Uncommon Reasons For Roth Conversions

Tyler Emrick:

Coming up on today’s show, I talk through the financial impacts of implementing a well-thought-out Roth conversion strategy, hear how my clients overcame the emotional struggle of paying a large upfront tax bill to help build wealth and provide better outcomes for themselves and their families. Today, what’s the big deal with Roth conversions and why should you care coming up on today’s show.

Walter Storholt:

Welcome to another edition of Retire Smarter. I’m Walter Storholt, and today, joined by Tyler Emrick, of course, Wealth Advisor, Certified Financial Planner at True Wealth Design, serving you in northeast Ohio, southwest Florida, the Greater Pittsburgh area, that’s where the offices are, but also serving you from anywhere at truewealthdesign.com. Visit there for the opportunity to schedule a 15-minute call with an experienced advisor on the team.

Looking forward to our conversation today, Tyler, you already teased us with it. We’re going to be talking about Roth conversions. Why should people care? It may seem like a simple conversation, but has a little bit more of a deeper emotional tone to it because of sometimes the tax bill, people get into their eyes and into their minds, and I think that’s why it’s going to be really valuable to explore that and also just to see the difference it could make in someone’s plan. So can’t wait to dive into all of that with you, and I hope you’re doing well, my friend.

Tyler Emrick:

Yeah, doing all right. Hanging in there, Walt. Appreciate it. Absolutely ditto everything you said. Excited and happy for the show today. I think it’ll be a fun one, even though it’s pretty dark and gloomy out here as I look out the window here on a Tuesday morning.

Walter Storholt:

Never good. But you know what? Better to have it dark and gloomy on a Tuesday than on the weekend, right? Get it out of the way now.

Tyler Emrick:

Yes. Agreed, agreed, agreed.

Walter Storholt:

Very good.

Tyler Emrick:

But you’re right. I think when we reach out to these families after at our progress meeting and it comes to the end of the year and say, “All right, hey, let’s implement that strategy.” Oh, well, you wouldn’t believe it, but of course when they see that big tax bill, naturally it’s like, “Well, hey, wait, what’s going on here? Why are we taking this stuff and why do we want to do that?” And I think that’s, again, pretty natural, especially when you see some of the checks that families are writing to the IRS to kind of complete these transactions.

That’s what I mean by that delayed gratification where it’s like, hey, you’re going to feel some pain now, but not losing sight of, well, why are you doing it? And what are some of the benefits and how is this Roth conversion going to put you and your family in a better situation going forward? As I think about today’s episode, I think that’s what we really want to kind of get into is some of the more unique ways of looking at these Roths and why you might want to utilize it. So that way when that big tax bill does come and you actually make that transition and to complete it, you’re like, “All right, hey, I can understand why we’re making this step.”

Walter Storholt:

Yeah, it’s the last thing people want to see at the end of the year when you have all sorts of other expenses, is then a big tax bill on top of that.

Tyler Emrick:

You got holidays, you taking some time off work, might be thinking about retirement and then, oh, wait, hey, you got to write this estimated payment or withhold this amount of taxes to do it.

Walter Storholt:

No fun.

Tyler Emrick:

Well, and of course, too, you think about it, the larger Roth conversion that you do, hey, the bigger that tax bill’s going to look like as well. So you definitely got to be mindful of that.

Walter Storholt:

It’s a sliding scale too. The better you get at the delayed gratification thing, the more that’s coming out of the pocket, right?

Tyler Emrick:

Yes. No, absolutely. I like it. That’s a good way to frame it. So what are some of these, other than the simple fact of looking at and saying, all right, hey, what’s my tax bracket now? What’s my tax bracket look like in the future? And do you have an opportunity to pay less in taxes now? I think those Roth conversions also can be used to protect your spouse’s future. What do I mean by that, protect your spouse’s future? Well, when we have a family come in and we’re starting to create a plan and starting to work with them, we traditionally take them through our Retire Smarter solution where we’re diving into every aspect of their financial lives. And one process or one step in that Retire Smarter solution process is what we call the risk mitigator.

