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Speaker: Welcome, everybody, to our webinar today on Roth conversions, specifically in light of today’s environment, the tax strategies that we can use to our benefit, and to ultimately your benefit, by utilizing Roth conversions. It is important to note that utilizing a Roth conversion, really to move and convert assets from a traditional IRA to a Roth IRA, is a tax strategy, a tax planning strategy specifically, that really could provide you with significant tax savings down the road, not only for yourself, but also your loved ones.
So, today what we are going to discuss is really the benefits of doing this, as well as some background into why, and then also go through the components of the process and then provide examples and illustrations to bring those to light. Those examples, we will expand on why 2020 is a unique year for taking advantage of Roth conversions specifically, due to some of the changes that occurred as a result of the CARES Act that was signed into law in March of this year. And why that Roth conversion could be, for you, more impactful today.
Before we get started, though, always important to look at the fine print. The purpose of today’s presentation is educational. Please know that nothing I’m going to talk about today is specific to you, or is specific to providing you personal advice, because your situation could be different. So please reach out to your advisor for additional information, who are all well-equipped to help you throughout this process, if ultimately Roth conversions seem like a good option for you.
So again, today’s ultimate topics that we’ll cover is basically breaking up today’s discussion into three components. First is what is a Roth IRA? What is a Roth conversion? And what are the benefits to using that? And then we’ll walk through the logistics of a Roth conversion. Again, like I mentioned, the components you should think about, and strategy. And then also dive into some examples – two specific examples – of how these work and really bringing those to light.
So, I’m really excited about this topic. It’s first and foremost important to know and understand the benefits of a Roth IRA. And those are specifically in the tax-free realm. Before we dive into that, I do want to provide some context that I’m sure you’re all familiar with. But mostly, I’m sure you’re familiar with diversifying your portfolio, having an appropriate mix of bonds and equities, and international and domestic stock, and that sort of thing. However, it’s just as important to diversify your balance sheet. And what basically that means is breaking up your balance sheet and having assets in a taxable bucket as well as a tax-deferred bucket, but also just as important is having a tax-free bucket, for all the obvious reasons.
And there’s different ways of doing that here. Your tax-deferred bucket is generally filled up of various types of qualified retirement accounts, such as a traditional IRA or a 401(k). And those help, because they ultimately allow money to go tax deferred. You do have to take out required minimum distributions out of those accounts when you turn 72. If you turn 72 this year or in future years, that was a change that happened due to the SECURE Act this year, which moved us from 70-1/2 to 72. But that’s your traditional tax-free bucket.
And then you also have the taxable bucket, which is your business, your real estate, your taxable brokerage accounts, checking and savings, that sort of thing. And your tax-free bucket, again just as important. And one of the key ways to fill up your tax-free bucket is really your Roth IRA. Some of the enhanced benefits that you get from that Roth IRA is it’s got tax-free growth. Right? Also, it’s tax-free withdrawals. So when you take funds out of that Roth IRA, it’s ultimately going to be tax free.
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So, the benefits of the Roth IRA are that tax-free growth, that tax-free withdrawal. Also, you don’t have required minimum distributions with a Roth IRA. Meaning, when you turn 72 you won’t be required, or will not be required, to take the funds out of the account if you don’t need it for your cash flow. Of course, when you do, it’s going to be tax free. So it helps the balance sheet, doesn’t cause additional problems there, by inflating your income in your retirement or your later years.
Filling up this bucket – again, utilizing a Roth – you can do it generally two different ways. You can do direct contributions into a Roth, but it’s important to know that there are income limitations to doing that. Specifically, Roth IRAs for individuals, about $139,000 limit, and $206,000 if you’re married filing jointly. Meaning that if your income limits, your modified adjusted gross income limits, exceed those, you can’t directly contribute to a Roth anymore. And a lot of individuals in a position to want to do this have exceeded those limits.
So there’s one other way to fill that bucket up, and that’s through utilization of a Roth conversion. And that’s ultimately what we’re going to spend the majority of today’s discussion taking about today. And I do want to encourage everybody, as we go along, to please ask questions. I definitely want this to be interactive. And I will pause at the end of each section as we go along and I will answer those questions. So please, just enter them along the way. And of course, any technical difficulties otherwise, please let me know as well.
