GRD Season 4 Episode 8-Should you convert if your tax rate is 37%_mixdown
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[00:00:00] Hi, I'm Ed Slott. And I'm Jeff Levine. And we're two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver, so that you can make better decisions because better decisions on the whole lead to better outcomes. And here's how we're going to do that. Each week, Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard-earned money.

At the end of each debate, there's going to be one clear winner you. A more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation to decide what's best for you and your family. So here we go. Welcome to the Great Retirement Debate. Hey everyone.

Welcome to the latest episode of The Great Retirement Debate. I'm Jeff Levine, and with me as always is Ed Slot. Ed. Good afternoon, sir. Great to be back here. We have a great topic today, one that we get lots of questions about, uh, what you got. Well, people always ask when I talk all about the Roth and [00:01:00] everybody knows I have a total bias to the Roth.

I admit that I love tax-free. And I don't know one client that ever came back to me that didn't love having a Roth. They don't even remember what it cost them years ago or even last year. So, uh, the question is. We get from advisors, they say, but I have a client that's in the top bracket already. Should he be converting to or she be converting to a Roth at the top rate?

I mean, they're already at the top rate. And that's the question. So I usually, oh, go ahead. I was gonna say, I think, you know, probably people are getting tired of us saying this, but it depends, right? Like ultimately, oh gosh, we should call this whole thing the, it depends as a podcast. That's right. It depends.

That's, that's always the answer. Look, if anybody tells you, well, look, there are a lot of, um, and I think on another episode, you call them thin influencers, right? A lot of people out there. Who like to just give blanket advice. If anybody ever tells you, everyone should always do this, or no one should ever does the, you know, do this.[00:02:00]

If, if, if there's such black and white terms, they're probably not doing you any favors. Because the reality is financial planning, tax planning, which is a component of financial, they're all so in intricate and nuanced. Everybody's situation is different. So it does depend, but ultimately. When we're talking about should you do a Roth conversion when you're in the 37% bracket, what, what, what the, what is sort of behind that question, right is, Hey, you are currently at the highest tax rate that exists today.

There is no higher tax bracket than 37% today. Does it pay to pay taxes now when your rate is at the top tax bracket? Or should you wait until the future to pay the tax at whatever future tax rate that is? In other words, will it be a higher rate than 37%? Will it be a lower rate? Will it be the same rate?

So. Before we get into it, and I, I turn it, you know, back over to you, ed. I think it's worth a, um, [00:03:00] I think it's worth a quick discussion of the math behind this. Now we could go into, you know, we could throw out spreadsheets and all sorts of calculators and things like that, but suffice it to say. In general, if you believe your income tax rate in the future will be higher than it is today, then you should probably convert to a Roth.

Now because you're paying tax at today is lower rates and in exchange, you're going to have the ability to take tax-free distributions later when your rate would otherwise be higher. Now conversely, if you believe you'll be in a much lower rate in the future, then you should probably wait. To do. Don't do Roth today, take a tax deduction today, and then in the future you can have that at taxable at that time, but it would be at that lower rate.

Now if you think you're gonna be relatively stable, in other words, you think your income tax rate will be even then mathematically, there's still in general a slight [00:04:00] math advantage to the Roth. Uh, and one of the primary reasons there is Roths have no required minimum distributions during your lifetime.

So whereas, whereas with the traditional accounts at 73 today, at 75 in the future. You'll be forced to take out some money, and even if you don't need it when you reinvest it, then those reinvested dollars you'll have to pay tax on the interest and dividends and capital gains with a Roth IRA during your lifetime, you never have to worry about that.

So bottom line here, mathematically speaking, for most people, tax rate higher in the future, go to the Roth now. Tax rate lower in the future. Tax, uh, tax deferred now into the traditional IRA 401k, et cetera. And if you think it's gonna be relatively even then in general, there's a slight edge to the Roth, but not as dramatic.

