10 Roth Conversion Red Flags:
- Wrong tax bracket timing
- Using IRA funds to pay the conversion tax
- Social Security provisional income
- Medicare IRMAA surcharges
- ACA subsidy cliff
- Educational credits
- Passive losses (real estate)
- Net investment income tax (NIIT)
- Capital gains rate bump
- State tax timing
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Transcript:
(NOTE: Transcriptions are an approximation and may not be entirely correct)
Joe: A Roth conversion could be a phenomenal retirement tax strategy, but if it’s mistimed, it could actually hurt your overall retirement. There’s a ton of red flags when it comes to tax planning, especially around Roth planning. Do you know what those red flags are?
Welcome to the show. Show’s called Your Money, Your Wealth®. I’m Joe Anderson, president of Pure Financial Advisory, and I’m with the big man, Big Al Clopine. Hello, Big Al.
Al: How you doing?
Joe: I’m doing fantastic. We’re talking red flags. We talk about Roth conversions quite a bit and how good they could be for individuals, but it’s not for everyone.
Al: You know, and I don’t think we’ve ever done a show where we talked about red flags. There’s a lot of reasons not to do a Roth conversion, so this’ll be kind of fun today.
Joe: It, yeah, there’s many — there’s almost more reasons not to do the Roth conversion versus to do the Roth conversion, but sometimes people hear a strategy and they jump right in. We’re gonna break everything down today on those red flags when it comes to hurting your overall retirement. That’s today’s Financial Focus.
Roth Conversion Red Flags: When This Popular Strategy Can Hurt You
All right. A lot of buzz when it comes to tax planning, and especially around IRA and Roths. Here’s why. 84% of all retirement accounts are still sitting in pre-tax accounts. When they come out of the overall retirement accounts, it’s gonna be taxed at ordinary income. There’s trillions of dollars sitting in 401(k) plans, IRAs, defined benefit plans, and the IRS is pretty excited about the opportunity to tax a lot of those dollars.
That’s why Roth conversions is a pretty popular strategy. And if you look at that number, Al, I can see why a lot of people are interested.
Al: Yes, I agree, Joe, because that would mean only about 16% of all retirement assets are in a Roth IRA. So there’s a lot of tax money coming. So let’s get into this, though, because not everyone should do a Roth conversion.
So let’s recognize that there are red flags, and then let’s also be able to assess the risks and, most importantly, how to respond to them. Is a Roth conversion right for you? Maybe it is. Maybe it’s not. Maybe this year, maybe next year, depending upon your circumstances. Joe, it’s still a great thing. You just have to be aware of when to do it.
Joe: Yeah. let’s take a step back and educate on what actually is a Roth IRA and what is a Roth conversion. All right, there’s a pre-tax retirement account. So that is a 401(k), it’s an IRA, it’s a TSP, it’s whatever that you have through your employer that you get a tax deduction. It grows tax-deferred, but when you pull the dollars out in retirement, you’re going to be taxed at ordinary income rates.
So these accounts were established, I don’t know, 50 years ago when tax rates were relatively high, so you got a pretty good tax deduction going in, and you never pay tax on the growth of those dollars. And in retirement, most people are in a lower tax bracket, so when you pull the tax, or when you pull those dollars out, there’s a little bit of a tax arbitrage.
“Hey, I’m in a higher tax bracket when I’m working. I’ll be in a lower tax bracket in retirement, so I can save some money on tax with the contributions. I never have to pay tax on the- the compounding growth of those dollars. And then when I pull the dollars out, then I’m taxed at a lower rate.” In theory, it works out really well for most Americans.
However, there’s a lot of people that built up significant amount of wealth in these pre-tax accounts. And when they pay the tax when the dollars are coming out, it could throw them up actually into a higher tax bracket. So strategy is that, “Hey, maybe I take some of these pre-tax dollars. I pay the tax today, but I don’t necessarily spend them or put them into a brokerage account.
I move them directly into a Roth IRA.” A Roth IRA is after-tax dollars since I paid the tax, but all of these dollars now compound tax-free. So I put $10,000 in. It grows to 20,000. I pull the 20,000 out, zero tax. So these are a really interesting account for a lot of people because there’s never tax again on these dollars.
Al: Very much so, but you have to be careful on how much you convert based upon your circumstances. And let’s go over the first red flag. Joe, you alluded to it, which is the- the bracket that you’re in. Maybe you’re working today. Maybe you’re in the 24% bracket, which goes up to about 400,000 for a married couple.
But when you retire, you’ll be in a 12% bracket, let’s just say, as an example. Do you really wanna convert and pay a 24% when you’re going to be in a 12% bracket later? In that case, Joe, you may wanna wait until retirement.
