Welcome to Episode 23 of Accessible Finance, where we demystify personal financial planning topics So you leave saying, I get it now. I'm Eric, Johns. And I'm Rachael Johns, let's dive in.

All right. So, Eric, we wanted to discuss Roth IRA's.

Yes.

How are they generally perceived by just the public Roth IRAs, I mean, I think they're just, they're the newest, right? So they're a bit, you know, there's some mystique there, I think Roth conversions have a Negative perception by some, even in the planning community.

They're they're probably over promoted but they are certainly useful tools to have right.

So they are there are some somewhat of the financial boogeyman right.

Especially you know older planners, old dog new tricks type thing.

They're newer and they're not comfortable with them and they think they're overused so they're going to be averse.

And the downsides if done incorrectly, they're pretty bad.

Yeah very large downsides very large upsides so high risk high reward plays you you need to know what you're doing.

On the high risk, high reward is less in the actual account itself and more just in the implementation if you're not sure what you're doing.

So I think, you know, in order to really ensure that what we're talking about with Roth is accessible as that is our name, I think we need to start with just kind of.

You know, zoom out a bit what our three accounts are before we start drilling down into it so that you know, viewers have.

A perspective as far as like what arena of this, you know, financial world we're kind of in.

So we're going to talk about the tax status of accounts.

So first, a Roth IRA.

What is a Roth IRA? Well, the tax status of that account is tax free, OK.

It's after tax dollars.

You've paid tax on the dollars, you put it into a tax free account and now when you pull the earnings and interest out.

Later, you're good to go, All right.

You've already paid the tax, so all of the earnings, including capital gains, dividends and interest that occur within that account are not taxable to you as they're happening.

And they're also not taxable to you later down the line, provided you've checked all the boxes.

At the end of the day, we know that like Uncle Sam always gets their money, right.

So in this way, you prepaid, correct.

You prepaid so that anything else that happens afterwards, what's yours? Uncle Sam doesn't even know it exists.

It is yours free and clear.

So that's the first bucket we're talking about is tax free.

Well, we're going kind of reverse order.

Yeah, but that's OK.

That's.

So that's our our Roth account, right.

So that's right.

What is a Roth RAF? That's it.

Bucket #1, tax exempt.

Rothing out.

Right, right, right.

I was going to go into the brief.

I already did there.

I already went there.

Brief caveat, Roth IRA is an account, not an investment.

OK.

So these investments, these accounts are not unique into which they can all hold the same things.

Correct.

Because we have interacted with clients and friends who have inquired us to like, what am I actually investing in when I invest in my raw.

And the answer, Well, I've had one better than that.

Whatever you want.

I've had a yeah, I contributed 6000 to my Roth.

And I'm like, oh, OK, great.

So what do you invest in? And they said, I just told you a Roth.

Yes.

I'm like, OK, we got some work to do.

Let's talk.

Correct.

Correct.

There's still elections to be made once you've put it in Iraq.

The only difference is the how it's handled tactically.

Right.

Right.

OK, so anyway, sorry, sorry for the detour.

Important.

Tax free Roth.

IRA.

Bucket #1, Tax free Roth.

Tax deferred, OK, That means I am not paying tax today.

I'm deferring the tax until later.

What that does mean though, is.

Active There are no tax consequences from the actions inside of that account in the current year.

What that means is interest, dividends, capital gains from buying and selling securities within a tax deferred account.

No tax impact on your current year.

You will be paying tax at a rate at the ordinary income at your current ordinary income tax rate when you withdraw the funds on the exact amount of the withdrawal of funds.

So nothing in there matters to you in the current year until you withdraw it.

Utah, Uncle Sam, like take a hike for now, like I'll see you later, right.

So you're seeing them at very different times, right, right, exactly.

So you're going to pay more in taxes, but like typically speaking, you're going to pay more in taxes.