So, let’s dive into Roth conversions, and really what are some things to think about? Again, this is that tax-free bucket, optimizing your tax-free bucket, by converting traditional IRA assets to a Roth IRA. So this is not directly contributing to a Roth IRA, but rather moving the funds from your traditional IRA over into your Roth. When you do this, there is a tax impact. You do actually generate taxation of those assets as ordinary income. So if I were to move $60,000 from my IRA over to my Roth IRA, that would effectively generate $60,000 of income that I would have to report on my 1040, or on my tax return, and ultimately pay taxes on it as appropriate.
So when you do this, you want to be strategic about it. You want to not only manage the tax brackets, but it’s also often looked at as a strategy when you have lower tax years. Whatever that might be. So the ideal time is when your taxes are lower. But often you see this in what we call a notch year, a year where, after retirement, before Social Security benefits, and ultimately prior to your required minimum distributions, which in 2020 and beyond is 72. So there’s these notch years.
I’m a visual person, so I want to show you what that looks like from a notch year. In this specific example, we have individuals who are used to making $200,000 a year. But having retired, they’re generating income due to their portfolio, but in this notch year here, their income is lower. And we’re before Social Security and before those required minimum distributions have to start coming out at 72. So you take advantage of that, basically artificially increase your income by moving the funds into a Roth, paying the income when you’re in your lower tax bracket, and really managing those tax brackets to your advantage.
When it comes to when to do this, how to do this, I do want to start with just an example. Take that $60,000 example that I used a second ago and take this client scenario of them retiring and the income dropping down to about 50,000. So, with my first example, I really want to expand on and discuss what it might look like to do a Roth conversion in one year. Not over time. We’ll talk about that in a second.
But if you just implemented this, a Roth conversion, in one year, in this particular client’s example, this year they have lower income than normal. Because they’re retired. But they do have income that’s being generated. And there’s $50,000, 300 of base income that they’re starting with. It’s what they’re going to have if they do nothing. Now, when they file their tax return, they are going to get a standard deduction. So when we’re looking at the strategies here, we want to take into account a full tax projection of what the tax impact will be for a year, and then we really want to fine tune how much you’re going to want to do as a Roth conversion for balancing both what you can afford to pay in taxes, while also the optimal dollar amount within the tax bracket that you’re in, so you don’t inadvertently push assets up into the next tax bracket.
As we’re looking at this chart, you’re going to familiarize yourself with it, this green area in the middle here, this is actually the 12% tax bracket. And that’s really what we’re navigating in this particular example. Of course, your income is on the left, the percentage of the tax bracket being on your right. And at the bottom, this is each component of the tax picture of what each piece is going to look at.
So now that we know what we’re looking at, let’s dive into the example itself. So, $50,000 of income… Of course, they get that deduction, as I mentioned earlier, your standard deduction, 24,800 for married filing jointly. In this example, $60,000 was the right number, both in a position to be able to pay the taxes on that, but also pushed us up into just the top level before we hit that 22% tax bracket. And ultimately results in about $80,000 in total income.
So the end takeaway here through this strategy, or result, is that we’ve put $60,000 into the Roth. Ultimate income is $80,000 that they would pay income tax on. And helps to fill up that bucket at the end of the day. In this particular example, due to the taxes, we’re always managing those brackets, as I mentioned. We want to stay in that 10%, 12%, 22% tax bracket. And in this case, we landed right there at the $80,000 range, and we filled the bucket in order to maximize and utilize the 12% tax bracket for this ordinary income.
So, very beneficial, in one year, in order to do that, given the management of those pieces. Because that money’s now going to grow tax deferred over time. But the value of a Roth conversion is really that systematic, year over year, disciplined and scientific approach to contributing funds into that Roth. And that’s what I want to show the power of over time.
So, to use the example that I just did, of $60,000, moving it into the Roth, but let’s not say we did that in one year. Let’s say we did that over the course of 10 years. In this particular case, from 62 to 72, moving $60,000 out of a million-dollar IRA year over year. And here, to acclimate ourselves to this chart, so you can see it – because there’s a lot of moving pieces – is… I’ll get my pen here. On the left is the actual portfolio size that we’ll be looking at. And then on the right there’s a few moving pieces. So this is effectively, for all intents and purposes, the Roth conversion amount, the RMD amount, and ultimately the income amount on the left here.
