Stop These Financial Mistakes! | What are the Key Factors to consider before a Roth IRA Conversion?

So you're thinking about doing a Roth conversion, but you're not sure what factors to consider. Today, we'll discuss three factors that you need to be aware of prior to doing a Roth conversion, and one you've probably never considered. Hey, my name is Casey Weade.

I'm the CEO and founder here at Howard Bailey Financial, and we're here to discuss taxes. We're here to discuss your IRAs and moving that IRA, that tax-deferred IRA, to a Roth IRA and key factors you should consider. Now, throughout the video, if you have any questions regarding anything that I discuss, I want you to drop those questions right down in the comment section, and I'll be sure to address each and every one of those.

If you have other things that you would like me to produce in a follow-up video, please drop those ideas in there as well. And if there's anything that I overlook, I'm not perfect, please let me know, and I will follow up as well with that follow-up video. Now today, we're talking about factors to consider when doing a Roth conversion.

And first and foremost, you're watching this channel, you probably already are aware what a Roth is, what a traditional IRA is, and what a Roth conversion is. So I won't get into all the nuanced details there. We're really thinking about the factors we need to consider, and of course, one that you probably haven't considered.

But from the basic standpoint, what we're talking about is taking those IRA dollars that you've never paid taxes on, maybe it was in a 401k or 457, a workplace retirement plan, you rolled it over to an IRA, may still be inside of your workplace retirement plan. And you're saying, should I take some of these dollars I've never paid taxes on, and I know that I'm going to be forced to pay taxes on them at some point in the future, whether I need to or not, I'm going to have to pay taxes on it, my kids are going to have to pay taxes on it. Should I go ahead and lock in those taxes today, move the dollars out of my tax-deferred retirement account, pay those taxes, and move it into a Roth IRA, maybe even a Roth 401k, if you're doing a conversion inside of your plan.

And in doing so, now you know you've never have to pay taxes on those dollars again, you've locked in your current tax rate, and they're going to grow tax-free without the need for you to take required minimum distributions. You'll also be passing those assets onto your heirs tax-free. Now, if you've decided to do this, which I encourage everyone that we visit with to at least do the analysis and see if this makes sense, this could be one of the most impactful areas of financial planning that you do around your retirement.

In doing this, there's four factors we're going to be discussing. Let's start with number one. And number one's fairly obvious.

That is, what's your current tax rate and your future tax rate? And the way that most people look at doing conversions is pretty straightforward. You want to know, am I paying less in taxes today than I'm going to pay in the future? Am I going to have a higher effective tax rate in the future than I have today? If I'm going to pay more in taxes in the future than I am today, I should do the Roth conversion. If instead, I'm going to pay more in taxes today and less taxes tomorrow, I probably shouldn't do the Roth conversion.

And that's the basic starting point. But one of the key factors is determining what current and future tax rates are going to look like. And that, for most people, is pretty easy to determine.

They assume, in general, taxes will go up in the future. If we just simply look at the history of tax rates, we can recognize that we're in one of the lowest tax rate environments in history. And we should take advantage of those lower tax rate environments that we find ourselves in.

And I've never asked anybody, over thousands of people I've asked this question to, I've never had anybody ever say they believe taxes will be lower in the future than they are today. So in general, we believe taxes will probably be higher in the future. That being the case, sometimes we just stop our analysis there and we go, yeah, we should do a conversion.

But we shouldn't stop there. We have to consider the next factor. The next factor being Social Security taxes.

This is where we get into some of those that are less often looked at or maybe overlooked. So your Social Security benefits, they will be taxable based on your income in retirement. And that is something known as combined income.

So your combined income is what is used to determine how much of your Social Security will be taxable. That's not your AGI, your MAGI, your Modified Adjusted Gross Income. This is going to be your income for things such as RMDs or Roth conversions, those retirement account distributions, any pensions, taxable interest, even tax-free interest, plus half your Social Security benefits.

And then they have different thresholds that you need to hit in order to find out how much of that Social Security benefit is going to be taxable. You could be paying taxes up to 85% of your Social Security could be taxable. And so what we might find is we do a Social Security analysis today and you say, well, if I don't do a conversion, maybe you're not paying any taxes on your Social Security.

Maybe 40% of your Social Security benefits are currently taxable. And when you do that conversion, all of a sudden 85% of your benefits are taxable. We need to take that into consideration to determine how much we're paying in taxes to do the conversion.

It's not just our ordinary income taxes that we think of because of the distribution in the conversion, but also how much more is our Social Security going to become taxable. But then we also need to look long-term. When we look out on that spectrum, and let's say you get to be 75, 80, 85, you look down the road, and due to your required minimum distributions coming out, maybe you weren't paying much in Social Security taxes.

Now your RMDs are getting bigger and bigger. And as those RMDs get bigger, now more and more of your Social Security is becoming taxable. And that IRA is now making you pay more in taxes, because now it's making you pay more in Social Security taxes.

And so we want to consider what the long-term impact of that is. And what if we do a conversion today? For some families, they're converting all of their tax deferred retirement accounts over to Roth. And then we fast forward, and someday we're not paying potentially any taxes on our Social Security in the future, and we get a lot of tax savings long term.

So we want to look at it over the long term, and also look at those Social Security taxes today. The next factor that we want to consider is the one that's quite often not considered. And so what do we talk about? Current and future tax rates.

