The current tax environment presents a unique opportunity for savvy personal investors to diversify their holdings and minimize their tax liabilities, especially given the uncertainty of the tax situation for 2021 and beyond. Chas Boinske and Pat Runyen talk with Rachel Kieser of Drucker & Scaccetti about the possibilities Roth IRA conversions may provide and discuss two example scenarios to help illuminate what might otherwise be a murky investment picture.
Today I’m joined by my colleague Pat Runyen, who runs the financial planning effort, and Rachel Kieser, who’s a CPA with Drucker & Scaccetti in Philadelphia. At Drucker and Scaccetti, Rachel assists high net worth family groups with individual tax and financial planning, family business tax planning, trust and estate taxation issues, family succession planning and private foundation compliance and consulting. Rachel and Pat will discuss Roth IRA conversion possibilities at year end: What the benefits are, what the mechanics look like, and we’re going to cover a couple of examples, and share the details of those examples in the show notes for today’s episode.
Example scenario downloads: Scenario 1 – Scenario 2
Rachel and Pat, welcome to the Wealth Cast! The discussion topic today is Roth IRA conversions, and you’ve been kind enough—both of you—to work on a couple of examples that we’re going to walk through eventually. But before we walk through the mechanics of a Roth IRA conversion and the benefits thereof, Rachel, can you just start with sort of a 60,000 foot overview of the benefits of a Roth IRA, and why someone might want to consider having one?
Sure. From a very high level perspective, some advantages of a Roth IRA—I’m gonna include first, just like a traditional IRA, the earnings within the account grow tax deferred, so there’s no tax on the earnings while the funds are in the account. But one difference between a traditional and a Roth IRA is that the distributions made from the Roth IRA are not taxable upon distribution, as long as the account is open for five years, the major advantage over the traditional IRA.
So this is not a short term strategy, then. This has to be a five year minimum strategy.
Yes, that’s correct. Another major advantage, and a difference between a traditional versus Roth IRA, is that a traditional IRA requires—once an individual reaches a certain age, they have to take required minimum distributions. With a Roth IRA that’s not required, so that money can stay in the account. If it’s your account, you can leave it in there. When you pass away, it can go to your kids. It’s not required to be distributed. And if it is—again, it’s tax free.
And then the last thing is that you can diversify your tax liability, so it gives you another bucket of funds to pull from, in addition to if you have a traditional. If you don’t convert the whole thing, it gives you another option, versus maybe a taxable account as well.
Gotcha. So so the thought is that maybe the tax rates in the future will be different than today’s rates, and we don’t know whether they’re going to be higher or lower with any certainty. So here’s an here’s a way to diversify that risk in your wealth. Is that correct?
Yep! Mmm hmm.
So Pat, how about for 2020? Any special considerations or opportunities that 2020 might offer us?
Yeah, Roth conversions have been a great strategy for a little while now, and maybe never as valuable, potentially, as this year. We kind of have the perfect storm of events: we obviously had COVID-19 this year, we had a big market downturn, and that played out in a couple of different ways that make Roths potentially advantageous.
First is that the CARES Act that was passed in March actually waives the requirement for any required minimum distributions from retirement accounts. So whether that’s an account you own yourself, because you’re over the age of 70 or 72 (depending upon when you turned those ages), or if you inherited an IRA that had required minimum distributions from it, those are waived this year, bringing, potentially, your income down.
Secondly, the fact is that most people—at least in their taxable accounts—were able to potentially take losses during the market downturn, which may have lowered their overall income.
And, just historically, we find ourselves in a very low tax environment for individuals. So it creates this perfect set of scenarios where you could have low income, you don’t have to take income out that maybe you don’t need through these required minimum distributions, and the income that you do have this year is maybe taxed at a lower rate. We see there’s there’s a number of opportunities that pushing income into this year strategically may be a good idea.
Gotcha. So given the the haziness about the tax rates in 2021, this might be an opportunity to take advantage of what as you mentioned, our historically low tax rates, and to Rachel’s point, diversify your tax risk. Right?
That’s right. Yeah, Iyou may have heard about this chance, but there’s an election this year! And that could bring upon some significant tax changes, potentially. So it again, just reinforces the point: I think if you polled thousand CPAs, I bet it would be in the 90th percentile of people that said taxes are likely to go up, rather than down. So this could be the lowest tax environment we’re in for quite some time.
And again, it’s 60,000 feet, we should add the caveat that every individual situation is different, right? Every person’s situation, the benefits from diversifying in taxes, the cost of the tax associated with RMDs—all those things are different. So as we go further in this conversation, I think it’s just important to point that out, and remind people that these are examples that we’re going to give, but your mileage may vary, and you need to really talk to your tax advisor or your financial advisor to make sure this makes sense for you.
