Jacob: Roth conversions are a powerful strategy to say, instead of being forced to take my distributions at, let's say, seventy five one day and take those distributions each subsequent year for the rest of your life, what if I decided to pay the taxes now and ultimately over the rest of my lifetime, I could have a lower overall tax rate or total amount of taxes paid? Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place. Hey there. My name is Jacob Duke, and each week, I'll be walking through different tips and strategies to help you succeed in retirement.
So let's go ahead and get started with today's show. Hey, friends, welcome back to another episode of Retirement Answers. As always, my name is Jacob Duke. I'm a certified financial planner, and I'm really glad that you're here. Thank you for taking some time to listen to the podcast.
I really hope you find value in it and learn something new here today in regards to your retirement and overall, just planning for it. That way you can have a successful retirement because at the end of the day, that's what we're about here at Retirement Answers. I wanna make sure that you get quality information that can help you retire successfully. So if you're a frequent listener or even if you're new to the show, I appreciate you being here and it helps me out a ton if you can give a rating and review on the podcast platform you're listening through, whether it's Apple Podcasts or Spotify. So like I said, if you find value in the show, I'd appreciate that a bunch because then other people will be able to find the show as well and learn from these same tips and strategies.
So by the title of the episode today, you can see that we're gonna be talking about Roth conversion mistakes. And I wanted to share these with you because Roth conversions are an important strategy for a lot of people in retirement, especially for those of you who have that large tax deferred four zero one k or tax deferred IRA account balance. Because if you don't pay those taxes on the income that you saved into that account while you were working, well, you're just gonna have to pay taxes later on, whether it be in the early stages of retirement, if you're making withdrawals or once you reach age 73 or 75, whenever your RMDs or required minimum distributions will begin. So Roth conversions are a powerful strategy to say, instead of being forced to take my distributions at, let's say 75 one day and take those distributions each subsequent year for the rest of your life, what if I decided to pay the taxes now and ultimately over the rest of my lifetime, I could have a lower overall tax rate or total amount of taxes paid. So that's the purpose of conversions is saying, I'd rather pay some taxes now as opposed to pushing those all into the future and have really high tax years later on for either myself, my spouse, or my kids or grandkids one day.
So that's the power of doing Roth conversions, but there are mistakes that can be made when doing them. And I wanna make sure that I clarify and kind of share these with you so that you can avoid these same mistakes whenever you're doing Roth conversions here in the future. So with that being said, let's go ahead and get started. The first mistake that I often see whenever someone's thinking about doing a conversion or trying to do one at all is that they don't understand their current tax situation. They don't understand where their income's coming from.
They don't know how that money is gonna be taxed. Is it gonna be normal income? Is it gonna be a long term capital gain rate? Those different types of income are gonna matter a lot, especially once you're in retirement. Now, if you're before retirement and you're still working, maybe you're a w two employee or perhaps you're ten ninety nine or own your own business, Those two different roles also have different, amount of taxes that you have to pay as either the owner of a business or as the employee of a business.
So depending on your source of income, your taxes will be higher or lower. Also, once we get into retirement, you're gonna have different sources of income from a Social Security standpoint, brokerage or taxable investment account, dividends or capital gains that might be coming in, distributions from your IRA, or perhaps even income from a part time job. All of those different types of income are gonna have different tax rates. If you're working and you're employed making money part time, well, you're going have to pay the FICA taxes on that income in addition to your normal income tax rate. But a four zero one ks or an IRA distribution that's tax deferred, whenever you take money from that account type, you're gonna pay your normal income tax rate, but you will not owe any FICA taxes.
So all these different sources of income are gonna matter in determining what your overall tax bill is each year. And remember, Social Security is not taxed the exact same way as normal income. And I'm not going get into how that's taxed right now because I've done previous episodes on it and don't really want to deep dive into that today. So go back and be sure to listen to, previous episodes on Social security taxation, but just know that at most 85% of your social security income will ever be taxed. And whenever it is run through the combined income or provisional income brackets, that will determine how much of your social security is taxed.
And remember, this is based on other income as well. So all of that to say, whenever you're doing a Roth conversion, you've got to understand what your current tax situation looks like right now this year, and then perhaps even looking forward and projecting forward, what that would look like based on when you decide to take social security, when a pension might turn on, when do you take money from your IRAs or your Roth IRAs or your brokerage accounts, and understanding the tax rate on each of those different types of account is gonna be important as well. So that's the first mistake I see most often is that people just simply don't have an understanding of what their current tax situation looks like and how their different sources of income will be taxed. So tip number one, make sure you kind of get a grasp or understanding of that. That way you can make an educated decision on when and how to do those Roth conversions.