Wrong Tax Bracket, Wrong Year: The #1 Roth Conversion Timing Mistake
Joe: Yeah, I think the biggest thing with Roth IRAs and Roth conversions, there is no limit on the conversion.
You can convert as much as you want, and sometimes people think you have to convert the whole account. “I have $200,000 in my IRA. I would love to get it into a Roth,” and then you move it into a Roth. with no limits, there’s huge mistakes that could happen So Alan alluded to here is that, what tax bracket are you in?
You don’t necessarily wanna pay a higher tax if you’re going to be in a lower tax bracket in the future. Now, of course, you have to forecast a little, a little bit here, make some assumptions. Where do you think tax rates are gonna go? Do you think they’re gonna go up? Do you think they’re gonna go down?
Do you think they’re going to stay the same? Then you have to forecast where your income is going to come from over that time period. Is it gonna be ordinary income, or is it gonna be capital gains? Is it Social Security income? Is it pension income? You have to do some planning and forecasting. And then finally, you have to understand how the tax system works, right?
Because we have a 10%, we have a 12, a 22, a 24, and so on. We stopped here at 24 because that’s at a pretty high-income threshold. But this is taxable income. So if I’m looking at, hey, I’m making $300,000 taxable income today And I’m going to be in the 12% tax bracket in retirement, it doesn’t make sense to pay 24, because if I wait a couple of years, I’m only gonna pay 12.
So understanding tax brackets, understanding what your income is, understanding where your dollars are gonna come from, I think, is where people misstep.
Al: That can be a big one, Joe. And so another red flag is if you’re using money from your IRA to go ahead and pay the tax, especially if you’re under 59 and a half.
The Tax Circle of Death: Why Using Retirement Funds to Pay Your Conversion Tax Costs More Than You Think
But just generally, Joe, when you’re paying that tax, you have to pull extra money out to, to go ahead and pay the tax on the conversion, which means you have to pull more extra money to pay the tax on what you pulled out to pay the tax. And it’s even worse if you’re under 59 and a half, because you pay a 10% penalty in addition, right, to the tax itself.
Joe: If you have no cash or non-qualified assets to pay the tax to do the conversion, in most cases it’s not gonna make sense. Just as Al says, it’s like this circle of death with tax. ‘Cause they, I gotta pull money out to pay the tax. I owe the IRS $20,000 for this $100,000 conversion I did, so I gotta pull $20,000.
All the money’s in my retirement account. if I pull $20,000 out, I’m not gonna net 20 grand, because I gotta pay tax on the 20,000 to give to the IRS. Oh, I gotta pull more out to pay… So it can be a little bit more expensive if you have no dollars or no cash to pay the tax when you do the conversion.
So huge red flag here. If you’re under 59 and a half, and you, don’t have cash, forget about it. Yeah. I think the tax is way too rich.
Al: It is. And of course, that’s just a general statement. I’ll say if you’re under 59 and a half, do not pull money out of your retirement account, ’cause you gotta pay federal and state tax on top of your other income, plus the 10% penalty, and some states have penalties too.
So here’s another red flag, and that’s if you’re in, at Social Security age and receiving Social Security, there’s something called provisional income, and provisional income determines how much tax you pay on your Social Security, anywhere between no tax whatsoever to paying tax on 85% of your Social Security at whatever your tax rate is.
And Joe, that’s a big one people don’t realize. They do a Roth conversion, it’s more income, higher provisional income, and now their Social Security is suddenly taxed.
Joe: Right. Yeah. Here’s your thresholds, 32 and 44 of provisional income. So the definition of provisional income is one half of your Social Security, and you can just add up your other AGI.
So that could be interest. That could be dividends. that could be IRA contributions. It could be, everything but, like, a Roth distribution. Even municipal bond interest is actually calculated in your provisional income. So they t- take a look at your provisional income, the IRS does, and if you’re below $32,000, guess- Your Social Security is 100% tax-free.
So if I can keep that provisional income under 32,000, I don’t pay any tax at all on the Social Security income. Now, between 32 and 44, up to 50% of the benefit is subject to tax. And then if I’m over 44, then 85% of that benefit is subject to tax. I still have a portion of the Social Security tax-free, but almost all of it is gonna be subject to my ordinary income tax.
So what we find is that if you do a conversion and put it into the Roth, that adds to your taxable or your provisional income. And then so now what you’re doing, $1 of additional tax could be 50 cents or additional 85 cents of income that would also create tax if you start, putting yourself in these thresholds.
