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Roth Conversions Done Right: What Great Advisors Know That Software Doesn’t
In this episode of Root Ready, James shares how advisors should think about Roth conversions—starting with the basics and not just relying on software.
Software can help with numbers, but it can’t see the full picture. James explains why Root advisors use software as a tool, not the final answer.
He talks through key things to consider before doing a Roth conversion, like future tax brackets, RMDs, charitable giving, and income thresholds. You’ll also hear why Roth conversions are more like “tax insurance” than a perfect plan.
If you want to better understand when—and when not—to recommend Roth conversions, this episode is for you.
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Advisory services are offered through Root Financial Partners, LLC, an SEC registered investment adviser. This content is intended for informational and educational purposes only and should not be considered personalized investment, tax, or legal advice. We do not provide tax preparation or legal services. Always consult with your CPA or attorney regarding your specific situation.
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Investment strategies discussed may not be suitable for everyone. All investments involve risk, and past performance is not indicative of future results.
Any opinions expressed are as of the date of recording and are subject to change.
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Welcome back to another episode of the Root Ready podcast. I'm your host, james Canole. Today is going to be a bit more of a technical episode and we're going to be talking about Roth conversions. Specifically, how should you talk about or frame Roth conversions when you're having a conversation with a client? The reason I'm doing an episode on this is because I do believe that this is one area in general where there is a right answer and a wrong answer for how you should present this. Now, this right and wrong answer, the principle of this, goes beyond just the concept of Roth conversions, but this goes back to one of the core, fundamental things we talk about what it means to be root ready Internally. How do we define the six standards of an excellent advisor, what we look for in every advisor at Root Financial? I reviewed all six of these pillars in episode number two of the Root Ready podcast, but one of the six was this A root advisor doesn't rely on software to make financial decisions, but knows how to use it as a tool when needed. So that is something that's very important to understand when we talk about what it means to be a root advisor, to be root ready. These are the things. This is one of the standards that we hold advisors to is, yes, there's an element of knowing how to use a software and knowing how to use a software very, very well to illustrate a point or to make a point, but you should not need software or depend upon software to know some core, fundamental principles of when a particular solution may or may not be useful.
Speaker 0:Explaining Roth conversions to clients is one of the areas where I see this show up. When we go through our interview process, when we are hiring for the lead financial advisor role, we role play and in the role play exercise, what we're trying to do is we give a prompt to the people who are interviewing, who are applying for the position, and I will come on, or a senior advisor will come on, and we'll do a role play scenario, in that we are trying to push, we're trying to press to say how do you think about certain concepts, how would you explain certain concepts? What's the reasoning that we're able to see you are using to defend what you're saying or to recommend what you're recommending? And here's a red flag for us is if we ask a question about Roth conversions and your answer is oh well, we would put the numbers into the software and see what it spits out. That's a red flag. Now, it's not wrong by default, but what it's showing us is that you are too highly dependent upon inputting numbers into a software program and seeing what it comes out in terms of the output, in terms of recommendation and Roth conversions, is one of those areas where you do need to be very technical and you do need to understand various nuances and different considerations when making recommendations, and software absolutely can help, but it should not be the be-all end-all.
Speaker 0:Let me tell you a story to illustrate why I was meeting with a new client. This was a few years back now, and this new client had done a lot of planning on his own, maybe more planning on his own than I had ever seen any individual do on their own. He was getting ready to sell his business to a private equity company, so he was going to have a good chunk of cash from the proceeds of that sale, and he and his wife also had about $3 million in pre-tax accounts between 401ks and IRAs, and they were in their late 50s. His concern was taxes, both in terms of income taxes today as well as future estate tax liabilities. Way down the road. He had modeled out a very complicated scenario, a very complex scenario, I should say. He was using the tool New Retirement, now called Bolden. He had gone through projections there, he had done his own spreadsheets, he had done his own analysis and he came back to me with the output of this and the output of that, or the actual takeaway of what he was going to do based upon his goals which, by the way, his goals were to reduce taxes income taxes while living and estate taxes upon his passing, as well as to do a lot of charitable giving and the output of his plan, which was essentially inputs he had put into the software.