Alright, the second mistake that I see when people are thinking about doing Roth conversions or not thinking about them is they're too focused on their tax bill right now in the current year, and not the benefits that they would be receiving from doing a conversion over the next ten, fifteen or twenty years, right? Whenever we think about a conversion, it's not so much about trying to save taxes right now, because in fact, you're gonna be increasing your taxes this year whenever you do a conversion, Because you've got some income already and then you decide to do a conversion, well, now you're adding that income based on the amount that you're converting, you're adding that to your tax bill, therefore you're gonna have it higher income this year, meaning you're gonna pay more taxes right now, but the benefit would be five, ten, fifteen, twenty years down the road for either yourself or your spouse or your kids or grandkids, because you're paying that tax now, and once it's been taxed and goes into your Roth IRA, it will not be taxed again. So for example, I've talked about this before, but the widow's tax trap, let's say there's a five year age gap between husband and wife and husband has a million dollars in his, tax deferred IRA or four zero one ks.
Well, if he's got that amount now, let's say fifteen years from now, it could be more than that, especially if he's not having to draw very heavily off of that account. Well, means whenever he passes away, let's assume he passes away first, whenever he passes away, then that means that that account will then be assumed by his wife, and she will be younger, and her RMDs on that account will still happen in the future, but the problem is is she's gonna be paying taxes as a single filer rather than a joint filer. So that's maybe one reason why you would think about doing conversions now instead of pushing those distributions out of those tax deferred accounts into the future is because if one spouse passes away and then the surviving spouse does not remarry, then they would be paying taxes as a single filer rather than a joint filer, which those tax brackets are condensed and compressed. And the RMDs, based on the account size are gonna be the same, and therefore the surviving spouse would have to pay a higher tax rate on those distributions. And the same thing goes for kids or grandkids one day.
And this is even kind of more amplified now that the SECURE Act's ruling is out, and we have to follow those rulings, especially whenever you receive an IRA or a tax deferred four zero one ks as a non spouse beneficiary. Because let's say that your child who's thirty years younger than you receives your million dollar IRA one day, well, now they have to distribute that full million dollars over a ten year period as opposed to stretching it over the rest of their lifetime. So they're gonna have to distribute a $100,000 per year for the next ten years after they receive that account. Meaning if they're making a $100,000 in their normal income from their job, now they're adding another $100,000 on top of that, basically saying they're gonna have to pay a higher tax rate on their inheritance. So if leaving a financial legacy for kids or grandkids or someone down the road is important to you and not leaving them with too much tax to pay here in the future, then paying the taxes now might be an advantage for you.
So just something to think about, and that's kind of the second mistake is too many people are focused on lowering their tax bill every single year right now, but they're not looking far enough into the future to say, hey, maybe I need to consider paying those taxes now, or at least part of them now, as opposed to kicking that can all the way down the road and then being bitten in the butt with a huge, huge tax bill for the rest of my life. So that's number two, don't focus on just right now. Think about the next five, ten, fifteen, twenty years down the road and how that impacts you and your family in the future. The third mistake that I commonly see with doing Roth conversions is for those of you who would be doing those before age 59.5. Now, there's no age restriction on doing Roth conversions, nor is there an annual maximum in terms of how much you can or can't convert.
Those are contributions that would be different. So on 2023, you know, 6,500 or 7,500 is how much you can contribute to an IRA or Roth IRA, depending on your age. 401ks obviously are higher, but, if you are before 59.5 and you take a distribution from a tax deferred account, like a four zero one ks, an IRA, or perhaps even a Roth IRA, not gonna get into that because it's not as easy as just saying if you take a distribution, there'll be taxed and penalized. But if it's a tax deferred account, you can't access that money before 59.5 unless some sort of exclusion is in place. Now, with that said, one of the issues here with doing a Roth conversion is we have to decide how we want to pay those taxes.
And I've recently put out an episode on that as well, so go be sure to check that out. In terms of two different ways to pay the taxes, one is you can withhold the taxes from the IRA whenever you're doing the conversion itself, or you can pay those taxes with cash you have on hand at the bank. Now, I walked through that in that previous example and kind of share with you the pros and cons of each and things to look out for. But one of the mistakes I see is whenever people are withholding taxes before age 59.5, because the conversion itself is not a penalized quote distribution out of your IRA because it's going into your Roth IRA. But if you withhold those taxes to pay the IRS, what you should pay, that means that the tax withholding is actually coded as a distribution out of the account.