So this is where we are taking your financials and your goals, and we are stress testing the financial plan under different scenarios and circumstances to say, hey, are you still going to be in good shape under this scenario? And one of those situations is the death of a spouse and taking a look and saying, well, how would the widower look financially under this circumstance? And what we find is a lot of times their surviving spouse’s tax situation is going to substantially change from where they’re at now. So maybe the best way for me to illustrate that would be through a quick example.

Let’s say you have a couple, and they’re in retirement, they’re living off their pension and social security, and then they have this sizeable retirement plan assets that are sitting in their 401(k) or IRAs that they have never paid taxes on. When we go through their particular plan, we look at it and say, “Hey, you’re living very modestly. You’re living well within your means, so there’s a very high likelihood that your retirement assets are not going to be used completely, and they’re going to continue to grow throughout retirement.” This is really not uncommon. And so we take that information and we say, “All right, hey, what happens if your spouse passes?”

Well, the surviving spouse is likely still going to have that pension if there’s a survivor benefit. They’re still going to have social security. Now, of course, one of the social security payments, the smaller one would go away, and then they’re going to have their sizable retirement assets to help them support their lifestyle. But as you think about them aging and continuing into retirement, there are still going to come a time where they’re going to have required minimum distributions. And what we find is a lot of times those required minimum distributions are going to provide more income than what that individual actually needs to live their lifestyle, i.e. they’re going to have an issue or could potentially have a tax issue when those required minimum distributions begin because they’re going to have to pay taxes on all that money in the year that they have to do that required minimum distribution. And that doesn’t change. That’s going to happen and continue throughout the rest of their retirement.

So you put your shoes in the surviving spouse’s situation and go, okay, well, my income hasn’t changed all that much, but I have this required minimum getting ready to hit and I’m no longer able to file my taxes jointly. You’re going to go under individual tax rates, which, if we look at individual tax rates, ordinary income rates, those brackets are much, much more condensed and go up much more quickly than if you are filing jointly. So if you have the same amount of income, well, that surviving spouse will likely be in a higher tax bracket than what they would’ve been if their spouse would’ve still been alive. So that tax scenario or that situation, thinking through that and understanding, well, okay, under a scenario in there, how much more in taxes is that surviving spouse going to have to pay will help you better put in frame, well, how high would we want to maybe take our income with a Roth conversion.

But taxes only tell one story. There’s also the good old IRMAA tier, which when I say IRMAA, which I know we’ve said that in the past before on many different podcasts, but that’s where your Medicare premiums, the Part B premiums, well, they can be increased if you make too much money. So, for example, the first Medicare tier, if you’re married and filing jointly, you can make about $194,000 a year before you have to start paying more on your Medicare Part B premium. Well, if you file single, that number is essentially almost cut in half and it goes down to $97,000 a year. So as a single individual, once your income hits that 97, now you’re going to have to start paying more for your part B premiums for Medicare. So they kind of hit you as a double whammy or could potentially hit you as a double whammy more on income taxes and paying more for your Part B premium through Medicare.

Walter Storholt:

Strikes me as one of those consequences, that’s that next level that the DIYer just often is never going to dig to or realize when it comes to hit them. That’s one of those nice ones where it’s good to have somebody who’s been there before, Tyler, to see these consequences and these things pop up. Since we’re talking about delayed gratification, I wonder too, you mentioned, okay, this is going to affect the spouse down the line. What about inheritance, legacy pieces of the equation? I would imagine since we’re talking taxes and delayed gratification things down the line, that would wrap into this conversation.

Tyler Emrick:

I agree wholeheartedly. I mean, especially when you consider some of the law changes around inheritance and receiving retirement assets. The SECURE Act passed a couple of years ago, well, there’s actually part two of that that happened more recently, but that SECURE Act actually changed the rules around how you have to distribute money that you inherit in a retirement account. And that includes not only Roth accounts, but also pre-tax retirement accounts like traditional IRAs and 401(k)s. And under the new rules, essentially, there are a couple of caveats where you might not have to abide by this, and you can go under the old, but for most individuals, if you inherit a retirement account from anyone other than a spouse, then you are going to have 10 years to pay out those assets. The IRS doesn’t necessarily care how much you pull out each year. They’re just going to look in and say, “Hey, within 10 years, that account has to be down to a zero balance.”

