Show Notes

• (00:44) Clarifying the 5-Year Roth Withdrawal Rules Once and For All (Elisa, Fremont, CA)
• (06:36) How Does the 5-Year Clock Work on TSP to Roth Conversions? (Wendy, NY)
• (11:03) Why Would I Contribute to Roth and Lose Today’s Tax Savings? (Champ Kind, Washington)
• (21:25) How Does the 5-Year Roth Withdrawals Rule Impact Taxation of Dividend Income? (Lias, CA)
• (38:04) Roth Conversions and RMDs on an Inherited IRA (KP, La Mesa)
• (44:25) The Derails

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Transcription

Today on Your Money, Your Wealth® podcast 404, Joe and Big Al clarify once and for all those 5-year Roth clocks for withdrawing money from your Roth accounts. How do the 5-year Roth rules impact the taxation of dividend income? Do they impact TSP to Roth conversions as well? Plus, why contribute to a Roth in the first place and lose today’s tax savings? Joe and Big Al rise to that challenge, and they discuss Roth conversions and required minimum distributions from an inherited IRA. Visit YourMoneyYourWealth.com and click Ask Joe & Al On Air to send in your money questions. I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA.

Clarifying the 5-Year Roth Withdrawal Rules Once and For All (Elisa, Fremont, CA)

Joe: We got Alyssa? Elisa?

Andi: Alyssa?

Al: Alyssa? Yep.

Joe: E L I S A. That’s not Alyssa.

Andi: Elisa.

Joe: Elisa.

Al: It could be Elisa or it could be Alyssa.

Joe: I like Elisa better.

Al: Okay.

Joe: Fremont, California. “Hey Joe and Big Al, still worried about the 5-year conversion rule. Former Fed employee converting TSP traditional every year since 2020. Age 63. I keep reading 5-year rule applies to each and every conversion and the clock start for each one. Please clarify the conflicting info once and for all. I drive a 2020 Honda Insight and have a Yorkie Poodle. Red wine, please. Love the show. You make finance fun.” She’s 60 or- Elisa’s 63.

Al: That’s correct.

Joe: Oh, man. The 5-year clock rule again.

Al: Here let me try. You always do it. You can correct me. So here’s maybe how to think about it. The origin of the 5-year clock is that when you set up your first Roth IRA, and when you withdraw the money from that IRA, it has a season for at least 5 years before you withdraw the income or growth. You can always withdraw the principal if it’s a contribution. Now, you have to wait till 59 and a half for this-

Joe: -or 5 years, whichever is longer.

Al: Whichever is longer, exactly. Yeah. So- but the conversions, it’s like well, you know, when you take money out of an IRA and you’re younger than 59 and a half, you have to pay a 10% penalty. So what the IRS did, they came in and said, you know what? If you convert money to a Roth IRA and then pull it out the next day, well, that’s a way to avoid the 10% penalty. So they came up with this rule that if you do conversions when you’re younger than 59 and a half, you have got to wait 5 years for every single conversion to be able to get access to the principal part. The income and growth has to be 5 years or 59 and a half, whichever is longer, but the principal part. That’s why they have that rule. Once you get to 59 and a half, that rule doesn’t apply because you can pull principal out on a conversion at any time you want. You still have to wait to 5 years for growth and income, unless you already had a Roth. If you already had a Roth, that clock already started when you started your first Roth IRA. So at age 63, you can do conversions all you want, right? And assuming that you already had a Roth IRA 5 years ago, you do a conversion, next day you could pull the whole thing out, even if it grew on that day. Or if you haven’t started Roth and the conversion is going to be your first Roth IRA, well, you gotta wait 5 years to pull any growth and income out. You can always pull principal out. Because- we’ll go back to this- because you’re over 59 and a half, we don’t have to worry about that 10% penalty rule. And I will say Alyssa or Elisa, whichever, it is confusing the literature, because a lot of the literature does not specify that fact, that this only applies to if you’re under 59 and a half. It just goes in with that rule. And Joe, I know you’ve taught before, and people have challenged you on that in class. Well, I just read you’re wrong, and it’s like, then we have to go through this whole thing again. But that’s the straight skinny.

Joe: Yeah, there’s two clocks, because people took advantage of the rule. People converted their money, and they took it out the next day and was like, I’ll pay the tax, no biggie, but I avoided a 10% penalty. And so the IRS is like, oh, damn it. Now we got to come up with another rule, right? That’s why each conversion has its own 5-year clock until you turn 59 and a half. And hopefully this will be the last time we’ll have to do this, but I doubt it.

Andi: We do have a white paper on this.

