Roth IRA Conversions Do They Make Sense? The Answer will Shock You!

Transcription

1 Roth IRA Conversions Do They Make Sense? The Answer will Shock You! Roccy DeFrancesco, JD, CWPP, CAPP, CMP The Wealth Preservation Institute 144 Grand Blvd Benton Harbor, MI

2 Roth IRA conversion basics What is a conversion? When you take a tax-deferred IRA and convert it into a Roth IRA. Upon conversion, income taxes are due on the entire balance. However, after the taxes have been paid, the money in a Roth grows tax-free and can be removed tax-free in retirement. 2

3 Continued If you convert under the age of 59.5, the 10% penalty is waived. However, when you convert to a Roth IRA, you must wait 5 years before removing the money to avoid the 10% penalty. The $100,000 limit on converting an IRA to a Roth IRA went away and there is an unlimited ability to convert to a Roth IRA. 3

4 Why convert? It sounds good in theory. Taxable IRAs can be tax-hostile because when you take the money out, you will pay income taxes on distributions. Roth IRAs while funded after-tax allow money to grow tax-free and come out tax-free. Therefore, in hindsight we made a mistake deducting contributions to a taxable IRA (or qualified plan). Right? 4

5 Conventional wisdom? Many talking heads, article writers, and computer programmers are telling us that Roth IRA conversions are good. Unfortunately they are wrong. The conclusion that you will draw from this presentation is that IRA Roth conversions do not make sense for most people if the goal is to maximize spendable dollars in retirement. 5

6 How do you know if a conversion makes sense? The simplest way is simple to run the numbers. The great thing about math is that when it s done right, it doesn t lie. But as you probably know, math can be manipulated very easily by the assumptions/inputs used to drive the calculations. Therefore, it is vital that you understand all the variables that are needed to determine if a Roth IRA conversion makes sense (and how I constructed the new Roth IRA conversion calc). 6

7 The variables The classic variables that everyone discusses: 1) Age 2) Amount of money in a non-roth IRA prior to conversion 3) Current income tax bracket Problem is most calcs. do not take into account our progressive tax system which may lower the taxes due on conversion. 4) Future income tax bracket 5) Assumed rate of return on investments The calcs do not allow for an input for mutual funds or other expenses. While this is an expense in both accounts, it will reduce the available dollars in retirement. 7

8 Continued 6) Are you using funds from your IRA to pay the taxes or other funds? This has a dramatic affect on whether it makes sense to convert. If you are using money from the IRA itself to pay the taxes, it s nearly impossible to make the numbers work. 7) Beginning withdrawal year. 8) Number of years you want to draw income. 8

9 What variables were omitted 1) Filing status for taxes Again the calculators simply allow for an input of your highest marginal tax bracket. Most people hardly know that. Therefore, the WPI calc. allows for an input of the client s AGI and allows them to pick their filing status. It then automatically calculates the actual taxes that will be due on all the client s new/additional income that comes from the IRA conversion. 2) State income taxes The calc. needs to allow for the payment of state income taxes if any (not all states have a state income tax). 3) Mutual funds, money management fees, or other fees levied on money in either the Roth or traditional IRA This does not have a great affect on the difference between which one is better, but you need the input to give a real world look at the amount of accumulation or retirement income. 9

10 Continued The following inputs are needed IF you choose to pay the income taxes due from the conversion from NON-IRA funds (which is the only time a Roth conversion will make financial sense). 4) Cost Basis of Assets used to pay taxes Some people will have money laying around in CDs, money markets, bank accounts, or bonds to pay the taxes (no real cost to liquidate and use to pay taxes). However, many people will have to liquidate stocks/mutual funds to pay the tax to convert their IRA. When you sell stocks, short-term and/or long- term capital gains taxes will be due. Those stocks have a basis that needs to be taken into account. This input is 10 for that basis.