With that sort of introduction, both of you have been kind enough to work up a couple somewhat common examples that we can share with with the listeners. Now, if you’re listening to this podcast, and you want to follow along in detail with these examples, we’ve made them available in the show notes for this episode. So you can go there and download them—they’re available—and it may help you better understand the logic of why this may make sense in a given situation.
Pat, why don’t you start with scenario number one, which I think we’re calling the bracket Roth conversion.
Yes. So often, when you’re looking for the opportunity to execute a Roth conversion, you’re looking to do it in a low income year. More often than not, the folks that fit this bill are folks that just entered into retirement. We base this off of a real life example of a married couple, both age 65, and they’re gonna find themselves in a very low tax bracket.
Their only income right now is some social security, some interest, some dividends, and maybe some capital gains, as you’ll see in the example. So even though they’re taking the standard deduction, they find themselves in a very low tax bracket. What they wanted to do was because the tax related to the Roth conversion is best paid with money sitting outside of a retirement account—they don’t want this to be a big cashflow burn. They want to keep the additional tax on this less than $10,000.
So with that said, in this example, that folks are looking to convert up to $65,000, to top out at their bracket. As you’ll see in the calculation, the average tax rate of adding this 65,000 to their situation is 14.4%. In total dollars of tax, that’s a $9,400 extra tax bill. However, because of the amount of this money that they’ll now have in a Roth, they get to grow that amount tax free. Assuming taxes rise in the future, as we show in the calculation, they’re likely to walk away after about 20 years, with $30,000 more in their pockets, lowering their lifetime tax bill.
So it’s the idea of, you can pay tax now or pay tax later, but if you can lower your lifetime bill, and have a tax free asset down the road to do it, it’s likely to make sense in an advantageous tax year.
And we see this fairly often: An individual or a couple retires, their income stream declines—obviously, they’re not working full time anymore—but they’re not yet required to take out Roth RMDs, the required minimum distribution, so they’ve got this sweet spot.
And you’re talking about taking advantage of that sweet spot by actually paying some tax—by doing what you think may be counterintuitive, which is increasing your tax bill—but the idea is to increase your tax bill to save future tax dollars.
That’s it, Chas, and the way I always say is “If you’re in a low tax bracket, that’s a great thing to be in, but you may be missing an opportunity.” If you have pre-tax assets in a retirement account, pay some tax voluntarily in that situation, up to a point that makes sense, and your tax preparer and advisor will be able to help you with that. And then you have the right to never pay tax on those dollars. Again, it’s a great strategy to lower your lifetime tax bill.
Yeah, obviously there are pros and cons to that strategy. You have to think about what your trade offs are. But you can calculate pretty clearly as the scenarios that indicate whether it makes sense to do it, how much, what your time horizon has to be, and how much risk there is in actually realising the benefit. The calculators available—the calculators that we use, and I’m sure that Rachel uses—allow you to accurately get an idea of what the tradeoffs are, correct?
Great! Thanks, Pat. And Rachel, you’re going to cover scenario two, which we creatively titled “The high net worth individual Roth conversion.”
Yes, very creative!
So let’s walk through that.
Yeah. So this scenario is also a 65 year old couple, Pennsylvania residents. In comparison to the first scenario, this couple has higher income at the level of about $500,000 before a Roth conversion. So they’re already in that top 37% bracket, even before taking into consideration the Roth conversion. I guess you could ask, “Well, why would they want to do it if they’re already in the top bracket?” In that case, it’s possible that they may never even need the traditional IRA funds, so this is kind of a way to maximise the inheritance to their children or even their grandchildren, by paying the tax up front.
Of course, like Pat said, the payment about the tax comes from funds outside of the traditional IRA; they are kind of pre-paying the taxes that their kids will not have to pay, because otherwise, they would have to inherit a traditional IRA and take RMDs from that account. So that could be a reason.
And then this couple also chose to kind of soften the burden of the Roth IRA conversion taxes by coupling it with a larger charitable contribution deduction in the current year—maybe they had been thinking of doing a larger charitable contribution, so doing the Roth conversion and the charitable gift in the same year kind of makes sense, because it will lessen the current year tax burden.
In this example, they’ve converted to $500,000 of their traditional IRA, but at the same time, but in the same year, contributed $225,000 of appreciated securities, which is an important item to point out, to a donor advised fund. So their net increase in taxable income was only $275,000 versus the total Roth conversion.
From that, the additional tax owed, after taking the charitable contribution into consideration, is about $87,000, or an average tax rate of 17.3%. Then after analysing the effects of that, and the impact of the investment of the funds over time, with a tax deferred growth, the couple, after 20 years will have about $250,000 more of additional value from doing the Roth conversion than if they had left it in the traditional.