Therefore, you're going to have that 10% penalty on that amount as well on top of your other taxes you're gonna pay. So for an example, you know, you're gonna have a $100,000 conversion, you withhold $20,000 for taxes, but you're under age 59.5. Well, since you withheld $20,000, that's gonna be coded as a distribution out of your account. And since you're not yet aged 59.5, you're going to have to pay a 10% penalty on top of the taxes for that $20,000 So now you pay a $2,000 penalty because you withheld the taxes from your IRA and you were under that age 59.5. So if you're gonna do a conversion under age 59.5, make sure you have the cash to pay those taxes with already on hand.
Now, once you're 59.5 or older, you can always withhold those taxes from your IRA balance. But even then, I've talked about that obviously in that previous episode, but even then it might not be the best solution if you have another option available in terms of paying those taxes with cash. So if you're under age 59.5, try not to withhold those taxes from your IRA when doing those conversions. The fourth mistake I see whenever people are doing Roth conversions is they're not factoring in their entire income plan, and that can lead to unexpected tax surprises. Now, this portion is primarily for those who are already in retirement, because let's say, for example, you do a $100,000 conversion, but you've already got a $100,000 of other income already coming in that's taxable.
Well, there are a few things that could crop up there. Number one is that if you're above age 65 and you're obviously on Medicare at that point, then, IRMA income related monthly adjustment amounts that could impact you and increase your Medicare premiums because you now have too much income. So whenever we think about doing Roth conversions, have to remember, hey, where are these Irma brackets? Where do they start? Where do they stop?
And which one am I comfortable with? Or should I go above those brackets or not? Is it worth it for me to do so? It may be worth it for you to do so. Irma is not always worth avoiding, but it's something to be aware of that way you don't get caught off guard.
Another thing too to think about is whenever you're receiving your Social Security income, you could be increasing the overall tax rate on that income because you now have new income that has come on to your tax return, therefore pushing you into a higher tax bracket, causing more of your Social Security income to be taxed. Remember up to 85% is the maximum. But let's say that you were only at 50% of your Social Security was taxable. Now you've pushed it up to 85%. Now you have a higher tax than you otherwise thought and more income than you otherwise thought.
So Social Security income is important to think about, but then also capital gains taxation, right? If we've got dividends or interest or or different things coming from a taxable investment account, and we're trying to realize capital gains to produce income, then then having a lower income to do that, make sure we're at least at the 15%, no higher than 15% long term capital gain rate. But if your income is low enough, you could be in that 0% long term capital gain rate. And if you do a Roth conversion and you're also realizing gains in your taxable investment account, you could have unexpected tax surprises on those capital gains whenever you thought they might be zero, but they end up being 15%. So just a few things to think about here.
Number one is, is it worth it for you to do conversions and push yourself into a higher premium Medicare bracket? Another thing is maybe I should delay my Social Security to do these Roth conversions in the early stages of retirement, because once I turn that Social Security on, yes, you can turn it off by repaying it back, but typically that's not what you want to do. But if I can hold off, continue delaying my Social Security, which increases your benefit, but then also lower your future tax bill by doing conversions while you don't have any other income, that would be wise of you because you're not increasing your Social Security taxation, but you're also allowing more room for yourself in the tax brackets whenever you're doing the conversions themselves. And then all along the way, understand where you are in terms of capital gain rates and whether you have any room to wiggle with at that 0% long term capital gain rate relative to your overall income. So just to recap number four here, make sure you understand your entire income plan before you start doing Roth conversions randomly.
A lot of people hear about the the fad that Roth conversions might be, and they're like, oh, I gotta do some Roth conversions, but they don't understand how that impacts them perhaps negatively, if they start doing those without understanding their entire income plan and kind of the different levers that could be affected there, whether it be Social Security taxation, perhaps pushing their their Medicare premiums higher, or ultimately saying that they're gonna have a lot higher capital gains taxes on their realized gains in their brokerage accounts. So think about that before you start doing Roth conversions and make sure you have a good understanding of what your income looks like and how it will be taxed whenever you're receiving it. Alright, the fifth mistake that I see is that many people, once they've done a conversion, they have no plan for that money once it's in a Roth IRA. Now, remember, a Roth IRA is a tax free account, meaning once the money's in there, you pay the tax on it. Therefore, the growth is tax free and you get to take that growth out in the future, assuming that you've had the account open for five years and, you know, you're age 59.5 whenever you take that money out.