Maybe that's not a helpful way to frame it, but you will pay more taxes, dollars, but you might be paying it at the same or lower rates in the future.

Does that make sense? So we want to pay taxes at the lowest rate.

That was probably an unhelpful detour.

I'm sorry I blew it.

This swear an example would come in handy which we won't get into just yet.

But again, like we are trying to like zoom out real quick onto the three different types of tax abilities of accounts, right.

So we've got our first one.

That's our.

Are tax free.

Are Roth where we say like, hey, Sam, nice to meet you.

Here's your money, all right.

Like, this is mine.

This whole pile's mine.

If the pile grows, it's still mine and mine alone.

Like you don't get to touch it, correct? Your tax deferred accounts, you and Uncle Sam kind of shake hands and say, see you when I retire, Like I'll see you later, we'll be back and I'll have more, but I'm not paying anything.

But in the meantime, like, leave me alone, right? Right.

So Sam takes a hike for that.

The third account, right, is your taxable account, which is you have already paid the taxes, OK.

And now you're going to pay the taxes as the actions occur, OK.

So they produce tax consequences to you in the current year that we're in.

And so that's going to be like interest and dividends in 2024, and I'm putting it on my 2024 tax return.

If I sell stocks and I have a capital gain or capital loss, it's hitting my return.

And so that is like your ongoing partnership with Uncle Sam, like you you've already and you've already paid the taxes once.

Now you're still going to pay the taxes on what happens with the things you pay the taxes on, correct, which is just your, you know, your checking account, your brokerage account, your ongoing, we didn't go into it, but the tax deferred or typically you're retired without OK, so 401K403B457-B.

Oh, I do want to make the point, IRA.

When we say like Traditional IRA that they're called a variety of things.

I've heard that like it's been called Contributory IRA, right? There's a Rollover IRA, Traditional IRA.

And then there will be, like you might hear, Inherited IRA, which will have marginally different treatment depending on your beneficiary status.

If you look up like what kind of tax deferred accounts are there, the list is extensive.

Whereas that is not true for your tax free or correct.

We're also just going to have Roth somewhere in the name.

It'll be Roth 401K.

You know, RAW SIMPLE IRA, now the SECURE ACT 2.0 did that or Roth IRA, which is why for us we try to imagine them as buckets of just like based upon how the funds in there are treated taxably.

That's where we're at.

So you've got your three different buckets and ideally you know you have funds in all three different types of buckets so that you can pull from whichever one is most advantageous to you at any given time, right.

From a tax perspective, correct.

Correct.

So.

Once you're in that raw bucket, that's kind of the one that we're going to be living in a bit, right?How do you get money into that? How do you get money into it? There are two ways.

A direct contribution, which is where you just contribute to it.

Like you literally just go to your your custodian press, move money.

It'll go from your checking account or wherever you want it to go from to your Roth IRA.

And there are limitations on how much you can contribute, right? Yes, absolutely. 7000 in 2024, I believe.

So you know, you're you're limited if you're if you're looking to really fill that bucket in a large and meaningful way.

7000, I am correct. 7000 and then it is an extra $1000 or over 50, there you go. 50 over, I'm sorry, correct.

Catch up contribution, correct.

So you could do a direct contribution.

OK.

What's the 2nd way conversion? Right.

And that covers what's called a back door Roth.

I'm only mentioning it because you're going to hear it heard.

I'm sure you're going to hear it at some point in your life.

It's going to be said by somebody.

It's just, it's just, it's a smaller conversion.

It's just a way to get around the contribution limits, right? But you can make a direct contribution if you're single and earn less than $146,000 a yearor if you're married filing jointly earning less than $230,000 a year in 2024, All right.

So anyway to do a direct contribution or you can do a conversion right now most people, I think don't really bulk necessarily at the direct contributions.

It's very clear what that is.

Straightforward, correct.

Exactly similarly as you would too in like your 401K.

It's just going into a different account, but.

When we talk about conversions, that's when people start to get there as they well should.

