What The Wealth Retirement Podcast

Decoding Roth Conversions: A Deep Dive into Strategies, Myths, and Tax Implications (87)

• Jonathan Bednar II, CFP • Episode 87

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Ever wondered how to make your money work better for you by leveraging the power of Roth conversions? Join me, Jonathan Bednar, co-owner of Paradigm Wealth Partners, as we journey through the complexities and benefits of this financial strategy. As a certified financial planner, I shed light on the essentials of liquidity, tax implications, conversion methods, and the best timing for conversions. We debunk the myth of income limitations and examine the impact of required minimum distributions (RMDs) on this strategy.

Dare to venture further with us as we untangle the implications of the Tax Cuts and Jobs Act of 2017 on the aspects of Roth conversions. We'll also delve into the long-term tax benefits of a Roth IRA and take a closer look at the potential future of tax brackets and their influence on the conversion decision. We'll expose the real costs and fees associated with Roth conversions, providing a complete lowdown on this financial strategy. So, if you're looking to make smarter and more effective wealth management decisions, then this episode is your perfect guide. Tune in!

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Thanks for Listening!

Jonathan

Speaker 1:

Hi, welcome back to what the Wealth podcast. I'm your host, jonathan Bedner, certified financial planner, co-owner of Paradigm Wealth Partners in Knoxville, tennessee. Today we're going to talk about what you should consider when you're doing a Roth conversion. The first thing that is important to consider is liquidity. First and foremost, do you have an emergency fund in place so that you have a solid foundation? If something comes up, you have access to capital that you can easily access without getting into your long-term investment? It's really important that you have some sort of financial foundation in the form of an emergency fund to access. The other thing that's important about liquidity is having access to capital, because when you do a Roth conversion, that conversion is actually a taxable event. Now, we're not talking about a backdoor Roth conversion. That's subject for another conversation. This is a regular Roth conversion where we're converting pre-tax dollars in an IRA account and converting that to your Roth IRA. That's a tax liability. That's a taxable event and creates a tax liability. You're going to want to understand what those taxes are. It'll be based on what your tax bracket is, what your tax rate is. It's important to understand what that is. The other thing that's important to understand about these tax implications is if you live in a state that has state income tax. Not only will you pay federal taxes when you do this Roth conversion, but you'll also pay state income tax. It's very important that you consider what are the tax implications going to be if you make this Roth conversion.

Speaker 1:

The next thing that I think is important is conversion methods. There's two different ways you can do a Roth conversion. The most prevalent and popular is the direct conversion route, meaning you, essentially, are signing a piece of paper and you're going to convert directly from one account into the other. The custodian is going to take care of actually transferring the funds from one account to the other. This is really important. It's the easiest way to do it and it's the way that we at our firm usually do this. The other way you could do this is technically in a 60-day rollover window.

Speaker 1:

So you take the money, you actually get a check written out to the custodian, made payable to the custodian for the benefit of your name. It's important that you do not cash that check. If you cash that check, it's taxable event to you. What you want to do is you want to take that and you want to actually take that physical check and you want to actually send that check to the custodian and deposit it into the new Roth account. That's an indirect, where you're actually taking a physical check to do this. Usually, this might be done when there's two custodians in play and you've got maybe one account at one place and the other account somewhere else. This is not as frequent. Usually this is done as a direct manner from one custodian to the same custodian and they're doing this transfer between these accounts internally and you've just signed off, essentially saying you're aware of this, you are signing off that you want this to be done and that you're aware that this will create some tax liability.