Joe: Here’s an example. Let’s say Elisa put in $5000 into a Roth IRA at age 50. Then she converts money at age 58. Well, that conversion would have to wait 5 years or until she turns 59 and a half is how it’s read. Instead of saying you have to wait two years. Because it’s not a 5-year clock. She’s 58. She turns 59 and a half, let’s say in a year and a half. So she really has a year and a half clock on that conversion. So it’s 5 years or 59 and a half to take the money out from a principal standpoint. But now she’s 60. That conversion has only been alive for two years, but she established a Roth IRA 10 years ago. So she’s good.

Al: On everything.

Joe: On everything. So because she satisfied the 5-year clock at age 50, and then so she satisfied the other 5-year clock because it’s 5 years or 59 and a half on the conversion. So each conversion has its own 5-year clock until you turn 59 and a half, and then that 5-year clock basically goes away.

Al: Yeah. And here’s another way to say it. Let’s say you’re 58. You do the conversion, you hit 59. You need the money. You got to get it out. There’s no other choice. You got to get it out. You didn’t make it to 59 and a half. You will pay the tax on pulling money out, as well as the 10% penalty. Now, you actually paid the tax on doing the conversion back when you did it at 58. But you will have to pay the 10% penalty when you’re 59 because you weren’t 59 and a half.

Joe: All right, hopefully that helps. Thanks, Elisa.

How Does the 5-Year Clock Work on TSP to Roth Conversions? (Wendy, NY)

Joe: We got Wendy writes in from New York. She goes, “Hi there. I really enjoy your show. I listen to it on my way to work in rural New York. I’m 58, plan to work until 70. I’m a federal employee for over 20 years. I have a traditional and Roth TSP. My husband has a Roth IRA. My question is about the TSP and how to plan ahead for Roth conversions from my TSP to an outside Roth IRA. My plan is open up a Roth IRA with nominal contribution and then start doing Roth conversions when I’m 59 and a half. Am I right that if I open a Roth IRA now, that would start the 5 year clock at my first contribution? Do I have it right that my TSP Roth does not count as a Roth IRA for the purposes of starting the 5-year clock as it applies to the rules for distributions from a Roth IRA. Really hope this makes sense. Thanks.” Yeah, Wendy’s on it.

Al: Yeah. That’s a really good question.

Joe: So she’s 58. She’s going to work until 70. Okay. Then she’s going to start doing Roth conversions at 59 and a half. I wonder why she picked 59 and a half.

Al: Well, I bet she’s thinking that you have to be over 59 and a half to avoid the penalty, which is not true. You can do a Roth conversion at any age. You don’t have to be 59 and a half. That’s my guess.

Joe: Yes, that’s a good answer. So she could do conversions now.

Al: That’s right.

Joe: But she would have to probably do an in-service withdrawal out of the TSP.

Al: Well, maybe that’s the limiting factor. Maybe there’s no in-service withdrawals until 59 and a half in the TSP.

Joe: I forget what that rule is. I don’t think so. I think you can do a one-time in-service from them.

Al: Can you?

Joe: Yeah.

Al: Okay.

Joe: So let’s say she puts it in the IRA. Not saying that she should do that, but let’s say she does. Then she could do conversions right away if that’s really what her plan is. So 59 and a half does not necessarily- I guess the point is I wanted to get that across. That for all the other listeners out there. You don’t have to be 59 and a half to do a Roth conversion. But she is correct. You open up a Roth IRA, you put a couple of bucks in. We’re heading in November. And so the 5 year clock would start January 1 of 2022. So, yes, you could put $1 in there and then when you start doing conversions at 59 and a half or 60 or whatever, you are good to go. Your 5-year clock started the year the first $1 went into the Roth.

Andi: The in-service withdrawal from a TSP is beginning at age 59 and a half.

Joe: Okay. I knew there was some nuances there.

Andi: Yep.

Joe: Okay. All right. Anything else on that one?

Al: Yeah, I think we got it, but maybe explain Joe, we got a minute left. Maybe explain why does the Roth and the TSP not count for your 5-year clock? Why is that?

Joe: It would count for the Roth TSP 5-year clock. But not the Roth IRA. Right? Because you got a TSP or 401(k). Those are different animals than the Roth IRA. So they each have their own sets of rules. So start a Roth IRA and then when you roll your Roth TSP into the Roth IRA, that will satisfy. So sometimes people think, alright, I’m going to roll it into the Roth IRA and then have access to it. You would have access to the dollars that you put in. It’s FIFO tax treatment. First in, first out. So whatever contributions.

Al: How about in a TSP, can you do a Roth conversion in-plan?

