GRD Season 4 Episode 9-Should You Tap Your Roth IRA Early_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. Decide what's best for you and your family. So here we go. Welcome to the Great Retirement Debate. Welcome back everyone to the Great Retirement Debate.

I'm Ed Slott, joined by Jeff Levine. Hey Jeff. How's it going? Good to be with you again, sir. Yeah. And today we're going to talk about something we get asked about from time to time. The Roth IRA. We talked all about it, but this is a [00:01:00] different scenario. People have a Roth IRA. Should I tap my Roth IRA funds early.

Now we both know the Roth IRA is the greatest account. That's ever been created. There's nothing better. It grows tax free for the rest of your life. No RMDs income tax free, I should say, and even 10 years beyond for beneficiaries. So smart thinking would say, you wanna hold onto that money, it's growing, compounding, accumulating, snowballing, absolutely.

Income tax free. Why would you touch it? So that's the question. Alright, well I think you said, should you touch your Roth IRA early? So early, lemme turn it back to you and ask you a question. What's early? Well, that is, that is the question early might be, some people might think early, even before 59 1/2.

Sure. That could be early. I've had people that tapped it in their nineties, I'm thinking of one client years ago, tapped it in his nineties and says, well, I'm gonna touch it a little early. Because I need it for certain things, but I really [00:02:00] wanted to leave it to my kids intact. It's been growing, so I'm gonna cut into it early.

Actually, it was a great estate planning move. This is a guy in New York that, uh, was smart. One of the clients that actually listened to me years ago that wrote the check 'cause nobody wanted to write that check for Big Roth conversions. Uh, early on, uh. Even my, uh, are both profession CPAs. A lot of CPAs weren't on board with that.

They said, why would you pay taxes before you have to? A lot of 'em still aren't. We have those discussions all the time. Alright, so, uh, he was one that actually listened and he wrote the big check. It wasn't even that big. I think early on he converted, I don't know, 500,000. You know, that is a big item. But he did it.

He saw the big check in the early two thousands. Yeah, yeah, yeah. So he did it. Uh, and then he was up to, I think when the time he called, he was in his nineties, one of my oldest estate planning clients, who I believe is still alive. You know, when I used to do the estate planning, I was in my say thirties and my clients were [00:03:00] 70, now I'm 70 and most of them are dead except for this guy and two others.

Alright. Uh, so. He called me. Uh, actually his son was on the line too because he realized he had a New York state estate tax problem. His Roth IRA was up to eight or $9 million. Unbelievable. All growing. 'cause he made that investment. The guy listened, made that investment in taxes, which is not even a blip on the screen anymore, right?

Mm-hmm. And it's eight or $9 million. But he realized. He could lose a million dollars or more in just New York state estate taxes. I'm making that clear because you know, even though the federal exemption is larger, some states have a lower exemption or some, most states are state estate tax free, but we still have Yeah, about a dozen or so states with a state estate tax.

Still that's lower. Yep. And then you have like the worst states on earth, like Oregon. Uh, hopefully, you know, not to insult anybody, but you only have a 1 million state ex, uh, estate [00:04:00] tax exemption. You gotta do something. Tell him to watch the podcast here. Do something over there. So anyway, uh, he was worried about it and his son told me, what can we do?

And basically I said, well, that Roth. He says, but I was holding that for my son. I said, give it to him now. Give it to him. I said, yeah, take $5 million out. Uh, we decided that would be the, because he had other assets too. Mm-hmm. Uh uh, I said, take $5 million out and give it to your son. I said, what, what about the taxes?

I said, there are no taxes. You're taking it out of, out of your Roth IRA, it's tax. Oh, what about my son? Doesn't he have no, there's no tax on gifts. New York State doesn't have a gift tax. He couldn't even, the son couldn't get around the fact, wait, just take $5 million outta my Roth and give it to my son and nobody cares.

No taxes. Yes. So that was a great estate planning play 'cause he lowered his estate and uh, I believe he's still alive. He probably built it back up again somewhat, but still that was a good move. [00:05:00] So in his mind that was early. I'll give you another situation early on the other side, and I know you've written about this, so I'll turn it over to you.

You've written articles I've seen over the years. I know you wrote. For us, and, uh, you even, uh, addressed it at some of our elite advisor meetings about using a Roth IRA early. When you use it for a child's education, you wanna talk about that. That might be a good early use. Yeah, absolutely. Yeah. I, I can think of a couple of times when, you know, to me the, the two definitions of early would be before 59 1/2, and the other one would be, uh, before you have, before you've run out of other money, because a lot of people say.

The Roth is the last thing you ever touch. So those, I say that, yeah, there you go. Well, some people, ed, you know, so, so let's, let's talk about those, you know, look first for, for, for college education, oftentimes if you're looking at saving for a, a, a child or another loved one for college, the [00:06:00] first account that you turn to is, let's say a 5 29 plan account.

And there's obvious reasons. It's a dedicated account for that. Uh, in many states that have an income tax, there's an income tax break at the state level, not the federal level, but at the state level, there may be an income tax break, and if you use the money for qualified higher education purposes, and actually now as we sit here, that those definitions of qualified expenses have greatly expanded over the years, but it's tax free.