Speaker 0:So he had said this is what I'm thinking of doing. Tell me how much will it save me in taxes? The output was something along the lines of he was going to set up a flip NIMCRUT. He was going to set up a donor advised fund to be the beneficiary of that. He was then going to purchase a permanent life insurance policy and put it into an irrevocable life insurance trust. He was going to use this to help do some of the charitable giving intentions he had. All the while, he was going to set up a pretty significant Roth conversion strategy where he would start converting good chunks of his IRA between his current age and the age of 75 when required minimum distributions would kick in.
Speaker 0:So a very, very complex strategy. But the output of the software said look, here's how much money this is going to save you in taxes. So in his mind he saw a very high tax savings and thought why wouldn't I do this? Now there's nothing necessarily wrong with that. That output the software generated, I'm sure, was right. The numbers were the numbers, the math was correct. But here's what a software can't do Software can't understand context and a software can't understand alternatives unless you're explicitly providing the alternatives for the software to explore.
Speaker 0:So after I had a chance to connect with this client and get to know him over the course of a few meetings, I was able to come back to him and say this strategy on paper looks really good and on paper is going to save you a whole bunch of money in taxes. But knowing what I know about Roth conversions and knowing what I know about his situation and knowing what I know about tax planning and retirement planning as a whole, I was able to say look, is there a simpler way to do this? What if we simply used your IRA and treated it kind of like the donor advised fund, in a sense that we didn't need to do the aggressive Roth conversions you thought you would need to do? Let's just implement a qualified charitable distribution strategy. As soon as you turn 70 and a half, you and your wife can gift multiple six figures at that point from your IRAs, which would have appreciated most likely. Pretty significantly. There are $3 million in our late 50s by the time that they were 70 and beyond. Good chance, that was a five, six plus million dollar account at that point.
Speaker 0:So I was able to walk him through without even having to use software in this instance. What if we avoided all of this? What if we avoid the complexity of this flip Nimcrut which, by the way, I had never even explored in detail until he brought that to me? We could avoid the complexity of the irrevocable life insurance trust, of doing the other things he talked about doing, because we could accomplish the same goal with a much more simple strategy. So that was a very complex solution that he brought and because I understood the strategies involved with Roth conversions, with qualified charitable distributions, with other things that were able to be done, we could simply say why don't we do this instead? Why don't we explore this alternative instead? We don't need to rely on the software.
Speaker 0:So I tell that story because if we had just relied on the software, the software was right, the math was right, there was nothing that was incorrect about the way the numbers were being crunched, the tax savings were there, but the software wasn't able to say okay, well, what about the complexity involved with this? What about the administrative cost involved with this? But, most importantly, are there other alternatives that are far more simple, far less costly and actually far more effective when actually implemented? So if you, as an advisor, don't understand at the core level, at a foundational level, why do we do Roth conversions, what alternatives exist? Yes, I'm talking specifically about Roth conversions today, but this is a principle that should apply to every planning topic that we're going to go through with clients. If you can't understand that at a foundational level and we're just relying on software, we're going to be very limited in terms of the effectiveness of our advice and our clients are not going to be served in the way that they need to and deserve to be served. So there's three things that I want to go through today. This is the framework that I like to go through, just almost a mental model or mental framework of what are the steps I like to take before I ultimately recommend a Roth conversion to a client.
Speaker 0:Number one I actually first want to know is there a good reason not to do a Roth conversion? Roth conversions are these things that you see them all over podcasts and YouTube videos and LinkedIn posts. It's one of these things that almost becomes for lack of a better word the hot topic. Everyone's doing Roth conversions, so why should you do a Roth conversion? It's very easy both for clients to get caught up in that of might as well do a Roth conversion Everyone else is doing it and even advisors to get caught up in doing it of. I have to add value. Therefore, I must recommend a Roth conversion.
Speaker 0:But before you do that, keep in mind Roth conversions can be extremely costly. In the short term. The benefit of a Roth conversion is going to come well down the road. It's into the future. If we're doing significant Roth conversions today, it could be tens of thousands of dollars that we are asking our clients to pay in extra taxes in order to accomplish that. That's a giant cost. Because of that. We want to make sure that this is absolutely the right thing to do. And how do we do that? We first try to poke holes in this. We first try to say what's a good reason not to do a Roth conversion.