So with that sort of baseline, ed, let me flip it back over to you and say, so where do you stand on this issue? 'cause as you said, this is a question you see. All the time. Oh yeah. Yeah. 'cause they always hear me talk about the Roth and they say, [00:05:00] should my client do a Roth conversion? That's what we're talking about.

As opposed to putting into a 401k or a Roth 401k. They already have the money in the IRA, uh, should they convert it to a Roth when they're already in a top bracket. And the thinking as you said. Most of their clients are telling them that, wait, I'm in the top bracket. I'm sure I'll be in a lower bracket in retirement.

It can't get any higher, so why should I convert now? So here's my feeling on this. I still think there's a good case to. To do that conversion because you are locking in today's rates. It's a known, it's a certainty. If you convert, now you know what the rates are. You don't know what future rates will be.

They could be higher. I think they will be at some point, but who knows? Uh, but it's highly unlikely they'll be lower. But then they say, alright, I, I agree with you. Maybe they won't be lower, but my rate, my. Be lower my personal rate below because I don't have my $500,000 [00:06:00] W2. Well, I don't know if I agree with that either because I've seen it in practice.

Now doing tax returns for people who were retired, but were high earners and in top rates. And it almost always seems to come out that people who are in the top bracket, that means they make a lot, they're good savers, they're good earners. Are always in the top bracket. So even once they retire, they don't have their W2, uh, they still are in the top bracket because they didn't do anything.

You know, not converting, doing nothing to me isn't really an option because if you do nothing, your IRA continues to grow and compound. And then when you hit RMD age, your RMDs alone. Could exceed what your best salary year was, and then you are right back at top rates in retirement the last time. You wanna worry about what future taxes could do to your standard of living in retirement.

You could lock that down now even though you're in a [00:07:00] top bracket now. And for the other people that say, no, no, there's no way I'll be in a, uh, in a higher bracket or, or even the same bracket. And then I say to them, but. Your situation changes. Yes, you don't have the W2, but you probably don't have home mortgage interest.

You probably, uh, don't have kids to support. You are not taking a deduction for your 401k, so you've got higher income and less deductions. To me, even if rates stay the same, it may cost you more in the future. And again, the the last thing, in my opinion, you want to worry about. In the future, in retirement when it's hard to change things is an unknown, possibly higher tax rate.

So that's my fear. Yeah, I think those are all really, really fair points, ed, and, and, and you're right, there are a lot of people who, you know, have been, have been victims of what a lot of people call the big lie, right? Like you'll be in a lower tax bracket in retirement. Uh, now it's important to note though that that's, that is still true for some, right?

There are some individuals, [00:08:00] and I, I think back recently, I think it was maybe in, um. September of 2023, I spoke with a, a, a good friend of the program, if you will, Ann Turon, who, uh, we both know Oh yeah, yeah. Many years over at the Wall Street Journal and she was working on an article of basically should you go into your, you know, a Roth or should you go into a traditional account.

And I was sharing with her the story of an advisor who I had met with recently who, who was sharing with me the story of a client who he recently started working with, where. The client had done well over a number of years, but you know, never top tax bracket had always done really well. So let's call it like three, $400,000 of income in today's dollars, which is great.

A, an amazing income for for many years, but had just in his late fifties recently, got a promotion at his job and all of a sudden was gonna find himself in the top tax bracket for the rest of his career. Uh, the advisor was, you know, trying to think through what to do with this particular client and [00:09:00] was trying to decide whether or not money should go into the Roth or whether it should go into the traditional side or whether they should do conversions.

And at this point, the client had no Roth money, so the advisor initially was thinking, boy, no Roth money. I, I probably should. Have them do some Roth now. This way they have a little bit in each bucket. And as we began to dive a little bit deeper through this, what we ultimately realized was this particular individual was gonna have a very nice retirement income by all expectations.

If you, you know, I kind of projected it out, let's call it something like 200, $250,000 in today's income, which for a lot of people in retirement, like. That is amazing. Like people would like that while they're working, let alone while they retired for that number of years. But 200 or $250,000 is not gonna be taxed anywhere near 37%, right?