11 Continued 5) Short-/Long-Term Ratio This input tells the software of the stocks you are selling to pay the taxes due on the IRA conversion what the mix is of short-term and long-term capital gains taxes on the sale of that stock. Some stocks will be sold with a long-term gain and some with a short-term gain (taxes at the client s highest marginal rate). 6) Short-/Long-Term Capital Gains/dividend tax rate on growth of the side fund To create an apples to apples comparison, if you did not convert your IRA and pay the taxes from other funds, those other funds would still be growing as part of your portfolio. Therefore, when you compare taking money from a taxable IRA vs. a Roth, you have to add to the funds from the taxable IRA withdrawals to the money you did not spend on taxes at conversion. When the side fund grows in the real world, there will be taxes on the gains. This is the field where the system pulls the blended capital gains/dividend tax rate on the annual growth inside the side fund. 11

12 And you thought Roth IRA conversions were going to be simple? The fact of the matter is that running real world numbers on Roth conversions is quite difficult. It s my opinion that the reason you have defective calculators and articles on the internet that are not accurate is because it s complicated to deal with all the needed variables. And therefore, the default position is to put something out that is easy to understand or use, even though it s wrong. Look at the following screen shot of a typical Roth IRA conversion calc. After what you now know, think of how silly it looks. 12

13 Classic internet calculator 13

14 My new internet calculator 14

15 Examples Using real world math with examples is the only way to figure out if IRA conversions make any sense. Age = multiple (see the next slide) Conversion amount $500,000 IRA. 7% gross rate of return on money in the IRA, Roth IRA after conversion, and on the side fund. 1.2% mutual fund expense. Income starting at age 70 for 15 years. Married filing jointly with no state income tax. Income (varies) see next slide. 15

16 Paying taxes from the IRA Current Annual Taxes due at Withdrawal from Withdrawal from Percentage Age Income Conversion Non-Roth IRA Roth IRA Difference 65 $125,000 $165,487 $47,748 $35, % 60 $125,000 $165,487 $63,297 $46, % 55 $125,000 $165,487 $83,910 $61, % 50 $125,000 $165,487 $111,235 $82, % Current Annual Taxes due at Withdrawal from Withdrawal from Percentage Age Income Conversion Non-Roth IRA Roth IRA Difference 65 $75,000 $160,487 $47,748 $36, % 60 $75,000 $160,487 $63,297 $47, % 55 $75,000 $160,487 $83,910 $63, % 50 $75,000 $160,487 $111,235 $84, % 16

17 Paying taxes due on conversion from other non-ira sources Current Annual Taxes due at Withdrawal from Withdrawal from Percentage Age Income Conversion Non-Roth IRA Roth IRA Difference 65 $125,000 $165,487 $66,401 $63, % 60 $125,000 $165,487 $86,689 $84, % 55 $125,000 $165,487 $113,267 $111, % 50 $125,000 $165,487 $148,066 $148, % The above assumes you have cash to pay the taxes. The following assumes you had to sell $50,000 basis stock to pay the tax (where the mix of long-term and short-term capital gains taxes upon the sale is 50%). Current Annual Taxes due at Withdrawal from Withdrawal from Percentage Age Income Conversion Non-Roth IRA Roth IRA Difference 65 $125,000 $165,487 $69,827 $63, % 60 $125,000 $165,487 $90,997 $84, % 55 $125,000 $165,487 $118,660 $111, % 50 $125,000 $165,487 $154,831 $148, % 17

18 Income taxes going up in retirement? Does that help? The following chart shows you what would happen if clients earning $75,000 a year have their income tax bracket go up to 30% as the top marginal rate in retirement. Current Annual Taxes due at Withdrawal from Withdrawal from Percentage Age Income Conversion Non-Roth IRA Roth IRA Difference 65 $75,000 $160,487 $65,932 $63, % 60 $75,000 $160,487 $85,884 $84, % 55 $75,000 $160,487 $111,946 $111, % 50 $75,000 $160,487 $146,324 $148, % 18

19 Using a bonus FIA One way to improve the numbers on their face is to use a bonus fixed indexed annuity. This is salesmanship. If you used a 10% bonus annuity and paid taxes from cash, a 55-year old earning $125,000 a year (married filing jointly) who is in the same tax bracket in retirement, the numbers would look like the following: Traditional IRA $77, Roth IRA $82,904 Wow, now it works right? However, if you used that same 10% bonus in the non- Roth IRA, you d be able to take $83,537 out of the IRA + side fund after-tax. 19

20 What conclusions can we draw? Very simply, converting a traditional taxdeferred annuity to a Roth IRA will NOT make sense for the vast majority of Americans. This presentation and the calc. simply deal with people who are thinking of converting their IRAs in the hopes that they will generate more after-tax retirement income. There are estate planning applications with Roth IRAs that make them very unique. That is outside the scope of this presentation. 20

21 Cost $25 a month. This will also be embedded in the full-blown financial planning software and can be essentially purchased for less in a bundled manner with that software. Free to those who meet production requirements. Free to those who are putting all of their business with Optima. 21

22 Questions Questions 22