Speaker 0:Now, there's countless reasons why you might not want to do a Roth conversion, but three basic ones. Reason number one is your client's not expected to be in a higher tax bracket in the future. Now, this is maybe painfully obvious, but remember what I said Sometimes we get caught in this zone of okay, a Roth conversion. Everyone needs a Roth conversion, because that's what everyone's talking about, that's what the client's talking about. Well, maybe it's very effective for some people. It absolutely is effective for some people. But there are many other people who I have seen doing Roth conversions where it was actually hurting them to do so. And the reason it was hurting them to do so is because they're actually in a higher tax bracket today than they're projected to be in the future. So why would we pay more taxes today when we're likely going to be in a lower tax bracket in the future and could simply take out our pre-tax funds at that point? So a very simple concept, but unfortunately, too many people overlook this.
Speaker 0:So don't just convert for the sake of converting. Convert, because there's a good reason to do so. Reason number two required minimum distributions are not projected to be an issue in the future. Now, for most people, they're not going to be in a higher tax bracket in the future in retirement, because they start spending way more in retirement. They're projected to be in a higher tax bracket because when age 73 or 75, whatever their birth year is is gonna determine that when their required minimum distributions begin, they're forced to take much more out of their IRAs than they otherwise would have wanted to or needed to. So if they're not gonna be in a position where RMDs are an issue, maybe you don't need to do a Roth conversion.
Speaker 0:What does it mean for something not to be an issue? There's not one perfect way of defining that, but one way to think about it is this If your required distribution is going to be less than you're already taking out of your IRA, that's not an issue to me Meaning. If we know that you're gonna be taking 60,000 after you want to take $60,000 per year out of your IRA to meet your living expenses and your required distribution is expected to be $50,000, it's not an issue. You're already taking more than you would be required to take out to start with. It's where you're only taking, let's say, $20,000 or $30,000 out from your IRA, because that's allowing you to meet all of your needs. But you're going to be required to take out $100,000, $150,000, whatever the number is, because you have a large balance in your IRA and you're being forced to take out more than you need to and in doing so it's pushing you into a higher tax bracket that you don't need to be in. So that's.
Speaker 0:The second reason is, if required distributions are not projected to be an issue, potentially no need to do Roth conversions at that point. So something to take into account. And then the third is this is if the client's very charitably inclined I just used the example of the client I spoke with a few minutes ago. If they're charitably inclined, if they're giving a lot of money to charity, to church, is there a different thing you can do? We do Roth conversions typically to prevent having to take out significant amounts out from our IRA. Like I said, that push us into a higher tax bracket once we hit those required minimum distribution ages.
Speaker 0:But what if we could solve that required minimum distribution ages. But what if we could solve that required minimum distribution problem by simply gifting a big portion of it to charity? Now, if you're not going to give money to charity in the first place, this probably isn't the best strategy for you. But for those clients that are going to and want to give a good amount of charity, to what extent can qualified charitable distributions from age 70 and a half and beyond offset the need to do Roth conversions today? These are the types of things that we need to be able to understand so that we can identify is there a good reason not to do a Roth conversion?
Speaker 0:Because, by the way, there's two benefits from this. Number one, if you walk your client through this and say here's how we're exploring this. Number one it shows that you have expertise. You really understand this. You understand the entirety of what you're looking at, to understand all the different details and nuances and decision points that need to be looked at before formally recommending this. So it demonstrates expertise. But number two, what it's also showing is that you're on their side.
Speaker 0:You're not just recommending this thing because it's a hot topic and it's a fun thing and everyone should be doing it. No, you are only going to recommend it if it's absolutely in their best interest. But what you're keenly aware of is the fact that it's going to be painful in the short term. You're keenly aware of the fact that this is going to cost them thousands, potentially tens of thousands of dollars in extra taxes today, and you're doing everything you can to see is there another way of doing this? And so by talking about it this way, not only are you demonstrating your expertise, but you are showing I'm on your side. I'm not just here to look at your money like it's a math problem and let me solve it for you. I'm also here to understand the reality, and the reality is it's not fun to pay those taxes up front. So I'm only going to recommend it if I can say, if I can show you with a high degree of conviction, that the benefit of this long-term is going to outweigh the pain of this in the short term, and that's going to help to align you with your clients and they're going to see that you're absolutely working for them.
