Episode #55: Why Roth Conversions Make Sense Today More Than Ever

Episode #55: Why Roth Conversions Make Sense Today More Than Ever


Despite the substantial decrease in taxes many Americans are paying because of the Tax Cuts and Job Act of 2017, it is important to keep in mind our rising federal debt. Now reaching over $21 trillion, the potential for a future increase in taxes is likely in order to cover this unprecedented deficit.

In this episode of Money Script Monday, Brian presents the window of opportunity you have to take advantage of the current low tax rate environment by converting your traditional IRA or 401(k) to a Roth IRA.


 

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Video transcription

Hi. Welcome to another episode of Money Script Monday. My name is Brian Manderscheid.

Today I want to explain why Roth Conversions make sense today more than ever.

Now, if you have a traditional IRA or 401K and have been thinking about doing a Roth IRA Conversion, you might want to ask yourself,

"Does it make sense to take advantage of this current window of opportunity where I can pay taxes at a discount today, or do I want to defer those dollars in the future when, in fact, tax rates may be higher?"

Essentially, we're living in a world where we're in a temporary federal income tax holiday where taxes are on sale.

You can pay them now or pay them later.

The former comptroller of the Government Accountability Office, David Walker, once said,

“We're heading to a future where the federal government will have to cut spending by 60% or double U.S. federal tax rates.”

So, today what I want to talk about are the key stats of Roth IRA Conversions, some strategies to explore, as well as a sample scenario involving a Roth IRA Conversion.

Key Stats

So first, let's talk about some key Roth IRA Conversion stats.

tax cuts and jobs act of 2017

The Tax and Jobs Act of 2017 really was a monumental piece of legislation.

The pieces I want to talk about today are relating to personal filers. Now, the top income earners, the top marginal tax bracket, went down from 39.6% to 37%.

So, on those last dollars earned, those high-income earners have a substantial decrease in the amount of taxes they're paying.

Now, as far as the seven federal income tax brackets, five of those seven were reduced.

Regardless of where you sit on the income spectrum, there's a pretty high likelihood you're in a lower tax bracket today than when you were in previous years.

The really key piece of this legislation is that it sunsets in 2026.

And what I mean by that is these tax laws are only good through 2025 on the personal side at which point, in 2026, they revert back to what they were before.

Again, we have this window of opportunity to take advantage of today, or we know the tax rates will be higher in 2026.

Additionally, there's a probability or a likelihood that a different administration or politician comes in, repeals these tax law changes, and puts something else instead, which may in fact have higher tax rates.

21 trillion federal debt

The second really key stat that you want to look at is the federal debt as a nation.

The federal debt is actually at $21 trillion, which is just a mind-boggling number.

The Congressional Budget Office, the CBO, estimates that we'll actually be in a $1 trillion annual deficit by 2020.

What that means is the federal government's expenses, meaning the Social Security, Medicare, defense, interest on the debt, etc., is going to be $1 trillion higher than the revenue that they're bringing in in the form of taxes.

If you've ever balanced a check book, you know that if you're operating in the red for a substantial time frame, it's likely in this time you're going to have some financial difficulties.

The other really key piece is, the Congressional Budget Office, the CBO, predicts that by 2028, the federal debt as a percentage of our GDP, gross domestic product, is to exceed 105%.

The last time we actually were at these record highs were in World War II which we had, obviously, some substantial difficulties as a nation.

future tax rates

So, the really key question to ask yourself again is where do you think tax rates are going?

Do you think they're going to be higher or lower in the future?

Strategies

We talked about some key Roth IRA Conversion stats, let's move on to some Roth IRA Conversion strategies.

Now it's important to mention that when you do a Roth IRA Conversion, you're going to do some income taxes.

roth conversion pay taxes out of cash accounts strategy

And you want to make sure that you have enough cash reserves, or cash flow, to be able to afford or pay for those Roth IRA Conversion taxes.

So, for an example, let's say you had a $500,000 IRA, $50,000 in cash, and let's just say a 30% effective income tax bracket.

If you converted the entire $500,000, you'd actually owe $150,000 in taxes which is more than you have in cash reserves.

So, for this scenario we'd actually recommend converting in stages, or allotting the conversions over time to an amount that you're comfortable with and had adequate cash and cash flow reserves to be able to afford those.

roth conversion pay borrow from cash value life insurance strategy

If you're lucky enough to have Index Universal Life Insurance that's max funded, you can actually borrow from these policies to pay the Roth Conversion tax bills.