Joe: I believe you can now. Before they were super restricted. I know they changed the rules on the TSP just a few years ago in regards to distributions. Now, you can take multiple distributions a year and some other things. But inner plan conversions, I don’t know the answer to that. And that’s something I think Wendy would have to figure out on her own.

Kiplinger calls investing in a Roth account “one of the smartest money moves a young person can make,” but those 5-year Roth clocks are tricky, as shown here, so make sure you understand them thoroughly before you make any further moves! Learn the where, when, and how of taking money out of your Roth IRA when you download our free guide on the 5-Year Rules for Roth IRA Withdrawals. Your age, when you make contributions and conversions, and the IRS order of Roth IRA withdrawals all impact your access to that money in your Roth accounts, so this is one guide you’ll want to keep handy. Click the link in the description of today’s episode in your podcast app to go to the show notes and get downloading.

Why Would I Contribute to Roth and Lose Today’s Tax Savings? (Champ Kind, Washington)

Joe: We got Champ Can- Champ Kind.

Andi: Kind.

Al: I wasn’t going to correct you, but this- that one’s too obvious.

Joe: Little Champ Kind from Washington. That’s Anchorman?

Al: Yeah. Sportscaster, right? Wapow wapoo.

Andi: Whammy.

Al: Whammy.

Joe: Whammy. There it is.

Al: Yep. Coming back.

Joe: All right. “Hey, guys. My friends have been pestering me about contributing to my Roth 401(k). I’m currently married and make $150,000 combined at the age of 33. Whammy.”

Al: All right. You could get away with it.

Joe: Hell of a job there. “We plan to retire when our retirement accounts hit $2,500,000 in our mid60s.” The guy is 33, he’s like, all right, 30 years, going to get $2,500,000. “We will then plan to withdraw $100,000 a year and receive $50,000 a year in Social Security. This will match our current income of $150,000. I’m not following the math why I should contribute to Roth.” Well, I can tell.

Al: Yeah, a couple of things missed here.

Joe: I’m trying to follow your math on your overall financial plan here. “We contribute to the traditional 401(k)s today. This saves us money in our marginal tax bracket at 22%. When we withdraw the money in retirement, we’ll pay taxes at our effective rate-” Well, you’re paying taxes on your effective rate today, too “-which we would expect to be lower than 22% at this lower income level. What am I missing? Why would I lose the tax savings at a marginal rate today to save taxes at effective rate in the future? Thanks so much for all the spit balling.” Alright, let’s kind of break this down for our friend.

Al: So they’re making $150,000 right now at age 33, which is great, and then plan to retire when their accounts to $2,500,000 in our mid60s. So, as you say yeah. Call it 30 plus years from now. OK, so let’s see, plan to withdraw $100,000 a year and receive $50,000 a year of Social Security. Okay, that’s all good. What about inflation? I don’t know what you’re spending right now, but let’s just say you’re spending, I don’t know, even if you’re spending $100,000 right now, what’s that going to be? What’s that going to be, Joe, in 30 years? Probably $250,000?

Joe: $100,000?

Al: Yeah. If you’re spending that today.

Joe: Okay, 30 years from now?

Al: Yeah.

Joe: What inflation rate you want to use?

Al: We use what? 3.8?

Joe: Let’s go 3.5%- future value of that is $280,000.

Al: So you’re probably going to be spending $280,000. In fact, probably if you’ve done a good job saving, my guess is you want to spend a little bit more than that because you’re going to have more time for travel, more time for this and that. So the fact that you’re able to withdraw $150,000, that’s great, fantastic. But that’s not going to cover your current lifestyle. And then with inflation, it changes tax rates. It changes all kinds of stuff. Remember, we’re probably in the lowest tax rates we’re going to see for some time, although we’ve been saying that for a long time. But it seems right now, Joe, because we’ve had such higher tax rates, at least throughout my career, this is really actually as low as they’ve been. And they’re scheduled to go up in 2025. And the fact that our government still is in debt, likely will probably go up at some point in the future. So tax rates will probably go up. I think inflation is missed here. And what the real spend, what the real need is how much you’re saving to produce whatever kind of income you need. And if you can have some of that in Roth, in fact, even a lot of it in Roth, you’ll be in a much better position tax wise, in the future.

Joe: Okay, so let’s look at this the opposite way. The present value of $150,000, right? So let’s just look at he’s saying, hey, I’m going to produce $150,000 of income in 33 years.

Al: What’s that in today’s dollars?

Joe: $50,00.

Al: $50,000. Can you live on $50,000?

