Coasting in Retirement Ep 17: The Good, the Bad and the Ugly of Roth Conversions & Back-Door Roths
Segment 1 (Show Open):
Good afternoon everyone! Welcome in. Welcome to Coasting in Retirement! That’s. Right. Thanks for joining us today, we’re excited and delighted to have you. I am your host, Josh Null, along side co-host Michelle Lee Melton, my radio midnight rider, the Abbott to my Costello…Michelle, how are you? Well, I’m excited to be back in studio in Coastal College’s recording studio here in beautiful downtown Fairhope, and I’m even more excited about the show we have today, as usual, we have another great show for those of you tuning in!
Listeners: Michelle and I are here today to discuss financial topics relevant to those of you in or near retirement living your best life along our part of the gulf coast. If you’re just tuning in to our show, welcome, you’ve listening to Lower Alabama’s most dynamic and interesting financial radio show. Here’s what we’ve got in store for you today: First segment – deep dive on our topic of the day. 2nd segment - at about 20 minutes past the hour - fan favorite, “Michelle with the News of the Week”. 3rd segment, roughly 40 minutes past the hour, ”Josh’s Crystal Ball and Big Mouth”. So buckle up, we’ve got a lot to get to!
Quick background on me for those new to the show. Again, my name is Josh Null, I am a fee-based financial advisor, I hold my FINRA Series 65 securities license, and I am the owner of Gulf Coast Financial Advisors, an independent investment management and financial planning firm with offices in Fairhope and Orange Beach, Alabama. You can find more information on me and Gulf Coast Financial Advisors by visiting our website gulfcoastfa.com, or feel free to give us a call at 251-327-2124. If you missed that, don’t worry, we will repeat our contact info several times throughout the show!
Alright Michelle, we’ve been doing a little traveling lately, this time to my hometown of Wappapello, MO. I say hometown but it’s really my “home region” because there isn’t an actual town of Wappapello, just folks living around a 8000 acre Corps of Engineer’s lake, you have to travel to nearby Puxico to find the nearest town. Your first trip to SE MO – what did you think? Well, last week we used a silly country song as our show inspiration, this week we’re going to use one of my Dad’s favorites for inspiration: the movie genre “Westerns”. Michelle, you like Westerns, correct? Favorite? Specifically, we’re going to use the title of a Clint Eastwood classic, “The Good, the Bad and the Ugly”, to discuss a concept that gets pushed pretty hard by my industry: the Roth conversion, often somewhat incorrectly referred to as a “back-door” Roth, it’s kissing cousin.
Let’s start with a basic Roth IRA explanation. Whereas your 401k plan or traditional IRA has pre-tax contributions, that is, any amount you contribute to these retirement plans is deducted from your overall income for the tax year, a Roth IRA is contributed to using after tax money. Also different is how the money grows – a 401k or traditional IRA grows tax-deferred, with taxes due once you start taking distributions, usually in retirement. Because the taxes have already been paid on a Roth IRA contribution, the account value grows tax free, and there is no additional income tax due when you start taking withdrawals. Another feature making Roth IRAs attractive are that there are no Required Minimum Distributions, or RMDs for short, whereas the IRS will require RMDs from your traditional IRA, typically the year you turn 72 years old, sometimes age 73 depending on when your birthday falls.
Now that you know the difference between a traditional IRA and a Roth IRA, a Roth Conversion is a pretty simple concept to grasp. Basically, you take a withdrawal from the assets that you have accumulated in a pre-tax qualified account, or in plain English, a traditional IRA, and then that withdrawal is deposited into a Roth IRA account soon thereafter. You typically can do this as an indirect rollover or as a direct transfer called a “trustee to trustee” transfer. When you file your taxes, you’ll owe income taxes on that withdrawal amount at your current tax rate. That is a your basic Roth conversion. Now, to keep this episode from being too confusing, I am going to give the basic differences between a Roth conversion and a back-door Roth, but we are going to stay focused on the more common concept of a Roth Conversion. Ready Michelle? OK. A back-door Roth conversion differs from a regular Roth conversion in that the funds being moved are after-tax IRA funds to an after-tax Roth IRA account. An individual may have after-tax funds in an IRA because they were/are unable to take a tax deduction for the contribution due to income limitations. Although taxes have been paid on the contributions, the earnings will accumulate tax-free but are subject to taxes upon withdrawal in retirement.
Listeners, hopefully you can tell from this word salad why we are going to stay focused on Roth conversions. A back door Roth is typically a more complex process, both should involve multiple conversations with a qualified financial professional. And both concepts have similar issues – it’s not uncommon for folks in my industry to promote this concept in what I call the “hammer in search of a nail” sales process. So that you are prepared if you ever find yourself in the mix of this sales process, today we are going to lay out the good, the bad and the downright ugly of Roth conversions, so that if you ever find yourself being told that nothing can go wrong with a Roth conversion and/or a back-door Roth, that it won’t coast you a dime and it’s the answer to ALL of your financial prayers, you can be like ol’ Clint and tell the salesperson, “Go ahead. Make my day.”