Speaker 1:

The next thing to consider is timing, and I am not a fan of timing the market, but I do think timing when it comes to these conversions could be impactful. So if you are doing a Roth conversion and the market's down I don't know let's say we have an ugly year, like we had last year in 2022, the market's down 20 or 25% that may be actually a prime time to do a conversion, because when you do a Roth conversion, you're actually converting on the value at the time of the conversion, and so if the account or the assets that you're converting are down again let's use 2022 as an example 20 or 25% then you could be converting at a cheaper valuation, which means that your total tax liability will be less, and that gives you the ability to get it moved into the Roth account and then benefit from the growth once the market and the account start to recover in the Roth account, which, as you all know, grows tax-free. So I'm not a huge fan of timing the market, but I do think again, there are some benefits when, if you're not doing Roth conversions every year, then it might make some sense to see what the market's doing and, if the market's down, take advantage of those Roth conversions at that time. The next thing to talk about is eligibility and limitations. So a couple of things to think about is there is no limitations on doing a Roth conversion or income threshold, so, unlike contributing directly to a Roth IRA, where there's some income thresholds that phase you out of being eligible in a Roth conversion, that is not the case. You can directly convert, no matter what your income is, and so that's a huge benefit if you're wanting to take advantage of doing those Roth conversions, not having to be limited by your income.

Speaker 1:

The other thing that is important to consider here is when you have a Roth, rmds are not required. So when you own or you not own, but you have a IRA account, assets in that account are going to be subject to RMDs, which is required minimum distributions at some point in the future. It's been raised a couple of times. The most recent raise happened December of 2022, and that raises the RMD age to 73 or 75, unless you've already started taking RMDs. Again, this is all for another conversation. What I want to point out is, if you get money into a Roth IRA via conversion or direct contribution, that money has already had taxes paid, so you're not going to have to be required to take RMD distributions like you would from a regular IRA. So there's another benefit there.

Speaker 1:

Something else to note if you're doing Roth conversions and this is a big one this is something that I think is important for you to think through and make sure you really wanna do this, because, as of 2017, in the Tax Cuts and Jobs Act recharacterization of Roth conversions, not contributions Roth conversions were eliminated. So now it is not acceptable to make a Roth conversion and then change your mind and recharacterize it back to a traditional IRA. So once you've made a Roth conversion. It is stuck and it is there to stay. So you wanna make sure when you're exercising the strategy and you're doing a Roth conversion, you wanna make sure that you're sure that you're wanting to make the strategy part of your overall plan and that you realize you're gonna have tax liability because there are no takebacks. This is locked in once you make that conversion.

Speaker 1:

A couple benefits of the Roth IRA. So things to think about when you decide are you going to make the conversion from your pretext to your Roth or even again contribute to a Roth. This is not about contributing to Roth. This is only about Roth conversions in this video and this podcast. But the benefit to the Roths are the money grows tax-free from now on. So you're not subject to paying or, number one, you're not subject to taking the RMDs which we just talked about. Required minimum distributions are not in play here, so you're not gonna be required to take money out. And then the other thing is the money inside a Roth grows tax-free. That's a huge tax benefit long-term.

Speaker 1:

Not knowing where tax brackets go, it's my personal opinion that taxes go up for various reasons, but the biggest is our national debt skyrocketed and the interest on that debt has skyrocketed. And then the other thing to think about is we have two roughly two and a half workers plus or minus this is real close for every social security recipient and that's down from several decades ago when we had a dozen workers for every social security recipient and there are fewer people working relative to the past and there's more social security recipients and our national debt is higher and that's telling me that at some point they're gonna have to raise rates to be much higher than they are today. So to me, in my personal opinion, that's a check mark for contributing and or making Roth conversions to that. You benefit from that tax-free growth and there's a couple of things to remember with that tax-free. I'll get into those here in a second, but I got a couple of other.

Speaker 1:

I think there's three or four other considerations to think about when you're doing a Roth conversion. Number one is cost and fees. I guess this is not number one, this is like number seven or eight, I've lost count. But cost and fees. Sometimes there are fees to do a Roth conversion as an administrative fee and a lot of times that's $25, at least our custodian. That's a $25 fee to make the conversion from pre-tax traditional IRA account into the Roth account and I think that's important to be aware of. But I would not let those fees wag the dogs or let those fees wag the dog. It's miniscule in the grand scheme of things and I still think the power of letting this money grow tax-free over your investment objective timeframe is a really powerful tool. Let's see paperwork and documentation. So this is important.

