Episode 17: Should I Do A Roth Conversion? with David McKnight

Hello. This is David McKnight, author of The Power of Zero, Look Before You LIRP, and the author of an upcoming book with which you may take a great interest, more of that in subsequent episodes. If you want to learn more about me, certainly go to davidmcknight.com. If you would like to subscribe, feel free to do so, you will get an email every time we have a new podcast so you'll always stay on top of all the latest from David McKnight.

The question when it comes down to Roth conversions is “How much tax do you want to pay? Do you feel like your tax bill today will be lower or higher than it will be were you to postpone the payment of that tax?” Now, I'm going to use an example today to try to drive home the point of whether one should do a Roth conversion or not. The example I'm going to do is let's assume you've got $1 million in your IRA and you want to pay tax, and this is going to be really oversimplified and I'm going to use a basic tax rate of 20%. Let's just say that your tax rate is 20% and you convert your IRA, afterwards, you will have $800,000 sitting in your Roth account. Some opponents of Roth conversions will tell you that, “Hey, if you convert your IRA to a Roth IRA, you'd no longer have that full million dollars working for you, you're not going to be able to accumulate as much money over time because the full million dollars is not growing and compounding in your investment account because you paid that 20% tax.” I have to remind people that although on paper, you have that million dollars, not all million of those dollars are really yours. You have to remember that when you decided to put money into that IRA or that 401(k), you essentially entered into a business partnership with the IRS and they are partners with you in that investment account. Guess what, as your portion of that IRA grows, their portion grows right along with it. Let's say, just to keep it nice and simple—I don't want to get into whether the tax rate I'm using is right or wrong, I'm just trying to illustrate an example here—but let's just say that 20% is the tax, then what we know is that 80% of that IRA is yours, 20% belongs to the IRS. You may be thinking that you're experiencing growth on the full million, but what's really happening there is you're only experiencing growth on that $800,000 because that's the portion technically that's yours. The 20% that belongs to the IRS, that's growing right along with your money but it's accruing to their benefit, not to your benefit.

Now, what happens if tax rates down the road are dramatically higher than they are today? What if they're dramatically higher than 20%? What if they go up to 30% or even 40%? Guess what, then you no longer have $800,000 accruing to your benefit, you have $700,000 or even $600,000, in which case, you would have been better off to have converted your IRA back when tax rates were 20%, because once you get that money, that $800,000 into the Roth IRA, you don't have to worry about the rise of tax rates over time, taxes can double, and if you're in the 0% tax bracket as it were, then 2 times 0 is still 0. You have to always remember that this argument that says, “You no longer have the full million dollars working for you,” is actually a fallacious argument because in reality, even today, even though it looks like on paper, you have $1 million, that $1 million is not really yours, in fact, it's hard to really say what percentage is yours until you know the tax rate that you'll pay at the moment when you withdraw that money, you really have no idea how much of that money is really yours. Guess what, it's hard to plan for retirement if you don't know how much money you have, so that's one of the rationales behind why people like to do Roth conversions. A bird in the hand is worth more than two in the bush, you know what tax rates are today, you're willing to assess whether that's a tax that you're willing to pay versus postponing the payment of that tax until some point further down the road when it could potentially be higher. Always remember that it comes down to the tax rate, where will tax rates are going to be tomorrow? Where will they be when you retire versus where they are today? It all comes down to the tax rate.

The real question becomes “How do we feel about the 22% and the 24% tax bracket? Do we feel like if we paid taxes on our Roth conversion at 22% or 24% that 10 years from now, we will look back and say that's a good deal?” I think that we have to ask this question within the historical context of tax rates. You don't have to go very far back in the history of our country to find tax rates, where the lowest tax bracket in that graduated cylinder was about 22%. If you go back to 1960 to 1963, the lowest marginal tax bracket was 22% and then the highest went all the way up to 89%. The moral of the story is as the highest marginal tax rate goes up, the lowest one tends to rise right along with it. I discussed in my last podcast episode how Larry Kotlikoff is predicting that should we do nothing given the fiscal gap in our country, 10 years from now, tax rates will have to rise by 51%, spending in our country will have to go down by 35%, guess what, if they choose not to mess with spending at all, that means that tax rates would have to rise even more than what he's projecting. The question comes down to this: Do you think if you paid taxes at 22% today, that would be a good deal? Do you think 10 years from now, looking back at the 22% tax that you paid on that conversion, that you spent your money wisely? This really comes down to if tax rates stayed level, it would probably be a mistake. You're paying 22% today only to forgo being able to pay only 10% or 12% should set tax rates stay level 10 years from now. But it really comes down to this: Can we really afford, as a country, to be charging people only 10% or 12% on their distributions from, by that point, what will easily be $30 trillion of IRAs? My position is an overwhelming and resounding no. I don't think that 10 years from now, the lowest marginal tax brackets in our country will be 10% or 12%, I think that they will be higher, and I think that if you paid taxes at 22%, you probably would not regret it, in fact, you would say, “Wow, I can sleep even more securely at night knowing that I paid the piper and I never have to worry ever again about whether tax rates will rise dramatically,” because you paid the piper and you did it at relatively low tax rates.