And then on the bottom, this is the value of the traditional IRA. And you’ll see that traditional IRA kind of flat line. It’s not moving up over the course of our 10-year period. And the reason for that is this example we are saying that that $1 million IRA is growing at 6% interest over time, so basically $60,000 a year. So if every year I’m taking $60,000 out and moving it into my Roth, I’m effectively just moving the growth out of the traditional IRA and moving it to my Roth. And that’s why the IRA is kind of flat lining over time.
So, first example is if we do this over the course of that 10-year period, we utilize the flat lining, if you may, and move that money into the Roth, this next bar that you’re going to see is a gray bar. And that’s the balance of the Roth. From basically 60 to 72, those funds are being contributed to it and growing, but you really see that Roth IRA take off. Because it’s growing tax deferred and there is no required minimum distribution. So, presuming you didn’t take any funds out of that bucket – because you didn’t need to, if you’re using the RMDs required from your traditional account to satisfy your needs, as well as your taxable assets – by the time you’re 85 here, that balance is quickly moving up, in this example, in the $2 million plus range, and then much farther than that as it goes up and to the right.
Now, one of the added benefits you get to doing a Roth is you don’t have an RMD, right? So, by moving funds out of your traditional IRA and moving it into your Roth, you’re actually reducing the value, or the balance, of that traditional IRA, which is helping to reduce the amount that you’re going to have to take out in RMDs in later years. And that’s what this next blue line you’re going to see demonstrates, is that that number continues to go down. Because the IRA is getting pulled down over time with the RMDs. They’re getting bigger as you get older. But you have to take out less of those. So the income tax impact is less on you, because you don’t have to take as much out. So that’s an added benefit to the Roth conversion.
If you didn’t do this, your RMDs would look like the red line that’s showing up here right now. The red line is what the RMDs would look like if you would just keep the funds in that traditional IRA, not done the Roth conversion. And as you can see, over time those RMDs go up dramatically, and ultimately exceeding a hundred thousand dollars a year, a hundred and fifty thousand dollars a year, very quickly. And again, that’s all ordinary income that’s dropping onto your tax return that you have to pay income on. So, it’s important to understand and know that, in addition to filling up that tax-free bucket, you’re also reducing the RMDs, which could help you from a tax perspective.
Taking it one step further, one significant value of utilizing a Roth is also the tax-free wealth transfer benefit you get. Due to the SECURE Act that went into effect on January 1st of this year, which increased the RMD age to 72, what it also brought with it is an acceleration of money coming out of an inherited IRA. So once someone inherits an IRA, if they’re not your spouse, and absent very few exceptions, they actually have to take those funds out over 10 years or less, which is an accelerated amount.
So you can actually use the Roth as one more layer of tax-free benefit, not just for yourself, but it’s now a significant value for that wealth transfer strategy, and something we work with our clients, with individuals like yourself, every single day. So it’s not just about you for when you’re alive, but also if you plan to pass these assets on to loved ones. You’re putting them in a position to have a tax-free bucket as well.
Looking at some questions that have come in, I think I’ve answered a lot of them. And I’ll circle back around towards the end and continue to provide additional guidance on some of the questions that I haven’t answered due to context.
The CARES Act changed the game when it comes to Roths, in the sense that two pieces of the puzzle have become more advantageous. Specifically, the CARES Act waived the 2020 RMDs required. And therefore opened the door for Roth conversions, especially for individuals that are in RMD status specifically. So if you’re over 72, you’re having to take funds out. Normally you’re not in those notch years anymore, and you’re not doing Roth conversions, because you have to take out the RMD and then you’d be able to take out your Roth conversion. So your RMD must be satisfied first.
Because you no longer have to satisfy the RMD, you now have an opportunity this year if you want to continue to contribute to your Roth through a conversion. You can really take advantage of that, especially given the fact that all the volatility may create opportunities for converting those securities in what might be a depressed value today. And of course you have that future growth potential for the Roth assets that are going to continue to grow tax free.