Speaker 0:So that's the first thing that I like to do is start with is there a good reason not to do a conversion? The second thing that you really need to understand as an advisor when you're talking about Roth conversions with clients, is you need to understand at a fundamental level the landscape in which you are working. So when does it make sense to do a conversion? Going back to what I started with, if your answer is when the software says to do so, wrong answer. Software is only as good as the inputs. Software is only as good as the data that you put into it. It lacks context. It doesn't have the ability at least not yet. Who knows where AI takes us, but doesn't have the ability to suggest alternatives in any meaningful way. So you have to understand why would this make sense? When does this make sense? How do we think about Roth conversions? And you have to really have a mastery of that. You have to have a really deep understanding of that so that you can apply that mastery to your client situation.
Speaker 0:But at a high level, roth conversions come down to one thing and that is will you be in a higher tax bracket today or in the future? And now this one thing is driven by two variables. At a high level, there's what I like to think of as the macro and the micro. The macro is what are tax rates at large going to be? You can't really control this. What are tax rates going to be at the federal level? What are tax rates going to be at the state level? Now, this, to an extent, you can't control, but you can absolutely adjust for it. Where maybe you have a California client today and you're considering a Roth conversion, but they're planning to move to Nevada or Texas or Florida, well, you don't know exactly what the state tax brackets are going to be. But what you can say is I'm going to a no tax state, so you have a good idea that there's going to be a far lesser tax bracket, maybe zero tax bracket if they move within states. But at the macro level, what you're looking at is what's the tax environment that all of us are working within that applies the same to all of us, that's, what are the ordinary income tax brackets? What do standard deductions look like? What are these things, what are these thresholds, these brackets that apply to all of us?
Speaker 0:Then, at the micro level, you have your actual client's taxable income. Their taxable income when they're working is largely going to be determined by their salary, most likely. But when they're retired, they might have IRAs, brokerage accounts, roth, iras, rental property, social security, pension All these things have different nuances, have different details to determine how they get taxed, which means you, as their advisor, get to help them put these things together in such a way as to minimize their lifetime tax liability. That's the fun part of retirement planning. It's not just here's your tax bracket today, here's your tax bracket in the future, your future tax bracket. To an extent, of course, it's easier to do this with clients that have a lot of different types of accounts and different types of income sources, but you get to put the pieces together and you get to help them understand not just where a tax bracket is going to be in the future, but what will your specific taxable income be in the future.
Speaker 0:Neither of these things we can control with perfect certainty. We at least need a benchmark. We at least need something to start from to give us a general sense of when you look at both the macro and the micro today, what does that leave us with when it comes to your actual tax liability? Then, once we have that, what is that going to look like in the future when we compare again macro tax environment as well as the micro, which is their specific taxable income. When we do that, we can say here's your projected tax liability. And really what we like to do is understand what tax bracket are you going to be in?
Speaker 0:Because if I'm looking at this today and I'm saying, okay, you're in the 32% tax bracket today and I'm expecting you to be in the 12 to 22% tax bracket throughout retirement and I'm expecting you to be in the 12% to 22% tax bracket throughout retirement, why on earth would I do a Roth conversion? Why would we pay taxes at a 32% rate today just to save taxes at a 12% to 22% rate in the future? That would make zero sense. Now, if you were in a 12% tax bracket today, let's assume maybe it's the first few years of retirement and you live off brokerage assets, maybe some social security, your required distributions haven't yet kicked in. Let's assume maybe it's the first few years of retirement and you're living off brokerage assets, maybe some social security, your required distributions haven't yet kicked in. Well, do we convert up to the 12%, up to the 22% bracket? Maybe, but it fully depends upon where you expect it to be in the future.
Speaker 0:This is where I'll go back to. If required distributions aren't projected to be an issue, you might be in that same tax bracket for a long time, but if required distributions are an issue, you might be pushed up into the 32% tax bracket or beyond, in which case that would make a lot of sense to consider a Roth conversion there, because you can pay taxes, you can prepay taxes in a way to 12 or 22% rate to save on a tax bill of 32% or higher in the future. So that's the way to look at it. Understand that at a core level, it's just us deciding when do we want to pay taxes, and ideally we want to pay taxes when we're in lower tax brackets. So we have to pay less in taxes when we're in higher tax brackets.
Speaker 0:And the better you can understand that, the better that you can articulate that to clients, the more sense it's going to make and you're not going to just be relying upon a software to give you an output, when that output may be based upon flawed inputs, may be based upon an alternative that works but is not quite as good as a different alternative, a different solution that you could have come up with if you understood, based upon your knowledge, your depth of experience, how this works and what we should be looking for as opposed to just relying upon the software. And then, finally, the third thing that I like to do when talking about Roth conversions with clients is have somewhat of a philosophical viewpoint on them. What do I mean by philosophical? This isn't to mean that this is part of your worldview or anything that you have a deep conviction in. It means that you have a way of viewing this. You do have a way of understanding how this fits into the plan.