With that base line, let’s be positive and start with the good. First, for high income earners, contributing to a Roth IRA is simply not an option. The IRS has income limits for Roth IRA contributions. For 2023, the Modified Adjusted Gross Income, or MAGI for short, income limits are $153,000 for single filers and $228,000 for married couples filing jointly. And even if you can contribute to a Roth, the contribution limit is $6500 per year, with an extra $1000 if you are 50 years or older, so it’s harder to accumulate a larger amount compared to the higher limits of other qualified plans. Now to contrast that, a Roth conversion has no income or contribution limits, so for folks that are looking for tax diversification, tax-free growth and don’t anticipate needing to take RMDs, a Roth conversion might be a great option.
Let me give you an example. Let’s say you have $1M sitting in your 401k. Let’s also say that you pay attention to historical income tax levels and realize that, while it may not feel like it, we are in a generally low income tax rate environment, and you are concerned about higher income tax rates in the future. Or maybe you anticipate making more income in the future, as with a business owner that has a maturing business. You could roll your 401k balance into a traditional IRA, take the entire amount out in one withdrawal, then place that amount into a Roth IRA. Sometimes you can roll directly from your 401k into the Roth IRA. Either way you’ll pay the income taxes NOW but your remaining balance will experience tax free growth and not have any more income taxes due when you withdraw it, plus you don’t have to worry about RMDs. Or in a more typical example, you take systematic withdrawals from your traditional IRA over a period of time and convert them to a Roth to avoid a one-time big hit on your taxes.
What are some other benefits of this strategy? Because Roth IRAs allow you to withdraw funds without increasing your tax burden and have no RMD obligations, they are less restrictive and can give you additional financial choices – including the option of staying invested in the stock market for a longer period of time. They might also provide some tax planning benefits if your other retirement assets are taxed when withdrawn. You could also avoid the Income-Related Monthly Adjustment Amount - IRMAA for short…what does that mean? If you are enrolled in Medicare Part B or D and your modified adjusted gross income is above a certain threshold, you pay a surcharge on top of your monthly premium. A Roth conversion could potentially help you avoid that extra cost, sometimes thousands of dollars for high income earners. Finally, if you leave a traditional IRA to an heir, they only have 10 years to deplete it in most cases, meaning larger annual distributions that could move them to a higher tax bracket. By converting to a Roth, your heir would still have to deplete it in 10 years, but those distributions would be tax-free.
The Good, the Bad and the Ugly. So, what’s the “Bad” in this situation? First, a big one. If you have to use funds from the 401k withdrawal to pay the income taxes due, you are going to be left with a significantly lesser amount of funds in your Roth. In the example we used with the $1M 401k balance and a one time withdrawal, you’re talking hundreds of thousands of dollars. And as anyone that has heard of draw down risk, it takes much longer to make up a loss of principal in your accounts than it takes to actually lose that principal – it’s simple math. If you lose 10% of your portfolio balance, you have to make more than a 10% return on your remaining investments because the growth is on a smaller bucket of money. Well, paying taxes out of your 401 or IRA balance on a Roth conversion is this rule pushed to the extreme – what once was a $1M dollar bucket of money may now be in the $650k range, depending on your individual situation. Turning $700k back into $1M takes time, especially when you are in or near retirement and trying to protect principal without taking a lot of risk in your investments.
You also lose tax deductibility on your contributions, especially for you high income earners that are fully funding a SEP, or possibly a 401k with matching contributions and profit sharing, or especially in the case of you all with a cash balance plan layered on top of your 401k plan. You also have to be mindful of the Pro-Rata rule, which is used to prevent people from dodging the Roth income limit to manipulate funds to decrease their tax bill. The Pro-Rata rule involves somewhat complicated math and planning that is best discussed on a case-by-case basis, which we can help with at GCFA, just call 251-327-2124. Lastly, on the bad side, the IRS generally requires any conversion to have occurred at least five years before you access the money, or you'll be hit with a 10 percent early withdrawal penalty.
Alright, let’s finish with the Ugly. As the Gulf Coast’s designated honesty broker when it comes to finance and investments, I often say things that don’t reflect too well on my industry. This will definitely be an example of that. As with anything that helps people avoid taxes or gives a salesperson an opportunity to make money by taking over management of a large investment account, sometimes “advisors” will tell you pie in sky things that are, let’s say in the gray zone at best, downright dishonest at best. For example, while it is true that you can sometimes use insurance products in your retirement accounts to access a more advantageous income tax outcome, if someone is proclaiming that you can do a Roth conversion with zero out-of-pocket tax costs, run, don’t walk, to your nearest fee-based or fee-only financial advisor. Another example is a marketing pitch where the account holder is told to use IRA money to buy a deferred annuity with a high surrender charge. The promoter will claim that the surrender charge can lower the value of the IRA for tax purposes, even though you won't actually surrender the annuity or pay the charge. Unfortunately, this ploy is illegal. The IRS cracked down on this scheme and made it clear that the surrender charge can only be subtracted from the IRA's value for tax purposes if the annuity is actually surrendered. Not only will the investor pay the full tax but will also pay a commission on the annuity purchase.