Many of these policies have low variable rates in the low 4's or, some carriers actually offer a 5% contractually guaranteed loan rate where you can borrow from the insurance company at 5% guaranteed and the amount you borrow continues to earn interest uninterrupted by the amount that you borrow.

They index returns you're likely to receive from the policy is very much likely to be greater than 5% if not 6% or 7%.

So, you can actually borrow from the policy and earn a positive arbitrage in the amount you borrow from.

This is a great way to be able to afford the Roth IRA Conversion taxes without shelling out that big check to the IRS.

roth conversion convert only top marginal tax brcket strategy

The other strategy we often employ for our clients is to convert only to their top marginal bracket where they are today.

Let's say for example, you have $50,000 of adjusted gross income and are married, filing jointly.

The top of your marginal bracket is $77,400 which is at a 12% federal income tax bracket.

What you could do is convert only $27,400, pay 12% in federal income taxes. Keep in mind, if you had more income over and above that, you cross over the 12% income tax bracket and actually jump into the 22% income tax bracket.

This is a great way to just use your current marginal bracket, the room in that bracket, without jumping yourself into a higher income tax category.

Sample Scenario

We talked about the key Roth IRA Conversion strategies, we talked about some stats as well, let's get into a sample scenario using a Roth IRA Conversion.

roth conversion pay sample scenario

Mr. Roth Converter, he's 45 years old, has $150,000 in his employer sponsored 401K, he's actively contributing to, and $300,000 in an IRA from a previous employer.

He's fortunate enough to be max funding in Index Universal Life Insurance policy and he continues to do so and has $150,000 of built-up cash value.

He also has $75,000 in cash reserves.

Now, their adjusted gross income is $165,000, married, filing jointly, which brings them in the 24% income tax bracket.

So, the strategy for this couple is, rather than converting the entire 300,000, pushing them into the next bracket of 32%, they could actually convert half of it, $150,000 in this tax year, 2018, and 150,000 in 2019.

By doing so, we're staying in the 24% income tax bracket and paying $36,000 in taxes next year, next April when we pay our taxes in 2019 and again in 2020 when we pay our taxes on the second piece of the conversion.

We can either pay $72,000 in total taxes from the cash accounts, which would wipe out all their liquidity or we could borrow using other people's money, OPM, at the guaranteed low interest rate of 5% from the Index Universal Life Insurance policy and rather than writing up that big check, we're just paying the interest on the loan at $300 a month.

Essentially the amount that you borrow is still continuing to earn those interest returns compounded uninterrupted.

So what are the results by doing this for this client?

Well, essentially what we're doing is we're prepaying $72,000 out of retirement income taxes.

If, let's say, on the $300,000 we don't convert, if tax rates don't in fact increase and stay at 24%, he'd actually pay $287,000 in taxes in retirement on the $300,000 of IRA.

Now, if tax rates, let's say, go up to 35%, he's actually paying $449,000 in taxes.

And, if let's say David Walker is, in fact, correct and tax rates double, he'd actually be paying $575,000 income taxes at retirement or he could make the decision to prepay those taxes at a discount at $72,000 today.

We talked about key stats of Roth IRA Conversions to consider, some strategies to look at employing, as well a sample scenario using Roth IRA Conversions.

So again, I would ask you the question,

“Where do you think future tax rates are going?”

Do you think they're going to be higher or lower in the future when you retire?

Let's think about it this way. You're currently on a path, let's call that a train track, and you see not too far off in the distance, there's a freight train coming your way in the form of higher federal taxes.

You have a decision to make. You could stay on that train track, your current path, likely to be floored by that freight train coming your way in the form of higher taxes, or you could make the decision to step off the train track and watch the train go by.

So let's say you're in a 0% tax bracket in retirement and tax rates double. Again, you're unaffected by that rise in future income taxes.

Thank you very much folks for tuning into another episode of Money Script Monday, we'll see you next time.

About Brian Manderscheid

Brian Manderscheid is the Vice President of Case Design at LifePro. He works with financial professionals designing advanced case illustrations that are built for longevity and are always in the best interest of the client.

Disclaimer

This information is meant for educational purposes only.

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