Tax Directors Candace Varner and Ben Hake are joined by their colleague, Tizzi Blackburn, to discuss Roth IRA conversions – the advantages, the rules, who’s eligible and when it makes sense to do one.
Learn more about the backdoor Roth strategy: https://creativeplanning.com/insights/explainer-video-backdoor-roth-ira-strategy/
The Standard Deduction podcast is hosted by Tax Directors Candace Varner and Ben Hake. This podcast is a thoughtful, informed discussion about ideas, trends and developments in taxes related to personal wealth management.
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Candace Varner: Hello, and welcome to The Standard Deduction. I’m Candace Varner.
Ben Hake: And I am Ben Hake.
Candace: And today, we have a special guest with us. Tizzi Blackburn, a managing director in our [tax] department and one of my personal favorites, is joining us to talk about Roth IRA conversions, everyone’s favorite tax topic. Good morning, Tizzi.
Tizzi Blackburn: Good morning, thanks for having me. I’m very excited to be here today, that was quite the big shoes to fill with that intro. Thanks, Candace.
Candace: No problem.
Tizzi: But I love to talk, so we’re just going to get rolling in and we’re going to start with just the basics of IRAs, Traditional vs. Roth, how they work.
So, the Traditional IRA is going to be funded with pre-tax dollars. That means you’re going to get a tax deduction on your tax return every year you make the contribution, it’s an upfront tax savings. It will grow in the account, it grows and grows and grows. When it’s time to come out, it will be subject to your ordinary tax rates and it will be ordinary income. Even though there’s earnings in there throughout the years of dividends or capital gains, they still come out as that ordinary income.
There’s a few age requirements I want you guys to keep in mind with these Traditional IRAs. The first is 59 ½ years old, you’re able to take out without any penalties from that IRA once you hit that age. The other age is even more important, it’s 72 years old. And that is when the IRS requires you to take a minimum distribution out, we call those RMDs. So, once you hit 72, you have no options, you have to start taking that ordinary income taxed at your ordinary rates out of the IRAs. When you pass away, the individuals who inherit these IRAs also have to take RMDs and are taxed at their ordinary rates.
The opposite direction is going to be the Roth IRA. These are going to be after-tax dollars, so there are no upfront tax savings to these Roth IRAs. The savings are on the back end and these accounts grow tax-free for many, many years, and when they come out, obviously that growth is tax-free and your after-tax dollars come out as well with no tax consequences when you’re deducting.
The big difference on this [Roth] account versus the Traditional, are there are no RMDs, there are no required minimum distributions, you can let it grow tax-free, you can never take out of it and then when you pass away, your heirs, who are inheriting this IRA, will also not be taxed. So it’s a great way to maximize tax savings with the growth portion and allow your individuals who are inheriting the money to not be taxed. So, what are the requirements to be able to contribute each year to a Traditional or Roth IRA? There’s three steps.
The first is going to be earned income. You have to have earned income to contribute a dollar or more to those IRAs, whether it be a Roth or Traditional. Earned income is going to be your wages on W-2s, your business income on 1099s, basically any income that has Social Security and Medicare taken from it is going to be your earned income. If you’re retired, unfortunately, you most likely aren’t able to contribute to those anymore.
Another piece to keep in mind is if you’re married filing jointly. If one spouse has earned income, then you both are able to potentially contribute to a Roth or a Traditional IRA, and that earned income counts for both of you.
The next step is going to build off the earned income. It’s going to be the maximum amount per year you can contribute. $6,000, currently, if you’re under the age of 50. $7,000, if you’re over the age of 50. But that being said, if your earned income is only $3,000, you can only contribute up to the earned income. So it builds off of that.
Finally, you’re going to have an AGI limitation, an adjusted gross income limitation. Once your income for the year is over a certain amount, you’re not going to be able to contribute the $6,000 if you’re under 50, or the $7,000 if you’re over 50. The only time that that income limitation is not going to be an issue is if you have a company and the company does not offer any qualified plans. No 401(k), no pension, no retirement plan whatsoever inside of the company you’re working for, you would be able to skip those AGI limitations and still be able to contribute to a Traditional IRA and get the deduction.
If your income is over that AGI limit with a Traditional IRA, you can still contribute. It’s just going to be after-tax dollars, and it will give you basis later down the road when you take those required minimum distributions.
So now there’s multiple people, I’m sure, who are listening, saying, “I don’t qualify for any of this. Why do I continue listening on this podcast?” But we’ve got more options for you guys, and Ben’s going to take it over from here.
Candace: They’re listening for the jokes, just so we’re clear.