The, the challenge though is like, what if you don't use those dollars for education purposes? Right. What, what happens then? And it becomes very inefficient potentially from a tax perspective to take those dollars out. There might be income tax cost on the earnings plus a 10% penalty. Plus at the state level they may recapture or take back any benefits that they gave you before in terms of state income tax deductions.

So that can take a potentially tax efficient tool and make it a somewhat tax inefficient tool with a Roth IRA. [00:07:00] If you were to instead potentially save in the Roth for a college education, if you are 59 1/2 and you've had a Roth IRA for more than five years, everything that's in your Roth is tax and penalty free for whatever you use it for, including education, of course.

Somebody listening today may say, well, I'm, I'm not gonna be 59 1/2 yet. I'll be younger when my kids go to college. Well, there are a couple of things there. One, any contributions that one, ensure Roth IRA could still come out tax and penalty free at any age for any reason, again, including education.

Two, if you converted any money, any conversions that were made more than five years ago. So if you do this five or more years before your child goes to college, any amount that you converted can also come out tax and penalty free for any reason. And on top of that, the other thing you could do is you could have your child take loans and you could let your Roth IRA, continue to grow, and then you could simply use that Roth [00:08:00] IRA to help.

Pay down that student debt perhaps after they graduate college, or when you do reach the age of 59 1/2 and everything is tax and penalty free. So there's a, a great thing there. The other thing I would bring up too, and, and I sort of alluded to it there already, ed, is that, you know, pre 59 1/2, that's generally the magic age for being able to access your retirement account penalty free.

But the way the tax code works is the 10% penalty in general is only assessed on the pre-tax portion of a distribution. Right. So to the extent that there are after tax dollars, you generally don't have the 10% penalty. That's why you can take out your Roth IRA contributions at any time. Tax and penalty free.

They're tax free because you didn't get a deduction for them. They're Roth contributions and they're penalty free 'cause they're after tax amounts. But without any sort of rule that sort of backstops this, it [00:09:00] would create a little bit of a loophole. For instance, if someone wanted to tap their. Their IRA money, a traditional IRA money, and they wanted to take out a hundred thousand dollars at, let's say age 45.

You could, instead of taking it out of the IRA, convert the IRA today to a Roth and tomorrow take the money out of the Roth where it would be tax free and in theory would not be subject to the 10% penalty. So as a way to. Prevent that sort of quote unquote abuse. Congress created a rule that when you make a conversion and you're under 59 1/2, the general rule that says if you are taking out tax free money, the 10% penalty doesn't apply.

Doesn't apply during the first five years or stated a little bit more simply if as long as you wait more than five years after making a conversion, whatever you converted is able to be taken out without a penalty. So if you're 45 and you [00:10:00] convert when you're 51, whatever you converted can come out. Not the earnings, but the conversion amount can come out at any time, tax and penalty free for any reason.

So some people are lucky enough. To retire early. They may want access to their retirement funds prior to 59 1/2. They may not want to pay a penalty. There are a couple of ways to do that. One is by setting up somewhat obnoxious 72 T schedules. I know neither one of us are really big fans of those 72 T distributions, but another one would be to have the planning forethought to convert.

Five or more years before that planned early retirement date, and now you can take out those conversions without any type of tax or penalty. Right. That's early. And that can be very tax efficient or do a series of conversions, as you said, because that five year little trap or to close the loophole that I, that, that was created, as you said, you can, uh, that five year rule you're talking about applies [00:11:00] individually to each conversion, each batch of conversions.

The what you were talking about there. That's right. That's right. That's different. We should point out That's different than the five year. I know, I know. We're getting into, yeah, there's two. But people often, I You probably get all the time Ed, like can you explain the five year rule to me? No. 'cause there's not the five year rule.

There's two of them. There's one that we're talking about for accessing converted money early. That one has a separate five year clock for each of your conversions. The other one that says, is everything tax and penalty free if you're 59 1/2 has only one five year clock from the first money you had, right?

We're talking about the co, what you said with the conversions. So if you had the fourth uh, forethought to do these conversions, you could pull from the older ones that have been held for five years and you won't have that problem. That's right. And it's automatically done, by the way, it's record kept. So if you, if you convert it 45 when you're 51, you could take out that amount.

And if you convert it 46, the [00:12:00] money you could take out at, at 52 from that, et cetera. So you're, you're absolutely. And but I wanna turn, I wanna turn back Ed to the other early because. The, the traditional advice that is given. I think you like not, I think, I know you just said that. I say that all the time, is like, don't use the Roth money until the very end.

Right. It's too good. It's the best basket of money ever created. Yes. Alright, so, so, so how, explain. To everyone why That's the general advice and why you, you tend to, to go that way. And then, then I wanna add a little bit about why maybe there may be certain circumstances where, um, you might not want to follow that typical rule of thumb.