Speaker 0:One way I like to think about this and I think a lot of people like to think about it this way is viewing Roth conversions as tax insurance. So let's think about insurance in this way. I have a term life insurance policy on my life. I hope that that term life insurance policy becomes a giant waste of money. I hope I pay premiums until the policy expires and I don't get anything from it. Why do I hope that? Well, obviously that means I'm not dead. It means I'm still here. It means I'm still living. It means life has gone according to plan. Everything else is better if that becomes a waste of money. However, if I need it, then I'm really glad I had it. The return on investment is enormous. It supports my family. There's a great outcome there. Not that I'm dead, of course, but the family's taken care of financially. They're not going to have any hardships.
Speaker 0:Let's relate that to Roth conversions. If you do Roth conversions and I won't call it a waste of money but if it actually doesn't turn out to be the serious tax savings you thought it would be that's probably because tax rates as a whole are much lower. In other words, everything else in your plan is going according to plan or is going better to plan. It's almost like that term life insurance policy. I'd be happy if these become a waste of money. I'd be happy if the Roth conversions become a waste of money because it means everything else is now going better.
Speaker 0:So when you look at it this way, what you're acknowledging is you have no idea exactly what Roth conversion strategy is the most appropriate. None of us ever will, and that's okay, and you need to let the client know that that's okay and that we will never have the perfect strategy. To do so, you would need to know exactly what tax rates are every single year into the future. You need to know exactly what growth rates are on your assets exactly into the future. The higher the growth rate on your IRA, your pre-tax accounts. The more required distributions you're going to have, the lower the growth rate. The reverse of that is going to be true.
Speaker 0:You'd have to know exactly how long your client's going to live, how long their spouse is going to live, if they're married. You need to know exactly when they're going to collect social security, when is their spouse going to collect social security if they're married. You need to know exactly what their spending patterns are going to be, exactly how much they'll have in dividends and interest in their brokerage accounts and their cash, et cetera. All these are things that we would need to know with perfect certainty to generate the perfect Roth conversion strategy. We will never know those things with perfect certainty, which is why we need to start with something almost to serve as a benchmark, to say, generally speaking, when are you going to be in a higher versus lower tax bracket? And as we can start to envision the course of their retirement and how will their taxable income ebb and flow and within which tax brackets will it be ebbing and flowing, then we can come up with a strategy and on top of that whole strategy, we can say here's our philosophy.
Speaker 0:Our philosophy is if this does not go perfectly according to plan. Maybe that's actually because the rest of your plan went according to plan, meaning tax rates as a whole came down, which means all of your other income sources are actually subject to lower taxes. You have less costs overall. So understanding this will allow you to be able to talk to a client confidently about Roth conversions to show them that you're on their side. Where is there any good reason not to do a conversion so we can save you the money? It's going to show your expertise that you understand at a core, foundational level why we do Roth conversions, not because a software output told you so, but because you get why they work and how they're going to apply to your client. And then you have this approach to it of how are we actually viewing this, what's the proper context to look at this? And viewing it as tax insurance can be a very effective thing to do in that case.
Speaker 0:So, going back to the pillar that I talked about at the beginning, what does it mean to be root-ready here? How do we think about being a great advisor? Well, a root advisor doesn't rely upon software to make financial decisions, but knows how to use it as a tool when needed. This is how you use it. This is how you think about it.
Speaker 0:Now, this, of course, is not a crash course into everything you need to know about Roth conversions. You need to know a lot of information about this. You need to know the rules around Roth conversions. You need to know how is this going to impact things at the ordinary income rate. What could this potentially do to capital gain rates if you're doing Roth conversions? How is this going to impact IRMA surcharges? What is this going to do to beneficiary planning or legacy planning? How is this going to impact provisional income? There's all these things that you need to understand, but you can't depend upon the software for that. You, as the advisor, need to embody this, to know this, to do this. When you do that, you can deliver the most effective advice. Yes, in this specific context of the Roth conversions, but apply that same principle to everything that we do as advisors, and there's nothing that's going to hold you back from being an incredible advisor to your clients.