There's a lot.

There's a lot more to worry about.

OK.

There.

There is.

That's correct.

So conversion is when you're taking money that is in a tax deferred bucket or in a tax deferred account bucket, right.

And you're going to convert it into a tax free account bucket.

So you're going from like what I, what I, what I typically refer to as a Traditional IRA to a Roth IRA.

All right.

And what that means is you typically are going to be paying tax the time you do it.

Because the the government's like, look, we're giving you.

You're going to have no tax on this account.

We've got to get our tax somewhere and they're going to get that tax at the time you convert the funds from one account type to another, right.

So that's typically, you know that that's what a conversion is and that's how it's taxed.

You're going to pay ordinary income tax on the amount that you've converted, correct.

So it's essentially as though all my tax return, I'm just reporting that I've made this much extra income.

And so.

There are a variety of of tax implications in the year that you make that conversion.

Correct.

It can bump you from 1 tax bracket into another depending on how much you're converting.

It can bump you up.

Yeah, you can go all the way up.

We've seen people go all the way up, right.

If you convert $1,000,000, theneverything over in 2024 is like 600,000.

Everything over 600,000 is taxed at 37%.

You maybe shouldn't do that, right? I want to reconsider it.

Yeah.

So I think it's important for us to really delve into when it's worth, when you should consider making a conversion.

And then?Why having a Roth account is so beneficial? OK, sure, let's real briefly talk about the comparison between a Roth IRA and a Traditional IRA.

Right.

Because we want to.

Roths are not strictly better, which means better in every circumstance.

They're not.

What I mean is if in most like sure, if you could have the same amount of dollars in a Roth or traditional, you're picking Roth every day because you're not going to pay taxes again.

So if I have 30,000 traditional 30,000 in Roth, I'm always choosing the 30,000 in the Roth because after tax money.

And all the growth is no tax consequence.

And when I pull it out, it's all tax free, right.

But your time horizon is really important, right? Correct.

So like, let's talk about what happens if I'm 30, all right, I'm 30 and I have $100,000 to invest.

All right.

And then I want the money when I'm 65, if I'm in the 22% tax bracket, let's say when I'm 30 and then in the 22% tax bracket when I'm 65.

And then we're assuming the same rate of returns on the funds when I'm 30, the same rate of return on the funds all throughout.

And then I'm withdrawing it at 65.

So if I took the like, what did we say 100,000? So if I just contributed the 100,000 to a traditional, right, right.

Because it's not taxed yet, right, Or the 78,000, we just took 100,000 and subtracted?Right, right.

So just 100,000 -, 22,000, we'regoing with 78,000 into a Roth.

When I look at my after tax dollars after 35 years, they should be exactly the same, correct? My after tax dollars are exactly the same, OK And if for some reason not, this is not?Realistic to happen, but it is an important comparison tool to say that if your tax bracket remains steady, your returns remain steady.

It shouldn't matter when you're paying the taxes because you're still paying the same percentage on the same dollar, right?If that was to be the case and we would view it as like a tie, there are two important tiebreakers I think that are important correct to to get into a little bit correct.

Roth Iras do not have what are called RMDS or required minimum distributions.

That is in a Traditional IRA or any of those account types like we said, contribute to whatever, whatever.

I'm sorry, the tax deferred bucket, I like to flip.

It, you know, it's just a it's a good thing to do.

It's nice.

It's a little stressful.

Anyway, sorry.

Back to RMDS, which needs required minimum distribution.

Remember, we're friends with.

We're not friends with.

Uncle Sam is just a very important part in our lives.

And so in that tax deferred account you told him earlier like, hey bud, like, leave me alone for now.

I'll see you in a bit.

Yeah, well, this is a bit.

He said 73 is enough of a bit.

You're starting to give me my money back.

OK, so you're gonna have to pay with what are called RM DS.

They take a it's done an on an actuarial table, it increases with age, right? Until you.