Again, this isn’t necessarily going to affect your spouse like the situation we talked with before, but as you start thinking about your children or who’s going to inherit your assets, it’s absolutely going to affect them as to, all right, hey, this inheritance or this money has to be used up. How can we do it in a very thoughtful manner? And as we think about and take that holistic financial planning approach, we think of it as financial or family wealth planning, where we’re starting to look at those iterations and saying, all right, hey, once your financial plan is in good shape, and you start to see good big numbers left at the end of your plan, and now you still have to start turning your attention to, all right, what does your estate look like and how can you maximize that inheritance for whoever is going to get it?

I think a lot of individuals kind of think about that family wealth planning is just for the ultra wealthy. “Hey, I don’t have necessarily enough funds or enough worry to be able to want to necessarily take this much detail or go into this much thought.” But I would argue that it’s important for just about everybody to kind of think about how that transition would work. And if we walk through a quick scenario of a family that I’ve worked with for a number of years, I think that might help illustrate the point a little bit.

They’re a married couple, they’ve been retired for a few years now. They live modestly, they live well within their means, and they’ve got about a million dollars saved in pre-tax retirement accounts. So when they do distributions from those pre-tax retirement accounts, that adds to their income and they have to pay taxes on it. And they have a daughter who does very, very well, but she’s going to be inheriting their assets once they’re gone. So if we start looking at just stress testing their situation in particular and say, all right, well, hey, what happens under the scenario that they pass and their daughter is going to inherit that million dollars inside of their retirement account?

Well, if she does inherit it, she’s going to be under that 10-year payout rule, which means that she’s going to have a million dollars that has to be fully distributed from an inherited IRA within 10 years. And what happens is when she does those distributions, those distributions get added to her income and then she pays taxes at whatever the income rate that she falls at. In her case, she makes about $70,000 a year. She’s single. So if we run through a quick scenario where she takes her inheritance and just spreads it out equally over the 10 years and takes 100 K a year, what that means is, is she’s going to be paying roughly about 24% in taxes on that 100 grand that she receives each year. Not a small chunk of change that goes to the good old IRS, I would say.

Walter Storholt:

No, no, not at all.

Tyler Emrick:

Yes. And she has a little bit of flexibility around it, but if she delays those payments, that just means she has to take more out later on down the road and that could bump her up into an even higher tax bracket. So 24%.

The conversation that I had with this couple was saying, “Hey, well, you know she’s going to inherit this money at some point down the road. You guys, when we look at your income situation, have the opportunity to take some of that million dollars out even though you don’t necessarily need it and pay taxes on it in the 12% tax bracket.” So that’s about half of what her daughter would pay in taxes. So another way to put that is, is for every $100,000 that they can get converted into a Roth for their daughter, she’s going to pay about 12,000 less in taxes on that money, which that’s not a small chunk of change, especially as you consider a million dollar distribution and adding up those numbers over time. And that doesn’t even really help reiterate the fact that, hey, now this money is in a Roth and it’s growing tax-free.

So I think as you look at your inheritance and your estate planning and how Roth conversions fit into that, you really got to have an understanding of, all right, hey, how important is leaving a legacy? All right, if your family is going to get some of this money, what does their tax situation look like and what situation would they be under if they inherited this and how can we make it to where good old Uncle Sam gets the least amount of tax payments possible on that money?

Walter Storholt:

No, it’s a great example of just how all of this sort of intertwines and then where that delayed gratification, not eating the marshmallow really pays off the future.

Tyler Emrick:

Not eating the marshmallow.

Walter Storholt:

Yeah. But this is really putting that, I think, into perspective because it’s one thing to talk marshmallows, it’s another thing to talk tens of thousands of dollars when it comes to passing along finances to a spouse. And then in this example, obviously the inheritance legacy angle. This makes a huge difference all from a simple choice of to Roth or not to Roth.