We talked about income-related monthly adjustment amounts as it relates to your Medicare, and then your Social Security taxes. This next one is paramount, and could be pivotal in your decision on how much you want to convert, and over what period of time you want to convert your IRA to a Roth. And that is your rate of return on your investments.

Your projected rate of return on your investments is paramount to determine how much you're going to do in conversion. And this might seem like common sense, but let me break it down. And this starts with us always looking at this thing called a break-even analysis.

So we want to know, when are we going to break even on our conversion? And if you've done any Social Security planning, you know this is one of the key factors in planning for Social Security. You say, should I file at age 62, or should I wait and file at age 70? Well that's eight years that I'm going to go without benefits. If I go eight years without benefits, how long is it going to take me with a higher benefit at age 70 to make up for what I missed out on? This is much the same thing.

If you're going to take an IRA today and convert that IRA to a Roth, and maybe you don't have any distributions you need to take from that account, now you're paying taxes on dollars over the next several years and doing those conversions that you wouldn't have had to pay otherwise. So the only reason we do that is that if it comes back to us in the form of lifetime taxes. And if we're looking at lifetime taxes, our lifetime taxes are made up of these different elements.

Our ordinary income tax. How much are we paying in ordinary income, state, local taxes by doing that conversion today? And what are we paying over our lifetime? And Social Security taxes are also needing to be factored in there. You need to factor in any Medicare premium penalties in order to do the conversion.

So you have to factor in all of these different things in order to determine what our lifetime taxes are going to be. We recently looked at an analysis for this couple, 65 years old, and they're looking at doing about $65,000 in conversions over the next five years. If they do $65,000 in conversions over the next five years, when they don't need to take anything from that IRA, it's going to cost them a lot in upfront taxes.

So we want to know, when do we break even? When do we get back that original investment? And then it may seem like common sense, as I said, if that rate of return gets higher, then we're going to catch up much sooner. And it's quite dramatic. So if we go from a 5% rate of return to a 7% rate of return, we may be cutting that break-even point by over a decade.

So we may get over a decade faster that we get back to our break-even point just because we earned an extra 2% rate of return. And this gets really exacerbated as we go from 5% to 6% to 7% to 8%. We catch up much sooner.

And one of the key reasons for that is our required minimum distributions, our RMDs. So depending on your date of birth, you're going to run into RMD age. But for most of you watching, that's probably going to be 73, 74.

Let's say that your required distribution age is 74. The way they calculate your required minimum distributions is based on mortality. So they use a mortality table, and it gives you a divisor.

You take the value of your IRA, divide it by that divisor, which is essentially your life expectancy, and that results in a percentage that you need to take out. That percentage at 74 is about 4% of the value of your IRAs, cumulatively. Now, if we fast forward to 84, that number is about 6%.

If we fast forward to 94, then we're taking about 10%. And so if our IRAs are growing significantly in value, we can see that that can become a real problem. And if we have, for instance, a $1 million IRA, and we're drawing 4% out, that's $40,000.

If that thing continues to grow, and it's growing at 7%, it's going to continue to grow because we're taking less than 7%. We fast forward, and now we have a $2 million IRA, depending on what your growth rate was. Now you're taking 6% of a $2 million IRA.

That's $120,000. So because that IRA grew so fast, and your RMDs got so large over your lifetime, it justified doing much larger Roth conversions earlier in your life to combat how fast, how quickly that account's growing. But we also need to take into consideration our heirs and the impact that that's going to have from a legacy perspective.

If your accounts are growing at a much higher rate, think about how much of a traditional IRA is going to be left behind. If you're going to pass away by you're 80, 85 years old, your IRAs continue to grow if you're earning a higher rate than the required distribution rate, and maybe substantially so. If you're leaving behind a half a million dollar IRA to your heirs, they're required to distribute that out over 10 years.

So even without interest, that's $50,000 a year. The reason they have to distribute it out over a 10-year window now is because they eliminated stretch IRAs. Your non-spouse beneficiaries can no longer take that IRA and distribute it out over their lifetime.

They have to take it over a 10-year window. So a half a million dollar IRA, $50,000 a year without interest. If it's a $2 million IRA, that's $200,000 a year without interest.

And we can see with interest and even higher rates of return, again, we're going to have a much larger chunk of those IRAs over that 10-year window going to Uncle Sam. And that's the bottom line. That's what we're trying to disinherit here.

We're trying to disinherit Uncle Sam while you're alive and after you're gone. So there's some things that we need to consider. We need to consider your current tax rate and your future tax rate.

We need to consider your Social Security taxes, what impact a Roth conversion has today and over the long term, what impact this has on your Medicare premiums today and over the long term, and pinnacle, of course, the focus of today's discussion, your rate of return. What is that rate of return that's expected? The larger the rate of return, the larger conversions that you should actually be doing today. Now, this might seem a little overwhelming and you go, where can I start with this analysis? If you want to get an analysis, a tax analysis, to see how all of these factors will really play into your retirement to keep more money in your pocket where it belongs, all you have to do is call the number on your screen, schedule time for a free tax analysis with one of our financial planners on our team, and we'll visit with you, run that analysis, and we can do that virtually or in person wherever you find yourself in the United States.