Having said all that, it's up to you. When it comes down to Roth conversions, you have to feel like that tax rate today that you pay today is going to be lower than what you pay in retirement, that ultimately is a decision that comes down to you. You could certainly listen to my feelings on the topic, you can research it as much as you want, what I would probably do is really home in on what the fiscal condition of our country is. What is the likelihood that tax rates 10, 15 years from now will be dramatically higher than they are today? I will tell you this: If you're younger than 50, it's a no-brainer, it makes a lot of sense to pay taxes at today's historically low tax rates, take advantage of today's low tax rates so that down the road, when you have fewer deductions and tax rates are certainly much higher than they're today, then you can look back and say, “That was a good deal. I am now experiencing a tax-free retirement.”

A lot of times we say, “If you do have a pension, it might make sense to see if you have a lump-sum distribution option that would allow you to roll that pension, that lump-sum distribution into an IRA, you could then convert that IRA to a Roth IRA, in which case, you could definitely get to the 0% tax bracket.” Remember, in my mind, the very best way to insulate yourself from the impact of higher taxes is to get to the 0% tax bracket. Why? Because if you're in the 0% tax bracket, 2 times 0 is still 0. That is certainly a no-brainer and there should really be no discussion there if you find yourself in a position where your best-case scenario is your money will flow into your tax cylinder retirement, land on top of your pension and your Social Security income, and be taxed at the 22%, or at least the future equivalent of whatever the 22% tax bracket is, and if tax rates double, that could be 44%.

I pointed something out to him that really, really got his attention, I said, “Look, have you ever considered what would happen if you died?” He said, “Sure, my wife would inherit my 401(k) or IRA.” I said, “That's right. But what happens to her tax bracket if you die?” Then he thought about it for a second, he says, “What would happen to it?” I said, “As a single person, the thresholds that govern the differences between, say, the 12% and the 24% tax bracket actually shrink by half. There's a good chance that if she got your pension and the taxable portion of her Social Security, that any money that she took out of her 401(k) or IRA at that point would probably put her in the 22% tax bracket. That's almost double where you are right now.” The point I was trying to make to him is that even if you don't believe that tax rates in the future are going to be dramatically higher than they are today, you should probably look at how long a widow or widower typically remains alive after their spouse dies. If you die and your wife inherits all of your money, there's a good chance she could be alive for 8 to 10 years. If she deigns to draw money out of those IRAs or 401(k)s, she'll be paying 24% tax. My point to him was why should you let a single year go by where you're not maxing out your 12% tax bracket? If memory serves, he had quite a bit of room in his 12% tax bracket to be doing conversions. You should be converting like crazy. I'm not saying bump up into the 22% tax bracket on your conversions, but don't let a year go by where you're not at least maxing out your 12% tax bracket because the minute that either you or your spouse dies, then the cost of being able to take money out of your IRA or 401(k) automatically just about doubles, not to consider the implications of what happens when you die and your kids inherit your IRAs. When that income flows to them after your death, they're going to have to realize, it is income, it's going to certainly be at higher marginal tax brackets down the road. This guy was 65 if memory serves, so he could die in 20 years, tax rates will certainly be higher 20 years from now, and your kids will be at the apex of their earning years, so these IRAs are going to flow into their tax cylinder and be taxed. Remember, the IRS forces you to take this money out. It'll flow into their tax cylinder and land right on top of all their other income. There's a pretty good chance if they are at the apex of their earning years, that's not going to be a 12% tax bracket.

That's really the main gist of the show today. Be very, very thoughtful about where your tax bracket is right now, where it is likely to be when you retire, what are the implications of dying and becoming a widow or widower, and what are the implications of passing this money on to the next generation? Remember, if you have money in a Roth IRA, it goes to your spouse, he or she doesn't have to worry about what tax bracket they're in. If it goes to your children, they don't have to worry about what tax bracket they're in because somebody already paid the piper. Guess what, if you're in the 12% tax bracket and you have room left in there, honestly, not a year should go by where you're not maxing that thing out.