Joe: So, yeah, if I’m looking at this and say, all right, Champ, if you’re living off of $50,000 a year, then okay, then your strategy is sound. And at $50,000 of, let’s say, taxable income, you’re probably going to be in a lower tax bracket for sure. But if you want to maintain your same lifestyle, then your math is wrong, your plan is wrong because he forgot inflation. And then where’s tax rates going to go? And then he’s looking at effective and marginal rates. Well, you’re still taxed at your effective rate in retirement, somebody’s going to be taxed at 10%, 12%, 22% or someone’s going to be taxed at 10%, 15%, 25%, 28%, wherever the rates go.

Al: Yes. If Alternative Minimum Tax comes back like it’s supposed to, it could be kind of an effective 35% rate. The other thing too is, don’t forget that all things being equal, you probably will make more at age 43, then 33, and you’ll probably make more at age 53, then 43 and so on. So you’re likely going to be making more and you’re going to be paying higher taxes. You’re probably going to get used to a higher lifestyle. So you have to factor all these things in. When you’re young, especially young in a down market, you want to get as much money as you can in a Roth IRA. It’s kind of like a no brainer if you consider all the financial variables.

Joe: One last thing, and then I’ll drop this. Think about it like this. The Roth IRA is going to be able to help you control your taxes in retirement. OK? And what I mean by that is that you’re going to have different areas to pull from because of all of the money that you have, this $2,500,000 that you’re going to save, and all of that is in a retirement account. And now Champ is getting a little fancy with us because he’s switching back and forth from marginal and effective. So if you think- and I like where you’re going with that, because the effective rate is adding your tax to your income or dividing your tax into your income- marginal rates- You’re taxed on a marginal rate, you’re going to be taxed a little bit at each of the different marginal rates. So if you think of it like this to say, hey, as I start pulling money from retirement and right now he’s in the 22% tax bracket, is there a way that he could stay in the 12% tax bracket in retirement but have higher income? And that’s true if you have diversification in your investments from a tax perspective. If you have money in a Roth IRA, you’re never, ever going to be taxed on those again because you’ve already paid your 22% tax on it. And then when you start pulling money out and let’s say tax rates go up, or if they stay the same, so you’re going to pull money from your retirement account, and you’re going to pay whatever tax on that. But then if you need additional needs or you want more cash flow, you want to go on a bigger trip, you want to go buy a car, you want to whatever, you have money in other areas that are not going to be taxed at all. It’s going to give you a ton more control over your lifetime. Last point for Champ. So if I’m looking at this, let’s say he saves $10,000, right? Okay, well, hold on. He’s got $150,000 in a retirement account, right?

Al: He makes $150,000.

Joe: Oh, that’s right. I don’t know how much he’s got a retirement account.

Andi: He doesn’t say.

Joe: Okay, so let’s just say he has $150,000 in a retirement account.
And he was in the 22% tax bracket, and that’s what his savings was on that $150,000. So that’s $33,000 of tax savings that he received over the years by putting that money into the 401(k), getting a tax deduction. Can you follow that? Andi, you with me?

Andi: Yep.

Joe: All right, good. So now he’s got $2,500,000, and now he’s got to pull that money on, and he’s going to be taxed on the $2,500,000.

Al: That’s right.

Joe: Let’s just say he’s in the 12% tax bracket. Well, he’s going to pay-

Al: $550,000.

Joe: (calculating) – at 22%-

Al: I thought you did it at 12%-

Joe: at 22% it’s $550,000, keep it apples to apples. (calculating) And 12% is $300,000. Okay, so he saved $30,000 in the 22% tax bracket. It grows to $2,500,000. And then he pulls the money out. And let’s say he pulls it out at a lower rate at 12%, he’s going to pay $300,000 in tax, right? And if he pulls $2,500,000, I know a lot of people are thinking I’m stupid by going through this example. And I know if you’re going to pull $2,500,000 out of retirement account, you’re going to be in a hell of a lot higher tax bracket than 12%. But over his lifetime, if he stayed in that 12% tax bracket, that’s the amount of money that he’s going to be paying tax. So the tax deduction that he receives, he has to pay back in the future with interest because there is no free lunch. You get a tax deduction today, but 100% of those dollars are going to be taxed when the money comes out. Either they’re going to be taxed when you withdraw to spend it, or they’re going to get forced out within an RMD, or you’re going to pass away and your spouse is going to pay it, or your kids are going to get hammered with it. So don’t get so caught up in, well, I’m going to be in this bracket, in that bracket, right? Whammy. We got to take a break. Whatever. I hope that my point is made. Champ Kind. Go watch Anchorman. Folks, if you never got what the hell we’re talking about in this inside joke, that was the stupid catch phrase.

How Does the 5-Year Roth Withdrawals Rule Impact Taxation of Dividend Income? (Lias, CA)

Joe: All right, let’s go. Lias. Lias? Is that what we’re-

Andi: Lias or Lias.