So that's the benefit and kind of the big draw for a Roth IRA is that it is tax free growth. Now, what's the mistake that people can make whenever they actually get the money into that Roth? Well, in my opinion, it's not investing it correctly, right? We're not investing it for growth, and we're not using that account type for its potential. Like if it's a tax free account, we want it to be growing as much as possible.
So what's your plan for that money once it's in the IRA? I've seen it so often where someone does a conversion and the money just sits in cash once it gets into the Roth and it's not be invested for five months, six months, a year, two years, and look back and like, man, I should have had that money invested. I just didn't know I needed to. And so understanding that once the money goes into that Roth IRA after you do a conversion, well, it's just going to sit in cash until you invest it. And then once you invest it to kind of deciding what you need to do and kind of invest that for depends on when you think you're going to need to use that money.
Right? If you're planning on that being something you leave as a legacy for kids or grandkids, or want to make sure a spouse is taken care of with low taxes in the future. Well, that means you probably don't want to use that Roth IRA money yet, and probably in the near future, you'd probably want to invest that a little bit more aggressively so it has time and the ability to grow. That way they can benefit that much more from the tax free growth in the future. So whenever you're doing a Roth conversion, sometimes whenever that money's in a Roth IRA, it may not be for you throughout the rest of your life.
It might be some for someone else might be for kids or grandkids or a spouse down the road. So just don't think that once the money's in the Roth, you're gonna start spending it immediately. Now, it may be depending on your situation, it may be something you want to do or need to do. But I would think of that Roth IRA once you've done a conversion as more of a long term bucket, because whenever you do a conversion, obviously, you're lowering your account balance overall to pay the taxes for that money to go into the Roth. So I would say at least invest it to try to get back to where you were in terms of total account balance.
And then you can start thinking about should I take money from this account to kind of combine with my other income sources? Or should I just let this account grow for my my grandkids or kids down the road? So, think about what's your plan for that money once it's in the Roth IRA. I find too many people are just have have no idea what their their goal is with that account. It's just more of their retirement savings.
But sectioning out each account type tax deferred, tax free, and then taxable, and assigning a purpose to each one is going to be important to you and your success long term and actually achieving your goals. Alright. The sixth and final mistake that I often see when people are doing a Roth conversion is that people are doing Roth conversions and they otherwise shouldn't be right. This is a common strategy or a tax saving kind of thing for people in retirement. Roth conversions is a really popular topic.
But what I found is that many people are trying or wanting to do conversions, and they otherwise just simply don't need to. There's no tax benefit to doing it, right? They're gonna pay way more tax now than they ever would in the future. And it really comes down to how much you have in those tax deferred accounts, Right? If you've only got 500,000 in a tax deferred IRA, well, it may not make sense to do Roth conversions because your RMDs are never going to be too large that you can't handle it from a tax standpoint.
And depending on your income right now and where that money is coming from each year, you may not have the room in your tax brackets to do it at a lower rate than you otherwise would have to pay in the future. So typically, just like as a rule of thumb, I anyway operate and say, if we have less than 500,000, I'm probably not doing Roth conversions or even considering at all because in the future, my RMDs are gonna be income I'm gonna be living on anyway. Therefore, it won't make a difference one way or another, and I'm probably not gonna have excess RMDs that I won't need. Also, it's typically not until maybe a million dollars or so that I'm thinking about, hey, Roth conversions might be something we need to look out, especially once you get to a million and 0.5, $2.03, $4,000,000. Taxes are a big deal at those asset levels, but many people that have lower tax deferred account balances, and that doesn't mean their overall net worth is low, just means they don't have much in those IRAs or 401ks.
They're trying to do Roth conversions to quote lower their tax rate in the future, but their tax rate in the future is not gonna be any higher because their account balance in that particular account type is not high enough to warrant, really high distributions in the future. So that's the sixth mistake that I see when people are doing conversions that simply people are just doing them when they otherwise don't need to be. So thank you so much for tuning into this week's episode of Retirement Answers. I hope you've kind of found this episode valuable in regards to mistakes that are commonly made with Roth conversions. That way you don't make and can avoid these same mistakes here in the future.
If you found it valuable, like I said, go ahead and leave a rating and review there on the podcast platform that you're listening through. Also, if you'd like to reach out to me and ask me any questions, you can do that by emailing me at jacobretirementanswers dot net. Otherwise, I hope you have a great week and I look forward to talking with you again really soon. Hey, it's Jacob again, and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at jacob@retirementanswers.net.
And I'd love to answer that question for you right here on the show. Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode. I look forward to talking with you again next week.