So you die.

Umm, you're gonna be paying, you're gonna be forced to withdraw some money so that you have to pay taxes on it and the government can take some of that, right? You can't just have it sit there forever and be like so.

So either you're gonna pay throughout your lifetime or when you're beneficiaries or the your heirs get those accounts, they're gonna pay.

So somebody's gonna pay taxes on a tax deferred account.

It's just not today, right? That's the idea.

Anyway, So Roth IRA have no RM DS or require minimum distributions, right? And then they're tax free to your heirs.

Does that make sense? So I mean, they're tax free to you.

They're also tax free to your heirs.

And typically right now with the current ARM, the current inherited IRA rules, you're going to have to, your heirs are going to have 10 years to withdraw the money, right? So for Roth IRA, they don't have to withdraw them, They can just wait 10 years and then take all the dollars out.

And again the reason that they have the 10 year rule is again so that Uncle Sam can continue to get.

All of his money on those tax deferred accounts, So if for some reason you found yourself in a situation where we could.

You know, magically know that your tax brackets are going to stay the same and that your returns are going to stay the same.

Those two things would be important tiebreakers for why you would still opt for the Roth and over, you know, a Traditional IRA.

There are, though, some caveat, like, you know, there are some select situations, I think, where the Traditional IRA would be preferable to the Roth.

Sure, sure.

We're talking if we're in a large, like if we're in a high tax bracket.

We're not.

We're not so much talking about contributions here.

But there are times where you would just want to avoid a conversion.

Yes, right we can.

We can do, we've done podcasts on when you when you should contribute, whether you should contribute to a traditional or a Roth and what that decision.

Correct, correct.

But.

You're not going to want to convert if you're in an already very, very high tax bracket unless you have another reason for doing so.

And another reason I mean it's like very specific circumstances, maybe you're we don't need to get into it, but it's typically the exception to the rule, OK, find us when protects market is right.

So I think when we talk about what is a Roth conversion, that's literally when you're taking assets that are in one account and just converting them to another account.

So you're just converting essentially one account type to another.

You can keep the assets the same, that's fine.

Or you could sell them in the accounts with no tax consequence anyway.

Remember we said that tax deferred and tax free.

Have no current year tax consequence from the actions inside the accounts.

I mean, doing so in doing that conversion, you're basically saying like hey Sam, like I told you that I didn't want to see you for like 30 years or whatever, but here's your money.

But here's some stuff like come and get it early like, I mean.

I don't want to pay you again.

I'll pay you today, correct.

So that's what it is.

And logistically, if you're thinking like, OK, that all sounds great, but how would I do this? You literally will just go to move money with your custodians or Schwab, Fidelity, Vanguard.

If you're, you know, listening to this, not working with an advisor, then that's probably where you're custody.

It's very easy to do.

It's incredibly easy to do right.

And there will be some large box, red box that says Are you sure you want to do this and not withhold taxes? Because it's scarily easy to do, correct.

And then we want to talk marginally, just real quickly.

When they give you that huge red box that says Are you sure you don't want to withhold taxes, maybe you should consider withholding taxes.

Especially if you're under 59 1/2, youcould probably not withhold taxes.

Why is that? Because if you withhold taxes, it's treated as a distribution from your tax deferred account.

And you will incur.

You might incur penalties if you're under 59 1/2 oryou don't check another one of the box.

They treated as though you've gotten an early.

It's just like you your.

Exactly.

They think you've taken your retirement early because that's what they're trying to pull because essentially you did, you took your retirement handed to the federal government, right.

You said pay taxes.

With my retirement account, if you say no, please don't withhold taxes, then you have the option to pay the taxes with other funds, other dollars in your taxable accounts.

Exactly correct.

Exactly correct.

OK, so that's what it is, right? You're just going to press move money and you're just going to go from traditional Roth, I mean Traditional IRA to Roth.

That's it.