Well, that's the whole point of the, of the topic on this podcast. I showed you one early, the 90-year-old took it out in his mind early. We took it out early for education. So the general rule is this, money grows the fastest because tax free money always grows the fastest because it's not eroded by current or future taxes.

So if you have an account growing, [00:13:00] that's the best account because you keep 100% of those gains. You never have to share it with the government. So in general, that should be the last basket you you dip into. So now I'll let you take it what we gave a couple of situations for gifting. That's a good vehicle.

Yep. And for, for things like education. Sure. And, and I would, I would say like one to, to just. Level set everyone. What we're really saying here is that as you get older, you may have various different types of money. You may have some Roth money that's available. You may still have, you didn't do every, you didn't convert everything, and so you have some money in your, uh, traditional IRA or 401k.

Maybe you have some money in a joint account or something like that. So you may have different types or pools of money of which to touch. And the typical advice is spend your after tax money or your taxable money or what some people call your already taxed money, right? Like your joint account money first.

Then after you've done that, spend your traditional IRA money. [00:14:00] And then after you've done that. Spend your Roth IRA money. That's kind of the, the rule of thumb that people would say to follow and, and what I would say is it's certainly a better. Path, if you will, than the opposite. It's way better than starting and spending your Roth first.

Alright. Did a traditional, did a big setup. Let's, you did a big setup here. I'm waiting for the exception. Alright, I'll get you. So, so the key point here though is that sometimes, many times don't wait until the very end to use the Roth. Because if, let's say you've spent through all of those other dollars and the only thing you have left is the Roth IRA.

Your tax rate is going to be 0%. Right? You won't use the That's right. Which in, in theory sounds great, but from a tax planner's perspective, the goal is not to have the lowest tax bill in any one year. The lowest, the, the ga, the name of the game is to create the lowest lifetime tax bill. Or in the case of retirement accounts, sometimes the lowest multi-generational [00:15:00] tax bill.

If it you're paying nothing in one year, it means you probably. Paid too much in a previous year to get it to that zero point. And so a better way of thinking about this might be, boy, uh, instead, and I'm just making these numbers up, but like I'm going to take out enough money from my traditional IRA so that I get to the top of the 24% bracket.

And then anything above that I'm gonna take out of my Roth ira. Okay. Because it'll be tax free and I'll keep my. Low average tax rate over time. So often it's not, do this first, then this, then this. It's oftentimes a combination of these different accounts that creates the optimal distribution path. Yeah.

You never wanna have a year where you waste a standard or itemized deduction. Uh, that's right. Or low brackets. So remember you have the standard deduction for most people, and the low brackets on top of that. For a married couple. Now, the first 30,000 plus of income that you have is tax [00:16:00] free, so why would you not want have at least $30,000 a year of IRA income to eat up that tax free amount?

It would be, uh, it would be blasphemous not to. Now of course there's social security and other things to throw in there, but that's, that's the point. And if you don't need the money, take it anyway and convert it to a Roth. That's exactly right. Yep. You still can use up that tax efficient amount. So it's not necessarily a matter of never touch your Roth or only spend the Roth at the very end.

Sometimes it's a matter of what is the best path to get you to the lowest lifetime tax bill Ed, any other times when you would see, uh, potentially taking the Roth IRA sooner? Uh, if you absolutely, like you said, you absolutely went through all the other assets, or you are in a high tax bracket and you don't wanna take more taxable money.

For some reason, you want to keep your tax bill low for a certain year. So maybe that would be a reason to pull some Roth money out. But in general, or maybe you inherited an IRA or something like that. Right. And you've gotta pull out and [00:17:00] your tax liability is already very high, but it's gonna be lower in the future.

Yeah. There are all sorts of reasons for that, but I think it's worth. Again, reiterating that what we're talking about are largely the exceptions or the exceptions, right? Yeah. The, the outskirts of the rule. But the general thought Ed, of course, going back to it is what, yeah. Hold on to the last, that should be the last pot of money you dip into.

It's the best money you'll ever have. The Roth IRA is the holy grail, growing income tax free for the rest of your life. No RMDs and 10 years beyond to your beneficiaries. Yeah. And, and 10 years beyond to your beneficiary after, after going tax free to your spouse if you have one. That's right. Yeah. So you could be talking about 20, 30 years.

I just saw a study that most, most, you know, we keep talking about these beneficiaries, uh, the kids and grandkids. I just saw studies came out a few weeks ago. Most of them, a lot of them, they say make it nothing because the spouse is going to live so long beyond, you forgot about the second spouse, what we're starting to call now, [00:18:00] lateral or horizontal planning before it goes down.

Indeed, indeed. Well, listen, the Roth IRA is certainly the less taxing account, that's for sure. And we hope that this was not a taxing episode of the great retirement debate for you to listen to. As always, the winner of our debates is supposed to be one person and that one person is you, the consumer who is armed with better information, better knowledge, so that you can make a better decision for you and your family and your loved ones.

Ed, thanks so much for your insights today. And thank you for joining us on this episode of The Great Retirement Debate. We'll see you real soon. 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 in corresponding arguments are those of the speakers and may not accurately reflect those of [00:19:00] focus partners.