Ben: It’s our sparkling personality, and then, B) tax information. So Tizzi’s kind of hitting on, she was focusing on the IRA. So one additional line I was going to add in there is that all that applies for a lot of employer 401(k) accounts, too. So you’ll have pre-tax traditional 401(k) contributions, where you get a tax deduction. Or your employer, while not required, it may also offer a Roth option, where you can take those pre-tax dollars and put it in, so you can put in $19,500, if you’re under 50, $26,000 if you’re above. Now obviously, Tizzi hit on the part that is most appealing to a lot of our clients and to most people in general, which is that if I have something I can put dollars into that I never pay tax on as it grows, for whoever receives income, that I never pay tax on it when it comes out, that’s super appealing.
So you may say, “Well $6,000, even $19,500 into one year is nice, but what if I want to get $100,000 into a Roth account?” And the IRS does have basically some provisions to allow for that. So, to be able to do that, they’ll say if you have other monies or assets in a pre-tax retirement account — so your 401(k), your IRA, SEP, those sorts of accounts. What the IRS will allow is you can move those, so let’s say we want to move $10,000 from that over to $10,000 into your Roth, then they will allow that and that’s called a Roth conversion. So that’s not getting new money into your total retirement accounts, it’s actually just moving kind of which bucket it’s from. So there is the provision to do that and you can really do any dollar amount.
So, you could do a Roth conversion of $1 or you could actually move over the entire account balance. Now, the reason most people aren’t just like, “Hey, let’s just move it all over and then I don’t pay taxes ever again.” The transaction where you move the funds from the pre-tax account to the Roth is a taxable event, so if you were to do that and we use that $10,000 example, that’d be an additional $10,000 of ordinary income to your tax return that you would pay tax on. So if you’re in the 22% bracket and you lived in Texas, you’d pay $2,200 in tax to be able to move those funds over. So a lot of clients are interested in that, but it’s a decision to be taken with maybe a little bit of planning and forethought.
Candace: So, you’re talking about making a conversion and basically creating taxable income. So it’s phantom income, I didn’t even get any of this, I just moved it from one account to the other. Most people want us to lower their taxes, and what you’re talking about is actually increasing our taxes that would be due this year. So why would anyone ever want to do this?
Tizzi: I think it’s kind of funny you mentioned that, Candace, and it’s a great question. What CPA ever tells a taxpayer to pay more in taxes, let’s trigger income and pay taxes, but there are some specific reasons why these Roth conversions would be a good idea. The first is if you have a startup business or a business that’s had a rough couple years and there’s large business losses. In turn, those business losses are creating very low AGI for the taxpayer, it may be a good time to hop on, do some Roth conversions to maximize maybe the 12% bracket or the 22% tax bracket, when we know normally when the business is having good years or the business gets up and running and profitable, you’re going to be in the higher brackets of 32%, even the highest bracket of 36%. So at the end of the day, it may be a good time to do some conversions, maximize those lower brackets, and get some money growing tax-free for you in the long run.
Another option are going to be the individuals who retire prior to 72. So maybe you’re 62, 65, 66, even 70, and you’re not required to take that minimum distribution yet until you’re 72, you have no earned income coming in anymore, and at the end of the day, you’re able to live off of after-tax dollars. So, your trust account, your taxable investment account, your savings account — if you’re able to live off of those, your taxable income is going to be pretty low for those years before you’re required to start triggering that ordinary income.
So those Roth conversions are going to be a great option for us to once again, maximize the 12%, 22% brackets, and be able to get some money working for us tax-free growth-wise in the Roth, in the long run. Another piece on that would be the more you convert to a Roth, the lower your IRA balances — your Traditional IRA and the lower tax you’re going to have later on — because those RMDs are going to be less when you turn 72, as well.
Ben: So, a lot of the ones that Tizzi was focusing on would be basically the idea would be a Roth conversion makes sense, or we’re going to pay less tax by triggering that income today versus waiting till RMDs start. We’ve got a lot of clients again, where when all that happens, maybe you’re going to be up on the 35% bracket. Although you don’t want to pay 22% on the conversion, it may make sense to do that now because you’ve basically locked in that tax savings on a spread. So a lot of those are going to be situations where you’re aware of it. You’re retired, so you kind of have a good idea of your income. There is another situation where we’ve seen it, the most recent example of this would be March 2020, when there’s a really strong pullback in the market.
So, in this scenario, you may be looking and saying, “Hey, by doing this Roth conversion, I’m going to pay the exact same rate.” So it’s going to be 35% to do this conversion. But, because of the pullback, all of that appreciation will be occurring in the Roth account, where it’ll be growing tax free. Now it’s a little bit riskier situation relative to, “Hey, I just know my income bracket is lower.” Because we don’t necessarily know when the rebound’s going to occur, or those sorts of things, so it’s definitely a more aggressive way to go about it. And another item to consider is that a Roth conversion is not something that can be undone. So if we trigger that, so we say, “Hey, we think our income’s low this year, we’re going to do a $70,000 conversion” Or, if the market’s pulled back, we’re going to do $70,000.