Joe: L I A S in California. “Greetings, Joe, Big Al, Andi. I found your podcast about a year and a half ago, and I love it. It’s been helping me to avoid overlooking details as I transition into retired life. My preferred ride is a Zero SR/S.”

Andi: I looked it up. It’s an electric motorcycle.

Al: Okay.

Joe: SR/S. I drank a bit of VSOP cognac with dessert.” A little VSOP. Al? I could see you drinking little VSOP.

Al: No, I’ll stick with the beer and wine.

Al: And occasional Mai tai.

Joe: All right, this is really long, so bear with me, folks.

Andi: If you need somebody to help with the reading, one of us could take over.

Joe: Oh, I got this.

Andi: Okay.

Joe: “I have questions about Roth conversions.” Great. “I recently retired. My wife stopped working a while ago. I’m 63. She’s 59. I wasn’t planning for early retirement, but I could no longer find satisfaction with the situation at work. While exploring my options, I realized that a few years ago, we already reached the threshold where our wealth was increasingly by more than the amount of my income. I started reinvesting my brokerage and retirement accounts to prove to myself that dividends could provide sufficient income and began the dream of being a fulltime caregiver to our current pack of rescue dogs for the remainder of their lives.” Oh, that’s very nice of-

Al: That is nice.

Joe: “Our retirement income has been provided by systematic surrender of a life insurance policy, increasingly from automatic or manual transfers of dividends from the holdings in an IRA, and 401(k), and traditional brokerage to our checking account. Now for the Roth questions. Would we benefit from systematically converting my retirement holdings to Roth accounts? There are 3 issues in particular I need to understand. How does the 5-year rule impact the taxation on our dividend income sources?” Okay. “Would I be subject to the pro rata rule such that there is no way to keep the Roth source dividends in the retirement account while I take out pre-tax source dividends as ordinary income, given that my IRA is still on track to annually pay over 10% of the account value in dividends?” Is this the magic beanstalk IRA?

Al: I think so.

Joe: 10% Big Al. I like that.

Al: Yeah, that’s good. That’s very high.

Joe: That’s legit. “Will RMDs not be an issue until I’m over 90?” So he’s anticipating 10% out of the account until he’s 90.

Al: Right. Because he only wants to take out the income, the dividends.

Joe: The dividends and the dividends are paying 10%.

Al: Yeah.

Joe: So he’s good.

Al: Yeah, he is good. Let’s see how long he goes. Okay, it’s about right about 90.

Joe: All right. So at 90 is your RMDs 10%?

Al: Yeah. You got to take a little more.

Joe: All right. “I read-“

Al: Actually 90- the year you turn 94 is when-

Joe: “I read at IRS.gov that my wife as sole beneficiary can assume ownership of the IRA account, both Roth and traditional. Is that the same for 401(k)s?” Yes. “I prefer that she can just assume ownership and continue any automatic distributions of the dividends I put in place. Are there any other issues I should consider?” Besides that you’re not going to get 10% forever?

Al: That would be amazing if that were true.

Joe: “Bonus question. Considering Social Security benefits, which I’d use as a contingency source of funds, is there a minimum age by which I must file or apply, even if it ends up that I never need the extra income? Our account balances are roughly $675,000 in the 401(k), he’s got $10,000 in a Roth, $610,000 in an IRA, $330,000 in a brokerage account, $20,000 in I bonds, $32,768 in a stable coin interest bearing accounts, $15,000 T-bills, $50,000 in checking and savings, and $125,000 HELOC.” Are you able to keep track of all that, Big Al?

Al: I’m trying.

Andi: So as for the question about minimum age to file for Social Security, there’s no point in filing after age 70, right?

Joe: Correct.

Andi: So that would be a maximum age. But in terms of minimum, the minimum is age 62, correct?

Joe: Correct.

Al: That’s correct also.

Andi: Okay.

Al: You take it at age 62, it’s a lower benefit for life.

Joe: He doesn’t need the money. He says he’s good.

Al: Well, he’s living off the dividends. 10%.

Joe: Some fat dividends. All right. “Our monthly expenses are $12,000, including taxes and gifting philanthropy.”

Andi: Philanthropy.

Al: Very good. You got it.

Joe: “Excess income is reinvested to mitigate inflation.” Oh, he’s got excess income. “A little more about me.” Can’t wait. “Brokerage of choice is TD Ameritrade-” Okay? “-especially because of their income estimator.” I know what he’s doing now. “My favorite analysis is seeking Alpha Premium. My self-directed retirement accounts have more holdings than some people would consider to be reasonable.” At least-

Andi: Sane people.