Speaker 1:

When you do a Roth conversion, that is considered a distribution from your pre-tax traditional IRA account, so that's going to trigger what's called a 1099R. That is, a tax document that tells the IRS that money came out of your IRA account and that would be a taxable event. Now there's also a special coding that shows that this was actually rolled over into a Roth account, and so you're going to also get what's called a Form 5498. That comes out usually in May of every year that shows that the actual money was rolled over into the IRA. So you're going to get two documents. One shows the distribution from the IRA that's the 1099R, which would be a taxable event we talked about those tax implications a few minutes ago and then later on you'll get a Form 5498 that shows the money actually went into, or the 5498 is what tracks those contributions, conversions, into accounts and in this case it would be into that Roth IRA. So those are two documents that you'll be aware of so that when you're filing your taxes whether you do it or you have a professional, certified financial professional or an enrolled agent and EA do those for you. You're on the lookout for those documents, to provide those documents.

Speaker 1:

The other thing to consider is let's find my notes, I think the only thing I think we haven't probably talked about is really, in order to benefit from a Roth conversion you want to take advantage of or you want to be aware of, in order to really benefit from the Roth tax-free growth and what it provides, you want to follow the rules. There's a couple of rules to actually get that tax-free growth. One is the five-year window. So any conversion that goes in starts a five-year clock and in order to have that money grow tax-free and come out tax-free, that conversion or contribution has to have been in there for five years. So it's really important that money is in there for five years, but it's also equally as important that you get a Roth opened and you get that clock ticking so that those contributions can go in and have that five-year clock ticking. That's the first thing.

Speaker 1:

The second thing to consider is the age of 59 and a half. In order to take this money out tax-free, not only do you have to meet the five-year window, but you also have to be 59 and a half to take the money out and actually be benefactor, benefit from the tax-free growth that the Roth is known for. So those are the two really important things when you're thinking about am I gonna get this money tax-free? If you're not following those rules, you're subject to taxes on the growth. You're subject to penalty if you take it out before 59 and a half.

Speaker 1:

So there's some things that you wanna be weary of. You can take your contributions out, the money that you contribute in. You can take those out without any kind of taxes or penalty. But I'm not trying to confuse that issue too much. I just wanna focus on the ability to take out the growth of your Roth IRA. You must have the money in there past 59 and a half and the money must be in there for at least five years. So you want that window ticking. These are we've been rapid-fired, but these are the things to think about when you're considering a Roth conversion and there's a lot that goes into play with. Is this decision right for me? What is my tax liability? Am I really gonna benefit from this long-term? What are the strategies? And a lot of times it might be helpful if you don't have a financial advisor, reach out to me. If you do have a financial advisor, reach out to your financial advisor and say, hey, just doing the Roth conversion makes sense. I think a lot of times it does, but it's something that you don't wanna do on a whim. You wanna have a strategy, you wanna have a plan for, so that you have that built-in to your financial plan on paper, on purpose, and it's being executed with reason so that it is actually benefiting you long-term.

Speaker 1:

Thanks for listening to the podcast. If you haven't already subscribed, please subscribe. Be confident in your retirement. Have a wonderful day. Thanks for joining me on another episode of what the Wealth. If you enjoyed the episode today, smash that subscribe button. It helps me more than you think. Also, if you found this episode insightful and light bulb went off, share it your friend, aunt Judy, the random guy in the office who's always talking about investments. Wealth isn't about just the chitchat. It's about our choices, chances and changing our financial futures. The information in this podcast is informational and general in nature and does not take into consideration the listener's personal circumstances. This podcast does not intend to be substitute for specific in financial, legal or tax advice. You should consult the approved qualified professional supplier to making a final decision. Securities offered through LPL Financial member. Finra SIPC. Paradigm Wealth Partners is the other business name for Independent Advisor Alliance. Investment advice offered through Independent Advisor Alliance, a registered investment advisor. Independent Advisor Alliance and Paradigm Wealth Partners are separate ideas for LPL Financial.