We have to raise the taxes by 50%, uh, which is not gonna happen in [00:10:00] order for that to occur. So in this particular instance, this individual was at 37% and was thinking, should I do a Roth conversion? The answer was unequivocally. Not, no, but not yet because you'll be in a lower bracket in just a few years.

Wait five or six years until you retire, and then look to do those conversions. But it goes back to the point of every situation is different for someone who may be in a higher tax bracket for longer. As you said, they may be accumulating enough funds where they're not at $200,000 of income in retirement.

They're higher or they're, uh, going to be the recipient of a 401k or an IRA that mom or dad had. And then when mom or dad die, they're gonna leave it to their kids and the kids are only gonna have 10 years to take it out thanks to the new rules. And all of that income is gonna be added on top of their existing income and that could push them into the highest bracket.

So there's lots of reasons why someone still might end up. At that 37 or [00:11:00] close to it rate in retirement. I like the answer. Not yet. It's way better than no. And, uh, my counter, I thought you were gonna go unequivocally when you said, I thought you were gonna say no, but you said not yet because you don't know.

There's, remember not converting today doesn't mean ever, so things may change, but if the, if somebody came up with the answer, no, I would take them farther down the line, depending on what their personal goals and legacy estate planning for beneficiaries. So, yes. Look at the beneficiaries. There are huge benefits for beneficiaries.

By the time a beneficiary, say a child inherits, maybe they're own in their own highest earnings years, and if the conversion wasn't done, they'd be inheriting literally the worst asset on earth to inherit a large IRA. And it all will get zonked with taxes at the end of year 10 at their own maybe highest bracket.

So if that's a consideration to somebody watching this and saying, well, maybe not for [00:12:00] me, but for my kids, what a great gift to give your kids. Uh, absolutely income tax, free retirement account that they can hold for 10 years, growing, building and compounding absolutely income tax free for at least those 10 years.

So that's another item to consider if that's important to you. Yeah. Let me throw one more out there for you, ed. And that is, you know, even if someone was going to be at the top tax bracket today, 37% and they thought they were going to be in a lower tax rate environment in the future, in some cases it still might be worth converting today.

Now would that cost them more money and be financially like dollars and cents if we were to put this out on a spreadsheet? Imp prudent. Yes, but one, as you have pointed out so many times, ed, there's the peace of mind of knowing, right? That you don't have to worry about that. So there's a non-financial benefit there, but even beyond that, right?

Let's, I want, I want you to just imagine Ed today that you have an [00:13:00] individual with $3 million in a an IRA and a million dollars in the bank, along with everything else they have, like they have other stuff too, but they've got a million dollars kind of put away in cash and, and $3 million in an IRA. All the math in the world, right?

When we're looking at these Roth analyses assumes that the $3 million in the IRA will grow at some rate in the future, and then you'll have that to take out in retirement. But the million dollars in the brokerage account or somewhere where the bank account will also grow at some rate and will be available to pay the tax liability on the distribution from the traditional IRA.

Or the other thing you could do is you could convert today and let's just say the $3 million cost of the conversion was a million dollars in taxes. Well, now you have no more bank account, but your $3 million in whatever it grows to in the future is going to be tax free. Well, here's the thing, if you.

Convert today and you [00:14:00] use the million dollars to pay the taxes, you've used it. Chances are the mindset is going to say, Ooh, my Roth money, that's my long-term retirement money. I'm not going to touch that yet. Right. And both in terms of the actual ability to not touch it, to, to control behavioral, you know, control of, I'm gonna leave that alone, but also the mindset of.

I'm gonna be a good long-term investor and not worry about the ups and downs of the market because it's my long-term money. There's a psychological process there. Whereas if we think about, let's say someone who has that 3 million traditional IRA and the, the million dollars in either a bank or a brokerage account, oftentimes the, the thought process is not linking the two of them, right?