If things change, so let’s say, we think we’re retired, but then, you’re bored being retired or somebody comes around and says, “Hey, given all your experiences, we need some managerial consulting.” So you end up making $40,000 or $50,000. That can change your results at the end of the year and that Roth conversion can’t be undone. So, a lot of these, we’re focusing not on doing it in January because we think we’re retired. But we’d like to wait until closer to the end of the year where the chances that something’s going to occur, that we weren’t aware of – so, taking a new job, the business rebounds and starts having a great year, or those sorts of scenarios where we’ve got a smaller amount of time where that can occur, so we don’t wind up with the tax situation we weren’t expecting. So again, the big takeaway is, can’t undo it, so we want to be able to have some certainty that tax outcome we think is going to occur when we do the conversion is a tax outcome that actually occurs when we get to filing the tax return.
Candace: I am getting a little anxiety, with you talking about when the market is down and what might change before the end of the year and all of these things, and it can’t be undone. I need to be able to undo things, I’m a risk-averse person. I’m an accountant, Ben. So let’s say, I’m a little leery of this and I don’t necessarily want to go all in and convert my whole IRA to a Roth IRA, it’s too much for me. Is there another way that I could maybe get a little extra into the Roth IRA, even though I’m over the income limits?
Tizzi: There is. There’s one more option, and I know earlier, I promised people, they should hang on with us here and, even if they don’t fall into those three requirements, we’re able to give them ideas. The Roth conversions are for individuals that maybe are retired, the next one is going to be something that we call a “backdoor” Roth. And the backdoor Roth is for individuals who maybe don’t want to go all in and transfer a ton at once with those Roth conversions, but also for people who have higher AGI. So, what the backdoor Roth conversion does is, essentially, you contribute to a Traditional IRA for that year. $6,000, if you’re under 50, $7,000, if you’re over 50 and, within 24 hours, we convert it to a Roth IRA. So we essentially say the contribution to the Traditional IRA is going to be after-tax and not a pre-tax deductible item for us, and we’re immediately doing a Roth conversion to convert it over, which creates the basis so that there’s no taxable income when you convert it to the Roth.
Now, wouldn’t everybody do that if it was that easy? It’s never that easy. So, the main kicker here is going to be that you cannot have any other IRA balances. None, they have to be zero. Traditional IRAs, rollover IRAs, so the 401(k) you had at your old company that you rolled into an IRA, SEP-IRAs, Traditional IRAs — you can’t have any balances. So you’re going to have one IRA with a zero balance every year, that jumps to $6,000 or $7,000, and then goes back to zero. If you have any other balances in IRA accounts, it then becomes a taxable conversion when you do the [Roth] IRA.
So, it may not be an option for everybody, but it’s a great option for people who are in the higher AGI amounts, have higher income, no IRA balances, and still want to contribute to their Roth every year. That being said, with all of these new regulations and ideas coming out from President Biden and his administration, I think it’s important for Ben to kind of touch on what changes are going to happen with these backdoor Roths and Roth conversions.
Ben: And it wouldn’t be a Standard Deduction podcast without the caveat that everything we’ve just talked about might be wrong in the coming months because of tax reform.
Candace: Not wrong, just changing.
Ben: Three of the big things that we’ve hit on, that may be considerations in that specifically, The House Ways and Means Committee has already come out and said that these are things they’re looking to change, would be that backdoor Roth opportunity that Tizzi literally just talked about. They’re looking to basically remove that provision, and the way they’d go about that is saying that if you put in non-deductible basis into a Traditional IRA, they won’t allow you to move those dollars over to a Roth. So that’s going to be one big one. The second, which I don’t know how applicable it’ll be, is that right now you could do a Roth conversion at any point in time. So, that scenario where, let’s say you’re a very high-income earner, you make a million dollars a year, and you will not operate on that market pullback where, “Hey, the market’s down. I want to get the appreciation on the other side.” What they would change now is saying that if your income is over a set threshold — I think it’s $400,000 for single, $450,000 for a married couple — then the opportunity to do a conversion is no longer available. You just outright couldn’t do any sort of conversions in the year where your income comes to that threshold.
And the final item that, again, one of the reasons a lot of people are interested in Roth IRAs is there is no RMD. They do have certain provisions that would propose that if your accounts in total, both pre-tax, so Traditional and Roth, get over a certain threshold, so $10 million or $20 million, that the IRS would still require a distribution out of that Roth and Traditional account to get the balances under those thresholds.
So there’s some changes that, again, could alter the strategies we proposed or kind of change that baseline understanding of how a Roth IRA would work. And obviously over the next weeks and months, we’ll probably get more clarity on that, be able to figure out and advise accordingly.
Candace: As with all the tax law changes, we will keep you updated — and it will change many times. Thank you Tizzi for joining us, so much. I really appreciate having you on, you’re wonderful, and thank you all for listening.
Tizzi: Thanks for having me guys, it was amazing. It was a great time. I hope everybody enjoys listening as much as I enjoy talking about it.
Candace: Awesome. All right, thank you everyone.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.