—assuming that the investments that they put in the Roth IRA are similar to the investments they had in their original IRA. So you you’re making an apples to apples comparison, correct?
Yes, that’s correct.
Super! Are there any additional considerations that individuals should think about when they’re when they’re thinking about the Roth IRA? In other words, is it best in some cases—it seems to me if if someone has all of their assets in an IRA, and they’re retired, this is less likely to be a good solution than if their assets are more evenly distributed among taxable accounts and tax deferred accounts, because they can pay the tax associated with the conversion out of their taxable account. Is that Is that a fair sort of line of demarcation? Does that makes sense?
Yes, definitely. Yeah. Because you need to pay the taxes from another source. So it’s definitely true.
And so that the issue there, Pat, is that if they pay the tax from their IRA, they’re just actually increasing their tax burden with additional withdrawals?
That’s exactly right, Chas. It diminishes the value of doing this. So some working rules—and these are general, obviously, to get more specific, get specific advice on your situation.
But the three general rules are: you want to do this and have the money stay in the Roth for at least 10 years, so that’s rule number one. Rule number two is you want to do this and pay the tax from an outside source. And then number three is, you want to have a tax differential, meaning the tax that you’re paying today, you’re assuming that the tax that you would have to pay down the road upon withdrawing from the traditional IRA or 401(k) will be higher. So if those three things ring true, this is probably worthwhile for pursuing.
And the one sort of subtle, but I think interesting benefit is that the money that you’ve converted—and you mentioned this before in the intro to these examples—one benefit of converting some of the money to a Roth IRA today is that your future RMD distributions are smaller. So you’re forced to take less money out of your IRA in future years, and that really only benefits you if you have money in both taxable and tax deferred accounts, correct? I mean, that’s where you get the biggest bang for your buck, just to re emphasise that point.
That’s right. And just keep in mind that those those ages have changed from 70 and a half to 72. So you have a little bit more time potentially, to execute something like this than you had previously.
So in summary, if I could just try to summarise this: Generally speaking, Roth IRAs offer all the features of benefits that you guys covered well, in the beginning, and 2020, may be a particularly good year to consider this strategy.
Is there a deadline that people have to think about? Is it 12/31? How should people think about the rest of the year?
So the conversion would need to be made by 12/31, but it’s always good to talk with your advisors ahead of time. I would start the planning now—you still have a couple months, but I think it’s better to have a plan. And then also, if there is some kind of dip in the market, you might not even have a Roth account set up. Put all the things into place to get ready, and then you can press a button and do it. So we have clients that are kind of in that process; they have the accounts, but they’re kind of waiting while the markets go down a little bit, because when the markets down, it’s a better time to convert because your taxable income will be as much impacted.
Yep. Understood, understood. Well, this is really helpful, and I think the two examples that you offered, are very, very common. I mean, we’ve seen these many times—both I think in your firm, Rachel and in our firm as well. If you, the listener, have follow up questions, etc., in the show notes for today’s episode, not only will you see these examples, but you’ll have the contact information for both Pat and Rachel. Feel free to reach out to them. I’m sure they’ll be glad to answer questions for you.
Well, thank you very much, both of you. I know there was some significant prep work for this podcast to get these examples together, and I appreciate it. Thanks for taking the time. Rachel, we hope to have you back. This is Pat’s second visit to the to The Wealth Cast, but I know it’s your first and I I really appreciate you being here.
Thank you so much for having me.
You’re welcome. Both of you enjoy the rest of the day.
Thank you for joining us today as we discussed Roth IRA conversions with Pat Runyen and Rachel Kieser. For more information about Roth IRA conversion possibilities, please do not hesitate to reach out to Pat or Rachel should you have any further questions or would like to work through an example that may be more applicable to your situation. Thanks again for joining us. Until next time, stay well.
Rachel Kieser, CPA, MT, is a Shareholder at Drucker & Scaccetti in Philadelphia, where she provides tax consulting and compliance services to high net worth families, their closely-held businesses, trusts, and private foundations.
Rachel currently sits on the annual fundraising benefit committee for Legacy Youth Tennis & Education in the East Falls section of Philadelphia. She also previously served as co-chair of the Young Proprietors Committee of the Center City Proprietors Association, where she developed educational programming on business matters for entrepreneurs and business owners, and as Treasurer for The Philadelphia Spin Coalition, a nonprofit organization that promotes movement and circus arts in the Philadelphia region.
Prior to joining D&S in 2011, she developed her skills at a larger regional firm, and as a tax analyst at a large public corporation in Philadelphia. She earned her B.A. in Accounting, Magna Cum Laude, from Moravian College in 2008, minoring in French, and earned a Master’s in Taxation at Villanova in 2016.
Original Release Date: November 18, 2020.
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