It's not a not a particularly complex transaction, right? That's what it is.

When do people usually do it?Right.

And this will kind of hit on why.

So when and why would you do this, right.

You would do it in a or I'll be speaking in a year where you want your income to be higher.

Why would I ever want my taxable income to be higher? Well, we want to pay taxes at the lowest rates possible throughout our life.

We're not looking to pay the least amount of taxes, right.

Like that's not really what we're mid maxing for.

We want the lowest rates possible, OK.

So what that means is if you're in the 12% bracket for example, or maybe even 22% bracket.

And either you or your heirs have an expectation of being in a higher bracket than the 12 or 22%.

Maybe your errors are very high earners.

Maybe they're CEOs, maybe they're in the 37% bracket.

You should probably be willing to pay tax on the 22% so that they don't have to pay them 37%.

And there's some, there's some considerations and some values discussions to be had there.

Maybe you, maybe you're like, you know what, they should pay the taxes.

I don't want to pay their taxes.

Let them pay the taxes.

Yeah.

Maybe you don't like it and it's not even going there.

Sure.

I would say the majority, if not all of the people that we work with though are very interested in making sure that the funds that are part of their family remain legacy and they would much rather see the funds go towards their heirs.

Then to Uncle Sam.

So they want to make smart decisions with money.

Correct.

And both for them and for their children.

Correct.

Right.

That's typically how it works.

And I mean, that's kind of what we would do, right.

So that's that, that, that that that tracks.

Yeah.

Alright.

So so we said, broadly speaking, when you want to realize more income, well, what is that? Maybe you take a sabbatical, right.

And so you went from making, I don't know, 100 and 5200 KA year.

Now you made, now you're now you're looking at 0 or whatever's produced in your taxable accounts, 'cause if you're taking a sabbatical, you probably aren't doing it with $0.00.

So you're going to have some money to check in your savings.

It's going to produce some income, but maybe it's only 10K.

It's important to note, I think, that like you're artificially raising your tax bracket now to ensure that you're lowering it later because you're not having to pay taxes when Uncle Sam decides to tell you you have to pay taxes through those required minimum distributions.

So if you're like, look I, you get to determine when.

To somebody else, right.

Right.

It's tax planning.

Again, we want to pay taxes when our rates are the lowest, right? Or or our brackets are the lowest, OK, so you might do.

The most common time When is the most common time that individuals execute a Roth conversion strategy.

And notice that I said strategy there, because it's not just a Roth conversion.

Typically it's not a one and done thing.

All right.

When might it be a one and done thing widow or penalty to avoid the widower penalty? That's when you're you're unfortunately an elderly couple.

A spouse dies.

Your spouse dies.

Right.

You're so now there's one individual instead of Mary.

Finally, jointly now we're finally single.

OK And you have to do it the very next year.

Yes, the time.

Correct.

The time horizon on something like that is very, very short.

And so you go from being able to be in A1 tax bracket to having all of those benefits essentially cut in half.

Your income's probably in this similar ballpark, or what? You're might be identical, right? Exactly, but your tax bracket is now twice as high as it was before.

Chances are you're retired, you have the RMDS, and now you're going to get hit with a higher bracket.

So look if your bracket if you might have been Mary.

Finally, jointly you might be in the 12% or 22% bracket.

Now that your spouse is deceased, you might instantly be kicked up to 24.

Yeah, 32.

Like it's suddenly very, very high.

And then once it's that high, it's not like it's going down.

You're there and you're going to stay there.

And then when RM DS kick in, you're going to continue living there, if not increasing from there, right.

So you might want a larger conversion than that.

So in that situation, rather than having it kind of process like you were saying rather than having it be a strategy over multiple years.

You're probably looking at one large conversion and Justice accepting that you're just going to kind of pay all those taxes at one lump sum.

But ultimately the ideal most common will be an individual retires or stops work, maybe they retire at 62.

R and DS are not going to happen until 73.