They look at their retirement money in the IRA as, oh, this is my retirement money, and the million dollars in the bank, or the brokerage has. Oh, well this is, this is not retirement money 'cause it's not in a retirement account, so I can spend it now. Well, if you spend it now, then you don't have the money to pay the [00:15:00] tax on those distributions in the future and all the math analysis in the world doesn't matter.

So in some sense, the Roth IRA, the conversion can be seen as a behavioral finance tool to create a forced savings account for the future tax liability that would've otherwise occurred. That applies to people who are in a top bracket. So that's why I believe in general, if somebody says, I'm at the top bracket now, should I still convert?

Generally, I would say the answer is yes, unless there are certain situations where they know there's gonna be a, a, a lull or not yet, like you said. Uh, where they're going to be in a lower bracket for sure, for some other reason, whatever that is, where we could take advantage of those conversions at that time.

And remember, we are, we are talking in extremes. You don't have to convert the 3 million, you know, at one shot you can do, uh, over time. I, I think, you know, I, I think I have a, a, a, we probably get to the same place. I, I maybe have a, a slight disagreement of [00:16:00] the typical person I see with a 37% tax bracket.

It's, it's probably to me a very much a not yet. There's oftentimes a. A a a few years where we can find where they're gonna have those lower income years. Yeah, exactly. Yes. Yeah. But um, but at the end of the day, as we keep saying, it is very much an individual decision. Do you wanna wait 10, 15 years, let's say, until you retire?

To make those conversions. You're risking tax rates being different at that time. You're risking run ups in the market between now and then. Think of the value today versus the value it might be in 10 or 15 years. And are you saving the, for the tax bill in accordance in the taxable account? It's a nuanced decision, which ultimately comes back to, as we often say, in many situations, getting the right type of guidance and advice from a professional.

Well, I think at the very least at, oh, sorry. Go ahead. Yeah, but I think there's one answer. Uh, we talked about all of these great considerations that people should take into account, but one shouldn't be, well, I don't wanna spend the [00:17:00] money now. Yeah. Pay me now or pay me later. But that's right. You're right.

That's a good point to make. You know, whereas with most other accounts or not, but like the money that you may have in a joint account or a revocable trust account, or an account in your own name, when you die. Like death is almost like the ultimate cleanser from a tax liability perspective. It wipes away all that, you know, the, the, the previous unrealized gain you have and your heirs can sell it tax free the very next day after you die.

But with a traditional IRA. That tax liability, it doesn't die with you. It lives on. Right. It exists as long as the account does. And so it's never a matter of am I going to pay or will there be taxes on these accounts? It's just a matter of how much it will be and when it will be paid. Right. So the idea of I don't wanna spend the money.

Well, you're gonna spend the money at some point, right, right. Matter, that's what I'm saying. Matter now or later. That should not be part of the [00:18:00] consideration. No, I don't wanna write the check now. Yes, I agree. Right? You're gonna write it sooner, you know, sooner or later it's coming out. Well, one thing you should do is write down the things that you picked up from this episode that relate to you, because ultimately that's what Ed and I are here to do.

That's what the Great Retirement Debate is about. It's about making sure there's one winner of every one of our debates, you the consumer, who can make a better informed decision based on the information and education you picked up from this discussion. So hopefully you've grabbed a few things. If you're in the 37% bracket, you now have additional thoughts to consider whether or not you should convert if you're not in the 37% bracket, that's okay. Same things in general apply to you about what your future tax rate will be. Ultimately, it's a good discussion to have with a financial professional. Absolutely a good thing to think about, and as a individual who has saved a lot in your retirement accounts, you wanna make sure that you make the most of it, so make the most of it.

Thanks so much for joining [00:19:00] us for this episode of The Great Retirement Debate. We'll see you real soon. Okay. Jeffrey Levine is Chief Planning Officer at Focus Partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice.

Certain information mentioned may be based on third party information, which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The topic discussed and corresponding arguments are those of the speakers and may not accurately reflect those of focus partners.