 60 to 65, potentially 70. Um, these Roth immersions still may make sense for you, right? Um, and. And the reason why I say that is a fit. One of your goals is to pass this down to your, your, uh, children. Then it may make sense because maybe you think you're going to live to 85, 90 years old. This, this money would continue to row for that amount of time. Um, and you know that, Hey, I won't touch it and this can be something my kids. Uh, we'll be able to, uh, benefit from and not have to pay taxes on. Right. And so. This is actually a conversation I had with a client a few weeks ago. They have, uh, enough money for them to live the retirement that they want. And then then some, and be able to still be able to grow their net worth over time. Right. And So, They could come back to me and say, Hey, we want to spend every dime. Right. We want to be left with one penny and that'd be great. That'd be awesome. Let's let's change your spending habits. Let's increase your spending so on and so forth, but their goal. Is to be able to leave some of this money or a significant amount of this money to their children. And one of the best ways to do that and their situation is do some of these Roth conversions now. So they have a very large chunk to give to their, their son and daughter, and they won't ever have to pay taxes on it, or at least for the 10-year window. Um, before they have to get that money out of the account. So. Um, this is a great way to, uh, kind of show a legacy play. Or, or, or pass money down to your heirs, right? Um, and so let's transition into coordinating. Um, With other strategies. So how does Roth conversions pair with other types of tax savings strategies? Right. And so often one that I'll use. Again, a client that I've been working with, um, the last couple of months, because he's preparing for retirement. Um, so we're going to coordinate Roth conversions. With uh, what's called net unwrap. realize appreciation. Right. And so, so one, what is net unrealized appreciation? it's a little bit of a tangent, but I need to explain it before we get into the strategy. So, this is where, um, you have some sort of concentrated, publicly traded stock inside of your 401k. Right. And let's say you bought that stock over the years, whether it's gifted to you from the company, or you bought it through your 401k. Plan itself and you paid a hundred thousand dollars for the stock, right? But the stock is worth$500,000. Well, what NUA will allow you to do is transfer that stock out to a brokerage account. You'll pay taxes on your basis. So the a hundred thousand dollars that you bought. Uh, the stock for, and then moving forward, any gains that you have would be taxed at a capital gains rate. So if your tax bracket is going to be at the 22 24 20. Or 24 or higher, right. Um, as the tax laws stand now. You're going to benefit from a lower capital gains rate than you will, that ordinary income rate as you start to take distributions. So you can see the advantage here. Taking this$500,000 out. Paying taxes on the. On the basis as you move it out. Versus taking this$500,000 out over time at a 22 24 30. Uh, something percent tax marginal tax bracket. Um, whereas capital gains rates are somewhere between zero, depending on your income. Or 15 to 20%. Right. And so, uh, this is a great way to kind of save taxes. So, so how do we coordinate this with, um, How do we coordinate this with. Roscoe versions. Right. And so let me find my notes here. So step one, right. We want to isolate and district distribute. Um, the company stock, right. Just as I talked about. So before we begin Roth conversions, we want to consider. Uh, the NUA strategy. Uh, on your company stock by moving these shares, um, from the tax deferred accounts. So the 401k account into a taxable account to effectively remove any potential large portion of your retirement assets. As ordinary income, right. So we can save on those taxes. Um, step two, we want to lower, uh, your pretax retirement account balances. Right? So. That is the goal. Right? So in the case of my client, his ultimate goal is one. To save on taxes, but to be able to pass down Uh, a large portion of his net wealth. Uh, net worth to, um, his kids on a tax-free basis. So, um, one I'll get a stepped up basis on this new stock that he's transferring over, uh, to this brokerage account that he had in his 401k. And it's up to once the company stock has been distributed via NUA, the remaining pre-tax funds can be systematically converted. So each year we're going to look at his tax bracket, what his income is going to look like for. that year, and then we're going to make some sort of conversion. Uh, to keep his taxes manageable over time. And so, uh, timing is everything. So for example, the NUA distribution is executed. Uh, in a year where you have low income, right? So hopefully the year after he retires, You'll have much lower income. Um, and then we can convert that because now his ordinary income tax would be much lower. Um, than what it is right now, while he's working. And so from there we can, uh, start doing those conversions. As well. So probably the year after, because he has about a hundred thousand dollars of taxable income. From that NUA conversion. Um, He will pay that taxes in the following year. We can start those conversions. And so over time, what this is going to do, one, he'll be able to pay long-term capital gains on any transactions that he has by selling that employer stock. And then too, he will reduce his R and D. Um, moving forward every time we do those conversions, so more and more of that money will become Roth money. Um, And so, uh, for him, that's going to save him. Uh, hundreds of thousands of dollars in taxes over his lifetime. Increasing his net worth. Um, hopefully in potentially, um, in the millions, right. And so obviously. Things can change. Tax rates can change. Laws can change. Maybe we don't get the expected return that we, um, project and things of that nature. Um, so all of this has kind of just a plan and we'll reassess that every year to maximize it as much as we can. But, uh, as it stands now, this is a great strategy. And how you compare Roth conversions with other tax savings strategies. Right. And so. Um, let's see here. So let's talk about some potential drawbacks or pitfalls that you want to watch out for. Right. Um, so the tax bill shock. Right? So if you don't plan. On how you're going to pay for these conversions, the taxes on these conversions, because remember if you convert 50,000. That's$50,000 of income. So how am I