Al: Yeah, and the reason that happens is because when you, if you’re going to be subject to provisional income and you’re not already paying the max on Social Security, you do a Roth conversion, yes, you pay tax on that. You think it’s the 12% bracket, but now all of a sudden more of your Social Security is taxable.
Oh, that’s also in the 12% bracket, plus state. So it can get expensive.
Joe: Absolutely. So there’s a lot of red flags when it comes to doing Roth planning. It’s not for everyone, so you have to look at your specific situation to see what’s right for you. You could hit these red flags and actually lose a ton of benefit.
Hey, if you want more help with this, you know where to go. Go to YourMoneyYourWealth.com. We have The Ultimate Roth Conversion Guide. YourMoneyYourWealth.com, click on that Special Offer. It’s free of charge. Click it right there. We’ll be right back.
Hidden Income Traps: How a Roth Conversion Can Trigger Surprise Taxes and Lost Benefits
Joe: Hey, welcome back to the show, folks. Joe Anderson, Big Al. We’re talking about the red flags of Roth IRAs. Go to our website, YourMoneyYourWealth.com. Click on that Special Offer. It’s The Ultimate Roth Conversion Guide. YourMoneyYourWealth.com. Click on the Special Offer. Download the guide. Hey, let’s see how you did on that true false question.
Al: Medicare IRMAA surcharges can cost high-income retirees up to $5,000 a year on top of standard premiums All right, first of all, what is IRMAA? It’s income related monthly adjustment amount. So what that means is when you’re on Medicare, the amount of your premiums that you pay is dependent upon the amount of income that you make, right? So in other words, the more you make, the higher the premiums, and Joe, this is asking is it $5,000 or something more?
Joe: 7,000, roughly.
Al: There you go.
Joe: They look at what your adjusted gross income is two years prior, and so they take a look and then that’s gonna dictate what your Medicare premium’s in. Let me break it down like this.
Medicare IRMAA, Social Security, and the ACA Cliff: The Income Thresholds That Can Derail Your Conversion
You wanna make sure where these Medicare premium thresholds are, and then that’s up to you. If you’re married, $220,000 of modified adjusted gross income. If you’re single, it’s half that. Call it $110,000. So if I’m at 110 as a single taxpayer, 220 as a married taxpayer, you wanna be careful of that threshold, because as soon as you go over that by $1, right, 218, now my Medicare premium jumped $100 a month.
If I jump it to 274, it jumps 240 additional a month, 385 additional a month, and $529 additional a month. So there’s these IRMAA thresholds that you have to think about when you’re doing Roth conversions. Again, Roth conversions is taking money from your retirement account, converting it into a Roth IRA so you never have to pay taxes on those dollars again.
But guess what happens if you convert too much? And if I’m already collecting Medicare, in a couple years you might be surprised. You’ll be like, “Wow, was that inflation? What happened to our Medicare premiums? They went sky high.” It’s because you jumped that IRMAA threshold.
Al: Yeah, because you did a Roth conversion, or had extra income, right?
And it is. It’s a two-year look-back, right? So the tax year that you’re in, it’s your income two years earlier that determines the amount of premiums that you pay. So just be aware of that. When you do a Roth conversion, you can jump up your, IRMAA premiums quite a bit.
Joe: All right. Here’s another health insurance gotcha, the ACA subsidies, Affordable Care Act.
You have to watch out for this subsidy cliff, because what could happen is that you totally lose your subsidy. So as you’re thinking about doing Roth conversion, it’s $84,600 as a couple, married couple. Just met with a client. They’re looking at this strategy to say, “Hey, I don’t want to do a Roth conversion because I’m getting these subsidies, which is significant.”
Al: So if you’re below those thresholds that Joe just men- mentioned, $84,000 for a married couple, your premiums are no higher than 8,400. But the actual premiums that you pay are likely closer to 2,000 a month, 24,000, in some cases higher- So if you’re doing a Roth conversion and getting over those limits, all of a sudden you’re paying the difference.
You’re basically tripling the amount you pay for health insurance.
Joe: All right, what’s the next one? Educational credits. Al, kick us off here.
Al: Yeah, so this is where you get $2,500 credit per student in college per year, right? And it’s a great credit. It helps pay for college. But if your income threshold is too high, it goes away.
There’s a phase-out period, and then you get to a period where you completely lose it. So again, you do a Roth conversion, you push your income higher, all of a sudden you’ve lost this credit, which effectively increases your tax rate.
Joe: All right, passive losses. So here’s one if you have real estate. So sometimes people think, “If I purchase real estate, it gives me a, huge tax benefit.”
It does, depending on what your adjusted gross income is. So if you’re between 100 and 150, you’re in this phase-out. You wanna keep your adjusted gross income or modified adjusted gross income under $100,000. If you’re adding income to the tax return, you could fall here or you lose the benefit altogether.