Joe: Sane people. “At least I can say that the complete failure of one stock or fund would have a manageable effect on our income. The accounts include a mix of dividend income funds, REITs, little BDCs, dividend growth funds, highly rated growth, and value stocks. I’m keeping records to annually reevaluate the holdings. I also own one stock from the business where I worked prior to the last one and one stock in a company that shares my name.” Okay.

Al: That means his company, I think.

Joe: Maybe that’s why he’s getting 10%?

Al: Well, his name could be Shell, right? It could be Shell Oil.

Andi: Have to see if there’s a company called Lias.

Joe: “Trust, wills, health care proxies, and powers of attorney documents are done. Thank you for your help. Lias from California.” All right, so he needs $12,000 a month, and I don’t think he’s got more than $2,000,000.

Al: Yeah, he’s got $1,300,000 million in deferred, and he’s probably got- call it $500,000 in other-ish. We’ll give him the benefit of the doubt, $2,000,000, Joe.

Al: Wow. Okay. His distribution rate has got to be, what, 7%?

Al: Yeah. Because he’s not collecting Social Security and he needs $12,000. He’s saying that’s covered by the income. Right. So, anyway 12 into 144. 12 months, 7.2%. You’re right.

Joe: Okay. So 7% distribution rate. He’s buying dividend- because he’s got the income estimator. So let’s just look at these high flying dividend paying stocks and I’m going to buy them due to the yield or the income.

Al: Because then you get to live off the income and you still own the stock. What’s wrong with that?

Joe: Until that whole thing blows up like a house of cards.

Al: Yeah. Whenever you get that kind of dividend return, there’s some risk there. Just be aware of that.

Joe: Risk and return are related a little bit.

Al: I remember- now, this isn’t a stock, but the most extreme example I remember is- remember the Puerto Rican bonds that were paying 30%, 35% per year? It’s like, yeah, that’s great, until they went bust and you didn’t get your money back.

Joe: Correct.

Al: Hopefully, you owned it 3 years, so you recovered at least your money.

Joe: So he’s talking about Roth conversions. Let’s answer that question. He’s a little confused on a couple of things, but it’s a really good question. So we can kind of help our listeners out, is that he wants to do some conversions, and he’s curious if he took money from the Roth. Because what he’s doing is he’s taking the dividend- the dividends are being distributed to his checking account, and then he’s living off of that as his paycheck. So he’s not selling any shares. He’s not doing anything like that. So the dividend comes due, the custodian automatically distributes that to his checking account, and it’s coming from his retirement accounts or brokerage accounts or whatever. And he’s like, hey, if I buy these great dividend paying stocks in my Roth, a) what’s the 5-year clock rule with that? Well, yeah, that’s income. You have to have a Roth for over 5 years or 59 and a half, whichever is longer, to receive any interest, income, earnings, growth, from the overall account to have it work to be tax-free. So if you were distributing dividends out, that would not fly. But he doesn’t necessarily want to do that. He was thinking, hey, is this pro rata? Can I let the Roth dividends reinvest and grow in the Roth while I take my money from the IRA because I’m getting 10% from the IRA? Yes. So you can keep the Roth growing, which you would want to do, and then you can get your 10% out of your IRA. So it’s not pro rata. So that’s the difference between a 401(k) if you have a Roth component and a standard component with the 401(k), depending on the plan doc, it might be pro rata. With a Roth IRA, and an IRA, you can pick and choose. That’s the whole beauty of tax diversification.

Al: Yeah, good point. And then also he’s got a Roth 401(k) for about $10,000, and that doesn’t start the 5-year clock for a regular Roth IRA. So you wanted to start that right away to get the 5-year clock running. Another thing to think about is let’s just say you are earning a 10% dividend even in your Roth. You could pull out- you’re over 59 and a half. In this case he’s 63. You could pull out 10% of your balance.
Even right after you do the conversion. The way the IRS looks at it is they have you take your principal out first and your income out second. So you don’t have a problem with that because of the way the IRS looks at it. Now, you yourself can think of it as your dividend, but the IRS is going to think of it as principal. Right. Basically, you end up in the same spot. Right. But you’re not going to have to pay additional tax on that.

Joe: So risky. This is pretty risky.

Al: It seems like it. Usually when you hear- and sometimes people come to us and say, I got a trust deed from a contractor for 18%. Seems like a great investment. It’s like, well, okay, well, that’s the bank wasn’t willing to make the loan at a normal interest rate, so they had to go to hard money or something like that, or investors like yourself, they’re paying a lot of interest for a reason. The same is true for dividends. There’s some risk there involved in the stock to get that kind of dividend.