The second component is offsetting taxes from your Roth conversion by utilizing the new CARES Act benefit of increasing the AGI deduction to a hundred percent of your AGI, for contributions to a charity. So I want to unpack each one of these for you, and talk a little bit about that waived 2020 RMD and where the opportunity is there.
Using this example, we have a husband and wife, spouses here, 72, 69. Older spouse, first year having to take an RMD. And we walked into 2020 with this expectation that they would be taking the RMD out for this year. So it’s in the plan, if you may. But the individuals here actually do not need the cash flow. They don’t need the funds, they have other funds to utilize. So the question comes up, and it came up here, of hey, we previously contributed to our Roth. We’ve converted assets. Can we do that instead?
And in this example, the answer is yes. In a normal circumstance, taking SECURE Act out of it, you would have an RMD of $60,000 in this example. With their other income being about 110,000, leaving their adjusted gross income at about $170,000. However, in this example, what if you didn’t take the RMD? No RMD, but instead used that exact same dollar amount and moved it into the Roth. You’d have the same AGI result, but instead of having the money sit in a tax-free bucket – sorry, a taxable bucket now – it’s actually in a tax-free bucket. So you get the best of both worlds, if you may, where you get the same ultimate tax result while also filling up that tax-free bucket. Which is a significant benefit at the end of the day.
If you wanted to take this one step further, and you’re charitably inclined, the CARES Act also brings with it an ability to contribute directly to charity and do a hundred percent offset of your AGI utilizing this charitable deduction. Only available this year, only available if you contribute cash directly to a 501(c)(3). So it doesn’t work for your contributing to a donor-advised fund, or a private foundation. But if you do this, you can literally wipe out your AGI through the contribution.
So, in that example I used a second ago, $170,000 of projected AGI, if you wanted to make a $170,000 charitable contribution, you actually could zero out your AGI. Obviously, you’d need to have a significant charitable intent, but we’re seeing that significantly right now. And it really allows you to take advantage of 2020 opportunities, because in previous years, likely in future years, the AGI deduction limitation is actually 60%. So you wouldn’t actually get to use the entire value and really zero out your adjusted gross income.
So, a lot of great opportunities at the end of the day when it comes to Roth conversions. Obviously, you navigate this specifically for yourself. You want to determine the cost/benefit of paying the taxes now and putting the money into that tax-free bucket. We do this every single day, obviously, for you. So your advisor will navigate that and come up with the correct amount. And of course you want to project your growth opportunity and needs to fill that bucket up.
You can also layer on strategies with the Roth IRA and these conversions. One I mentioned a second ago was that wealth transfer opportunity, filling up that tax-free bucket for your beneficiary. Even though you might be paying the taxes now, we are in what many would consider the best income tax environment we’ve ever seen – meaning low income tax rate, stretched out tax brackets, low top marginal rates, and so on. So now might be the best time if, in the future, taxes are higher. No one can predict the future, but we did just issue a multi-trillion-dollar relief bills and such. Billions of dollars’ worth that are ultimately going to have be paid back in the future.
So, filling that bucket up for your beneficiaries also provides a value, because they don’t just inherit that money tax free, and get to take out – if you have large balances – millions of dollars’ worth of tax-free assets with the Roth.
Also, backdoor Roth conversions, there’s also some hidden advantages for taking advantage of this. And employer plans, those are very niche and specific, but if you layer these on you can continue to get more and more benefit in filling up your bucket.
So that will conclude ultimately our discussion action items. Definitely reach out to your advisor, see if it’s right for you. And ultimately determine what’s most appropriate for your situation, and how best to facilitate this for you.
Important to note that if you want to go back and look through this webinar again, it will be posted on our insights page. Also on the resource center. We have a lot of great resources specific to our current environment on that resource page. Look at the top banner ad. A lot of good materials. But also, in our insights page, articles, webinars, and so on, on a variety of wealth management topics. So I encourage you to go there. And also, as I mentioned, reach out to your advisor if you have any questions, nuanced items, and so on, to take this to the next step, if it’s of interest to you.
So, without further ado, just due to time, what I will do is… Again, I answered a lot of questions that came in. I will individually respond to the various questions that came in, if I don’t think I answered them. But without further ado, I thank you all for taking the time today, and have a fantastic rest of your day.
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