Al, help us layman people, talk about passive losses and what do they actually mean.
Al: Yeah, so that’s, Joe, when you have a rental property. When you have a rental property, it’s considered a passive loss, and in general, you can only take passive losses, if you have passive income. Except, here’s the exception.
If your income, is below $100,000, you can deduct up to $25,000 of your rental property losses against other income. But once it gets over 150, you can’t deduct any. It just gets suspended. You get to deduct it later in another year, or maybe you use it when you actually sell the property, but in the current year where you want it, you can’t take it.
And then there’s that phase-out period between 100,000 and 150, so that’s where you might get some of the credit versus not all. But again, this is a way, you do Roth conversion, all of a sudden you lost this deduction.
Joe: Yeah. It’s just understanding, again, taxes. As you’re doing conversions, or if you’re thinking about it, there’s all sorts of different obstacles and red flags that could maybe pause, cause you to pause to, to do the strategy.
Al: The next one is net investment income tax. So this is where your interest, dividends, capital gains, passive income, being real estate. So you have to pay an extra 3.8% tax. It’s called a net investment income tax. That’s when your modified adjusted gross income for a married couple is over 250,000, for single it’s over 200,000.
So Joe, yet another tax that you might have to pay if you convert too much.
Joe: Yeah. If we skip ahead to capital gains, and we can kind of combine these two, is that the capital gains tax is an additional tax to the net investment income tax, or the net investment income tax is an additional tax on your capital gains tax.
Now, there’s three different thresholds when it comes to capital gains tax, and what a capital gains tax is, it’s tax on a capital asset, such as a stock that’s sitting in your brokerage account. You bought it at $10 a share, now it’s $15 a share. That $5 a share of growth when you sell that stock is going to be subject to a capital gains tax.
It also could be subject to the net investment income tax, depending on where you fall on your tax return. If I’m in that 12% tax bracket, $100,000 of taxable income or less, there is no tax on my capital gains. So if I’m retired and I do not have any income, I could sell up to close to 100,000 or more of stocks, bonds, mutual funds that are sitting in my brokerage account, and I could live off of those potentially and not pay any tax at all Now, once I jump from that 12% tax bracket all the way up to about 615,000 of income, your capital gains rate is 15%.
This is on the federal side. And then once I get over that 600, now my capital gains are 20%. So there’s an additional tax that we just talked about, was the net investment income tax, is an additional 3.8% tax on top of the 15 or the 20. So f- finding out where you fall is key.
Al: Joe, we get this question too, which is, “Oh, you know, I’m b- I’m in the 12% bracket.
I’m gonna sell my property, have a million dollars gain, so I don’t have to pay any tax.” No, it’s only up to the 12% bracket, so that’s if you had a gain of less than $100,000, as Joe just mentioned, if you have no other income, right? So if you’re, over that, you’re gonna have a tiered bracket. So you’re gonna have 15%, 18.8, 24.23.
Joe: Gets confusing. Lot of things to know, lot of pitfalls, lot of red flags. So go to our website, YourMoneyYourWealth.com. Click on that Special Offer this week. It’s our Ultimate Roth Conversion Guide. It’s gonna talk to you about when to do it, when not to do it. What are the red flags? What are the green flags?
When we get back, we’re gonna talk about solutions. When does it make sense to do this Roth conversion? When are the green flags up and the red flags down? We’ll see you in a minute.
When Roth Conversions DO Make Sense: Green Flags, Smart Timing, and the Long Game
Joe: Hey, welcome back to the show. Show’s called Your Money, Your Wealth®. Joe Anderson, Big Al Clopine. We’re talking about Roth red flags, when not to do that Roth conversion. Go to our website, YourMoneyYourWealth.com. Click on the Special Offer. It’s The Ultimate Roth Conversion Guide. YourMoneyYourWealth.com. Let’s see how you did on the true/false.
Al: A Roth conversion will affect state taxes. Very possibly, right? It depends what state that you’re living in. In most cases, yes, you will pay taxes on your IRA, Roth conversions. Some states you don’t, just a very few, and some states don’t have an income tax, so Joe, you wouldn’t have to pay tax there. But in most cases you do.
Joe: Yeah. I think what we find is that if you are going to move to a lower-cost state from a state tax perspective, or if you go to a state that doesn’t have state tax, does it make sense to wait to do the conversion? And the answer is absolutely, in most cases, because you can have a significant savings here because you avoid the state tax altogether. Al, talk to me about stacking.