going to pay my potential 10 to$12,000. Tax bill, am I going to withhold it from my traditional IRA that I've just converted from? Or am I going to pay for it out of pocket? So don't get shocked with that tax bill. Um, moving forward. And if you're under the age of 59, anything or 59 and a half, anything that you withhold. Um, we'll be counted as a distribution. So then you potentially have some, some penalties there. Which again, as long as you run that through the cost benefit analysis there, if it still makes sense. Uh, maybe you still do the conversion or, uh, you take less of a withholding and pay a little bit out of pocket and things of that nature. So you can kind of finagle that a little bit, but be aware of the taxes. The other thing that a lot of people don't consider. Especially as they do these conversions, um, close to 59 and a half, um, is the five-year rule on Roth. Uh, IRAs. So it's, you have to have the money. Uh, in that Roth IRA for five years. Or 59 and a half, whatever comes last. So if you're 58, And you don't have a Roth IRA, but you open one up and you do conversions to get some of that money in there. You got to wait five years. Uh, five tax years before. You can start taking that money out as a qualified distribution. Now you would have access to the contribution or the conversion that you've already paid taxes on. Um, but just be aware that any growth there. Would it be subject to that 10% penalty and taxes. If you don't wait that full five years. So just keep that in mind. The other thing is state tax considerations. So if you live in a state where there is state taxes, fortunately, I live in Florida, so I don't have to worry about that with most of my clients. Um, but you do want to plan for those state taxes. And then market timing. Right. So obviously it would be more beneficial to convert on a market downturn. Right because then technically you're converting more shares. Uh, at a lower cost. Um, but just be careful of trying to time the market, like any other type of investing strategy. We don't want to time the market. We want to be. And we want to have more time in the market. Right? So come up with a plan, stick to the plan. If you happen to have opportunities to, uh, convert at a much lower rate. Uh, take advantage of that, but don't, don't have the plan of, I'm just going to wait until the market. Pulls back 20%. Cause that may never happen. Right. Or a 50% or whatever, or it may take 10, 15 years to happen. Right? Um, and then you could have been converting along the way. So have a plan stick with the plan. Now. How do we, what are some practical tips to implement these types of strategies? One and the obvious one is a work with a financial planner or a CPA that experience with Roth conversions. Um, and other tax savings shattered GS. Um, again, talk about a lot about tax planning. Don't go to your tax preparer. About these types of strategies. If they're not doing tax planning for you tax preparation and tax planning. Or two different things. You want someone to do that? I. Experience with tax planning. So someone that is going to look forward in your financial situation and help with the strategies. Right? So again, work with a financial planner or work with a CPA that does tax planning that can help you with these strategies. Plan out a multi-year. Timeline. So we want to have a plan in place, especially for these Roth conversions. Um, how much are we going to convert or make sense to convert? Over a five or 10 year period. But we also want to take a look at that each year, because your situation may change year to year. The tax rates may change every so often. Um, so we want to take a look at that plan and reassess that plan every year, but have a longterm plan in place for some of these Roth conversions of that is, uh, one of the strategies that makes sense for you, right. Um, And then obviously consider your state taxes and future. Um, plans to potentially move. So if you're retiring and you want to you'll live in Florida and you want to move to Alabama. Uh, you're going to have a state income tax. So how does that. Uh, change your plan, if at all right. And so how does, um, the Palm valley pathway? And so I mentioned this process a little bit, um, before and a couple of other episodes. How does Palm valley wealth management. Work. Um, and help in these situations where Roth conversions could and would make sense for, uh, their clients or potential clients. Right. And so the first thing we're going to do is we're going to organize and look at all of your retirement accounts and their tax characteristics. Do you have the three bucket approach? Or do you only have pre-tax or you only have after-tax or you only have Roth? What does that look like? Um, and how do we, uh, assess that and get a good, clear picture, right? And then once we have an idea of what that situation looks like, we'll optimize it. We'll run multiple tax projections from our financial planning software in our tax planning software to, uh, make sure that. Uh, conversions make sense for you. So, um, if it's something that we think is going to make sense, then we'll run those projections. Um, in CCD spot. Spot is how much should we convert? We convert it like, cause remember, look at, so I was in may look, good, look better. And they look worse. So where can we find how much we want up or on a yearly. And then we'll bring incorporates into raw financial planning, everything else full. So whether that be. Or just to Billy later, you mean on taxes? Um, and then, right, so you come up with the plan implementation of this part sometime are right. So Dr. Stoney and sings. Uh, them and adjust a year. Change right. And so the Hathaway. From my clients. It's something where you listen to this podcast. I really think that versions. I wouldn't go to my website and.com can schedule them. We can kind of have. Let's see if that. Uh, I appreciate again, share this with a friend. Go to YouTube. Be page two. It. You on your favorite pod, um, as the be able to help more and save on taxes. The money into Roth. Their financial goal. Kind of just the two that. Uh, next one into charitable giving 10 a compliment. For Maxim chair, we'll give him. The Christmas. Okay. Um, in the giving moods, having a, uh, episode would be, uh, combat. I appreciate you got. Um, again, and we'll see. This pod educational purpose is not meant to be fun or. Or tax, please seek a planning channel. Tax legal professor during your own such do not division solely based loan. Hello. And please keep in mind when making durations.