OK, with Secure Act 2.0, OK.

So you've got 11 years there between 62 and 73 to where you can start increasing your your.

So your taxable income might be quite low.

You might have a lot of money in a taxable brokerage, right?And then you might typically what happens for Americans, OK, we stuff a ton of money into our active retirement plans, which are almost always tax deferred.

They can be Roth, but people kind of typically, typically again are confused.

And if they're current retirees, Ross probably were very foreign to them or weren't around until they were in their 50s and they were just kind of like, I don't know about this new stuff, right.

We don't know how long this is going to stick around.

They might revert if we're not in it.

So anyway.

Large amounts of tax deferred balances usually have some sizeable brokerage balances, which means just taxable accounts.

So they might have 500K in a taxable 3 million in tax deferred, 0 in raw.

OK, that happens a lot.

So they might want over time to execute like a series of raw conversions over their years while they live on those, they use that 500K and the the income and the income generated from that $500,000, whether it be capital gains, dividends or interest, they're going to live on that 500,000 and they'll pay the tax on the Roth conversion from that 500,000, right? And then we'll start converting some of that 3 million so that when our RM DS do start hitting, they're not hitting us for like 150 , Kright? They we don't want to get.

Just grilled with these R DS.

All right.

It's just it gives you a bit more control over being able to hone in on.

How much money you're getting based upon how much money you need, rather than artificially having to realize income when you don't need to.

So there's definitely, there are huge upsides to doing it, but as we've discussed, there can be massive downsides if done incorrectly.

You can blow yourself up.

Yeah, you can, right? So you don't want to do that.

It's a it's a tool to utilize.

But again, the downsides are real.

Be be careful.

But yeah, most common, you'll do it over the course of those eleven years.

You won't just you might agree to convert to the top of the 22% bracket each year.

For 11 years.

And maybe that's only converting like, I don't know, two $300,000.

OK, well, it's better than 0 because like if you, if you, if you take nothing else away, note that most financial planners and tax planners really all, I would say all should be advising you in such a way that you're trying to minimize your tax brackets or the taxes, the percentage of tax paid on your income over the course of your lifetime.

Does that make sense? That's what you're solving for like on the last day that you're on earth, you're able to retroactively look and say like.

What percentage of my income did I pay in taxes or what percentage of my like, I don't know, worth did I pay in taxes? You should be able to feel as though you've had somebody in your corner if you're working with professional to make sure that that number is as low as it could possibly be.

It's lifetime taxes that we're talking about not like current year.

We're not trying to stay in the.

We actually don't want to have years where we have 0 taxes paid.

We want to fill up the 10 to 12%.

Those lower ones take advantage of them while they're there.

The 40 I haven't yet to meet anyone that I've told no, no, no, let's, let's stay in the 12% bracket.

Let's not fill it up.

Let's leave some space at the top there.

Almost correct.

You're always going to want a capital gain, Harvest, Roth, convert, something like that.

And you know, the idea is really to work with somebody that will make recommendations for you, various recommendations.

But.

Meet you kind of at a level that you're comfortable at as well.

So you know what we like to do if we're working with somebody on Roth conversion is say, OK, here are different hypotheticals.

Here are different scenarios are if we converted this much, this is what your tax analysis would look like.

This is what it will look like moving into the future.

These are what your RM DS might look like when you get there.

If you convert this second amount, this is what that would look like.

And so we may give three or four different scenarios to a client to discuss the pros and cons and then make sure that they're comfortable with the decision that they're making.

And that we've already have a plan in place to fund the taxes for that conversion.

That's exactly right.

That's great.

That's fantastic.

It is.

Alrighty, guys.

Well, thanks for listening.

And if you enjoyed today's episode, please follow and review the show.

And if you have any topics you would like discussed or financial problems you'd like to solve, go ahead and e-mail us at podcast@equilibriumfp.

com or visit the website equilibriumfp.

com.

Thanks till next time.