Al: All right, so this will be a little bit of a recap what we just talked about, but what can happen is that you pay higher taxes. That one’s kind of obvious, but maybe even a higher tax bracket that you’re going to be in retirement. Potentially higher Medicare premiums, we just talked about that.
Lost credits, education credit, that passive loss deduction might go away. That’s a lost deduction. So just be aware of all these things that can happen when you do a big Roth conversion.
The Roth Conversion Checklist: What to Verify Before You Convert
Joe: Let’s get a checklist involved here. All right, you gotta forecast your taxes. First, you have to understand how the tax system works. It’s a marginal tax system. You have to find out where you fall on that marginal system and do some forecasting. Where you sit today, where do you think you’re gonna sit tomorrow, right? How are you going to do the conversion tax? How are you gonna fund the tax on the conversion? Are you gonna pay the tax out of the conversion, or do you have cash outside of your retirement accounts to help fund that conversion?
If I’m collecting Social Security and I have no other income sources, right? If I do a conversion, it could create more taxes. And then also we talked about the ACA subsidies. A lot of things to be thinking about from a checklist perspective.
Al: Okay. We’ve got a second page of this checklist. So IRMAA, so that’s part of this, right? You have more income from a Roth conversion, you will potentially pay more for your Medicare premiums, so be aware of those thresholds. Credit eligibility. We talked about childcare. There’s other credits too that may be phased out when you have more income from a Roth conversion, passive losses being one of them.
On real estate, right, it’s a deduction that goes away. Passive loss deduction, it would get suspended, you use it later, but where you want it is right now. And the net investment, income tax, that’s an extra tax on your capital gains when you reach certain income thresholds.
Joe: We talked about all the red flags, all the bad things that you wanna look out for when you’re doing Roth conversions. But in my opinion, I think the Roth is probably the best vehicle for retirement that was ever created. It absolutely gives you control, and it gives you something that’s called tax diversification. Most people have heard of diversify your assets, but a lot of you don’t diversify from a tax perspective.
What I mean is how much money you have in tax-free, a Roth, how much money do you have in those tax-deferred accounts? How much money do you have in non-retirement accounts? What is the percentage that you have in each of them? If I were to guess, I would say most of you have the bulk of your liquid assets, 80, 90%, in a traditional retirement account, and then the other 20 or 10% is probably sitting in a brokerage account or a Roth account.
That is not diversification. You wanna be more diversified because it gives you a lot more control as you’re taking distributions in retirement. RMD, a required minimum distribution. The more money that you have in a Roth and less in a retirement account- You’re going to eliminate a lot of that RMD because the required distribution is based on traditional retirement accounts, not Roth accounts.
So if I look at my traditional IRA, they’re gonna look at the balance and they’re gonna put a formula based on that or a percentage to distribute out. Why do they have the RMD? Because the IRS wants their tax. So you have to pull money out, you have to pay tax on it if you need the income or not. By doing a Roth conversion, that’s gonna lower that account balance, increase your Roth balance, so even y- you still have the wealth, but it’s gonna reduce the amount of RMD.
Market downturns. Market drops 20%, huge opportunity, I don’t care what tax bracket that you’re in, is to do a Roth conversion. Because you’re converting the same amount of shares at a lot lower stock price, or a mutual fund price, or an ETF price. It doesn’t matter. Right? Market goes down, this is when you start acting from a tax planning perspective.
And then finally, I think legacy planning. If you wanna have a legacy, give money to the next generation, a Roth IRA is the best vehicle to do so versus your traditional. Because they don’t have to pay tax on those dollars once they inherit it. It could stay in the account as well for another 10 years.
The retirement accounts, the standard retirement accounts, you pull those dollars out, taxed at ordinary income.
Al: Yeah, legacy planning, to me, is such a big one because you think about it, so you set up a Roth for yourself, and if you pass away, your spouse gets that Roth account, also tax-free. He or she passes away, then your kids get it tax-free.
Now, they do have to distribute it out over a 10-year period, but it’s tax-free. So you think about it, what’s the best gift to give to your kids? That would be a tax-free gift, and that comes from a Roth IRA. Just be careful, though. To get that Roth conversion, make sure you’re doing it at the right time for you so you’re not paying extra taxes.
Joe: All right. That’s it for us today. Hopefully you enjoyed the pitfalls of Roth conversions. If you want more help, go to YourMoneyYourWealth.com. Click on our guide. It’s The Ultimate Roth Conversion Guide. YourMoneyYourWealth.com, click on that Special Offer, download it right there for free. It’s our Ultimate Roth Conversion Guide For Big Al Clopine, I’m Joe Anderson. We’ll see you next time, folks. Hopefully you enjoyed this one.
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