Tyler Emrick:

Yeah, I think a lot of times people try to boil down that decision to very simple terms as, “Hey, what’s my tax bracket now versus down the road?” But when you take that more holistic approach and have a good understanding of what the family’s trying to accomplish, and what are some of these other scenarios that might come up and how can we use that information and the data from what those scenarios look like to better make informed decisions now, I think that’s where the value comes into play when you start thinking about taking that holistic approach and working with more of a, say, a financial advisor and a wealth planner as opposed to someone who’s just going to necessarily, “Hey, I’m going to manage your assets,” or, “Hey, I’m going to talk to you about this life insurance policy,” or whatever the case may be.

Because as we start thinking about these decisions, what you’ll start to find, and what you’ve hopefully have found, maybe, especially if you’ve been a long-term listener, is that these decisions have ramifications across every aspect of your financial life. So looking at them inside of a narrow view doesn’t paint the whole picture. So the more we can broaden that view and take into consideration all these different scenarios, I think it’s just going to put you in a better situation to make better informed decisions going forward.

Walter Storholt:

It’s just one of those examples. I mean, this is just one area of improved financial planning, and you see the difference. Now, you work with a competent planner who can do this multiple times over, not always of the same magnitude, but these things start to really compound and add on top of one another when you, okay, we’re going to improve our Roth decision making in our financial plan. We haven’t even looked at the investment component, we haven’t even looked at the full tax component, just one angle of it. All of those things start to come together and you can see where planning really, really makes a difference.

Tyler Emrick:

It does. And to build off that a little bit too, I mean, I tend to talk a little bit more about the softer side of financial planning in these episodes.

Walter Storholt:

Sure.

Tyler Emrick:

I think that tends to lean more towards my personality and just how important it is, I know for me personally, to have a relationship with the families that I work with because you think about that family that we just talked about and their daughter and that situation. Well, the more I know about their daughter and her situation and what the expectation is with the assets and how that family uses their money and that they’re not likely to go through it, all these little things add up in culmination to help me be a better financial advisor and to help give better recommendations as they start thinking about things like Roth conversions and maybe having a little bit of pain upfront to put themselves in a better situation going forward. If, as an advisor, we don’t know those things or understand our families in that way, it becomes increasingly difficult to make recommendations like this if we don’t have the full picture. Does that make sense, Walt, or we kind of hit it there? Again, I talk a little bit more about the softer side of things.

Walter Storholt:

It does, yeah.

Tyler Emrick:

That lends to, I think, some of the value that that provides.

Walter Storholt:

Well, those two things combine, the softer side and then the actual hard number part of planning. You really can’t just do one or the other. They really do become intertwined if you’re planning properly. That’s the great thing about the way that you guys operate at, of course, True Wealth Design. And if you have been having any questions popping up into your mind throughout today’s episode or you’ve got something else on your mind, it may not necessarily be about Roth conversions, but some other element of your plan that you need some clarity on, a great first step to take is to get in touch with Tyler and the team at True Wealth Design by just going to truewealthdesign.com and clicking the “Are We Right For You” Button that’ll help you schedule a 15-minute call with an experienced advisor on the team. Again, just go to truewealthdesign.com and you can also find that link in the description of today’s show so you can get there very easily. You can also call if you prefer the old-fashioned way. 855-TWD-PLAN. Is that number 855-893-7526.

Well, Tyler, great breakdown on today’s episode of Roth conversions. Very much appreciate it and we’ll look forward to talking to you or perhaps Kevin. I believe there’s a rumor he may make an appearance on the next episode.

Tyler Emrick:

I think so. We’ll see.

Walter Storholt:

Whatever we’ve got in store, we’ll be looking forward to another good conversation with you guys next time. Thanks so much for your time.

Tyler Emrick:

All righty, have a good one, Walt. We’ll see you.

Walter Storholt:

You as well. That’s Tyler Emrick. I’m Walter Storholt. Thanks for joining us. Hope you got a little smarter today, and thanks for tuning in to the Retire Smarter podcast. See you soon.

Speaker 3:

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