Joe: What happens to the stock price once they issue of the dividend?

Al: It goes down in this example, goes down 10%, right?

Joe: No, it doesn’t. Not mine.

Al: Yeah, well, it does.

Joe: How many times have we heard that?

Al: I know. So, I mean, let’s just say you have a stock worth $10 to make it super simple, right? And so you got a 10% dividend, you got $1. And let’s just say the market stayed the same, right? No market movement.
The next day your stock is going to be valued at $9 a share. Why? Because the company distributed some of its net worth.

Joe: Yeah, capital.

Al: Right. And so it gets subtracted from the value. That’s the way capitalism works. So just be aware of that. When you think you’re kind of having your cake and eat it too on the dividends, you’re actually every time you get a dividend, the stock price goes down. And sometimes people say, Joe, Al, that’s not true because my stock price went up. Well, that’s because the market went up. Good for you.
But if the market had stayed flat, your stock was what it was, minus the dividend. That’s your new share price.

Joe: Right. Well, I’m just going to keep on holding this because I’m going to continue to get these dividends. Well until they cut the dividends.

Al: Yeah. And they’re paying you 10% now to entice you to put your money in. Which means there’s some kind of risk here. Right. Which means it may not be sustainable. So just be aware of that when you hear things like this that sound too good to be true, there are some strings attached and strings are usually the risks associated with it.

Joe: Right. When you’re looking at a retirement income strategy, I think a lot of times people will think, alright, well, here dividend paying stocks because here I’m not going to sell the shares, I’m just going to receive the dividends. You have to understand the market’s a little bit more. He’s looking, you know, I guess he’s reading what was it? Smart-

Andi: Seeking Alpha.

Joe: Seeking Alpha.Larry Swedroe was on that. And that’s a good website. I like Seeking Alpha, but just be careful. I guess you really need to do some more homework. If you’re taking a 7%, 7.5% distribution rate from your overall portfolio, that’s rich. And I think he’s young, right.

Al: He’s 63, wife is 59.

Joe: That money has got to last quite some time.

Al: And typically at those ages, we would say 4% would be rich, right? Yeah. Maybe 3.5%.

Joe: And he’s at 7.5%, right? Yeah. So he’s bridging the gap to Social Security and he might think he doesn’t necessarily need it. I’m going to tell him right now that, yes, you will need that money because you’ll probably want to get your burn rate somewhere close to 3.5%, 4%. But I like the strategy. Great questions. Really insightful. With the pro rata rule. No, that doesn’t apply to IRAs and Roth IRAs. Should he do conversions? If he’s taking that big of a distribution, he needs every penny he has. So if he did conversions, he’s going to lose some of that brokerage account to pay the taxes on the conversions. And if he believes that his 10%- the RMDs are not going to matter anyway. But we like to look at first what do you have, what is your cash flow need?
And not take any more than 4%, 3% out of the portfolio. And then from there we look at a tax strategy. And then from there we look at how should all of this be invested? What he’s doing is the opposite. He’s picking investments that on the TDA yield reader shows a high income- or income reader. It’s like, wow, look at this high income. So he’s picking these investments and then he’s placing them wherever he has excess cash. Feed me the dividend. Feed me the dividend. Right.
He’s taking care of the rescue dogs, which is very sweet. But it’s just done a little bit backwards of how I would look at it. I would first try to make sure, do I have enough? What is my income need? What is my fixed income sources down the road? All right. And then from there, what is my tax strategy? How much should come from a Roth IRA versus non versus whatever? And then go from there.

Al: I will say one other thing quickly, Joe, and that is 7% distribution rate still might be okay if Social Security and/or pension benefits are high.
Right. So you could have a step period where it’s higher. That can be okay. But you just got to look at that carefully.

Joe: Yeah, I guess my whole thought process is if someone believes they are going to receive 10% per annum, I would just be careful with that line of thinking, that’s all.

Al: Yeah. I agree with that.

Last chance to register! Learn how recent tax legislation and proposals impact you, your family and your retirement savings, and understand the strategies that can help you reduce your tax liability as you plan for retirement. Register for our free End of the Year Tax Planning webinar with Pure Financial Advisors’ Tax Planning Manager, Amanda Cook, Equire, CPA, tomorrow, Wednesday November 16th at noon Pacific time. Click the link in the description of today’s episode in your favorite podcast app to go to the show notes and reserve your spot now and to download the companion End of Year Tax Strategies guide.

Roth Conversions and RMDs on an Inherited IRA (KP, La Mesa)

Joe: We go La Mesa. KP from La Mesa. “Hello Andi, Al, Joe. This is KP from La Mesa. Love your show. Have been a loyal listener for quite some time. I have an inherited IRA from a deceased spouse. I withdraw $6000 that’s the RMD, and I transfer it to a Roth IRA every year.” So she’s taking an RMD, paying the tax, and then she’s contributing that or he’s contributing that, to Roth IRA. That’s valid as long as KP has earned income. So using that, pay the tax and then go ahead and kind of put it right back into the Roth.

Al: Yeah. And a point there, Joe. If you have to take a required minimum distribution, you cannot put that directly into a Roth, right?

Joe: Right. You can’t convert the-

Al: Yeah, that’s right. You have to pay tax on it. Right. So now you got it in your taxable account or your checking account, whatever. Now if you make enough earned income, if you have $6000 of earned income, you could do a Roth contribution as long as you’re below the income limitation rules. So that would be the step there. So you can do that, but it’s not a direct transfer.

Joe: “I also have an IRA of $100,000. I’m thinking about doing Roth conversions. I’m 55. My question is, what’s the difference between Roth conversions from IRA to a Roth IRA? Should I convert it now? Is there a limit amount to convert from IRA or should I wait until I’m 60 year old to convert? My AGI is $100,000. Thank you.” Alright. I think maybe the question is what’s the difference between a contribution and a conversion?

Al: Yeah, it’s hard to say the way it’s written. I’m not sure either. But maybe we’ll address both and we’ll talk about why you’d want to do a conversion, I guess.

Joe: Sure. Because you cannot convert an inherited IRA, right?

Al: Correct.

Joe: So KP is doing that right. You can’t convert an inherited IRA, take the distribution, pay the tax on it and then, as long as KP’s got income, make the contribution of $6000. Right. So that’s all good. So you can do that all day long as long as you have the earned income. The next question is all right, hey, I’m 55. Can I do a conversion? The answer is yes. So you don’t have to be 60 or 59 and a half to do the conversion. You can convert at anytime, any age, whatsoever. No problem, no big deal. So if you have this other IRA that’s worth $100,000 and you want to start doing Roth conversions, you can- there is no stipulation with converting an IRA to a Roth IRA. There is stipulation with an inherited IRA going into a Roth IRA, which we discussed. So yeah, but the AGI is $100,000. I guess the next question Al, is KP single or married?

Al: Well, good question. I assume single because he or she lost their spouse. So let’s go with that. He or she, since we don’t know.

Andi: KP.

Al: KP, I’ll just say KP. Yes. KP would probably be, I’m guessing with the standard deduction maybe just at the bottom of the 24% bracket because that’s about $89,000, something like that. Or maybe the top of the 22%. But anyway, if KP does a conversion, it’ll be taxed at 24%. That’s what it appears from the facts that we have. Then the question is what you could do that now? Is that a good deal right now? What’s special about 60? Are you going to retire at 60? Is your taxable income going to be a lot lower? Maybe you’ll be in lower brackets. Well, that’s worth considering. On the other hand, if you’re going to be in this bracket for a while and being that the stock market is down best time to convert is right now. Right? Because any future growth, the recovery, the market recovery will be in the Roth IRA so thinking about that way, it is a good time to convert. But it really depends upon what your income is going to be in different stages. We know at age 72, you’ll have to take a required minimum distribution. We know that by age 70, if you have to take Social Security. If not, you can take it as early as 62. It depends what your plans are. It depends what your income brackets are and all these different years to figure out how much you should convert and when to convert.

Joe: Yes, but the sooner you convert, the better in most cases, if your tax bracket is going to be the same-

Al: If it’s the same, I agree.

Joe: Let’s say 22% to 24%.

Al: Okay, I’ll buy that, but-

Joe: That compounding effect of tax-free growth, and tax rates are going to go up at some point. So you want to get it in there as soon as possible, of course, in doing all your analysis.

Al: Yeah, well, I mean, here’s where it may not make sense is if you’re in the 22%, 24% bracket right now and you’re always going to be in the 12% bracket in retirement, then you wouldn’t necessarily want to pay all that extra tax. So I think you do have to do the analysis to make sure. But let’s just say your bracket is same or similar. Then I would do it all day, because the sooner you get it in, the better. And the market is down right now, you get that future market recovery in the Roth IRA and not have to pay tax on that.

Joe: Yeah, I agree with you wholeheartedly there, Big Al. All right. Well, thanks, KP from La Mesa. I appreciate the question. Alright, that’s it for us today. We’ll see you again next week. Keep your questions coming in, folks. The show’s called Your Money, Your Wealth®.

Andi: Help us coin a YMYW catch phrase, and Sunkist in the Derails at the end of the episode, so stick around.

The Derails

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