Finally, another scheme has you liquidate your traditional IRA, move the money to a self-directed IRA, then invest in various businesses, real estate, private equity funds, and limited partnerships. Not that these are bad investments in and of themselves, but where the “advisor” runs afoul of the IRS is by saying that because these investments are illiquid and you don’t have a controlling interest, so you can discount the value of the self-directed IRA when converting. Self-directed Roth IRAs are fine, but the IRS will not look very fondly on such a discounted valuation, plus why would you want a significant portion of your account in illiquid investments that may be near impossible to access when you need the funds? Sure, you may get a discount on taxes, but all too often the investments are not great – they’re often only great at paying the “advisor”, typically a broker, a high commission.
So there it is folks, the Good, the Bad and the Ugly of Roth Conversions. Interested in having an open and honest discussion about this concept? Then give us a call at 251-327-2124 or make an appointment on our website gulfcoastfa.com. That’s gulfcoastfa.com.
Alright folks, coming up next - There’s always a lot going on in the world! Particularly the world of finance- this past week was certainly an example of big news in finance! Every week Michelle and I scour the interwebs for helpful financial articles related to our topic of the day, especially articles that pertain to those in or near retirement. Join us after the break to hear Michelle and I discuss this week’s relevant headlines in our “Michelle with the News of the Week” segment. Stay tuned!
Segment 2 - Michelle with the News of the Week:
Josh: “Welcome back to Coasting in Retirement, your host Josh Null here! As we discussed before the break, every week Michelle and I scour the interwebs for helpful financial articles related to our topic of the day, especially articles that pertain to those in or near retirement. Michelle and I are going to help you all understand and decipher the deeper meaning of those headlines, or at the very least, provide context. So with out further adieu, here’s “Michelle with the news of the week!”:
1. Michelle: Alright Josh, let’s kick it off with one of our favorite sites, Kiplinger. They have an article titled “Beware Peddlers of Roth Conversion Tax Ploys”. You hit on many of the topics of this article in the “Ugly” part of our discussion in the opening segment, so let me touch on a part of the article you didn’t reference. According to an article, there are advisors that say to take out a loan equal to the full amount of the Roth conversion then use part of that money to pay the tax bill while investing the rest in life settlements. What is this witchcraft? First, I can’t imagine a scenario where someone should take a large loan out as they are going into retirement, and two, what little I know about life settlements is that it depends on someone you don’t know dying in a timely fashion. This smells to high heaven, but am I missing something here? Is this a valid strategy?
Josh: NO
https://www.kiplinger.com/article/taxes/t048-c000-s001-beware-peddlers-of-roth-conversiontax-ploys.html
2. Michelle: Next up Josh next up is an article from Forbes, with a very wordy title: “Peter Theil has accumulated $5 billion in a tax-free Roth IRA designed to help the middle class save for retirement, according to a new report”. Whew. According to this article, in 2001 Thiel acquired PayPal shares for his Roth IRA at 30 cents a share, then experienced a tax-free gain of $31.5 million when eBay bought out PayPal for $19 a share in 2002. The article goes on to state that Thiel was able to build the original $2,000 in his Roth into a tax-free balance of $5 billion because he then used sale of eBay shares to buy shares of other startups at low prices. I did some research and apparently Theil is not the only one to do this and it finally caught the attention of Congress, which appears to be trying to close this loophole. What are you thoughts on this?
Josh: I’m conflicted because while this is definitely not the original intent of the Roth IRA, it’s a brilliant strategy. Discuss the Clinton administration putting in income limits for Roth’s. Eliminating roth conversions, what congress was somewhat incorrectly referring broadly to as back door Roth’s, was part of the Biden’s Build Back Better act, but that provision was removed at the last minute and Roth conversions continue on.
https://www.forbes.com/sites/sarahhansen/2021/06/24/peter-thiel-has-accumulated-5-billion-in-a-tax-free-roth-ira-designed-to-help-the-middle-class-save-for-retirement-according-to-new-report/?sh=204ee5a22627
3. Michelle: Alright Josh, our first article didn’t cast the best light on Roth conversions, and the second article may not seem great either, depending on the reader’s viewpoint, so let’s get back to basics with our next article. And lookee there, it’s a commonsense article from your site, gulfcoastfa.com! It’s simply titled, “Roth Conversions: What you need to know” and I think it does a good job of succinctly laying out things to consider for a Roth conversion, as well as clear process instructions. I think this is probably as good as time as any for you to lay out an example conversation you have with clients consider a back door Roth. So the floor is yours:
https://gulfcoastfa.com/blog/roth-conversions-what-you-need-to-know
4. Michelle: Last article of the day. Forbes seems to have a lot of content related to Roth conversions, so let’s reference them for a 2nd time. This article is timely because it takes into consideration some relatively recent legislation that affected Roth conversions. It’s called “3 Roth Conversion Traps to avoid after the SECURE Act”. This article talks about things to consider if you’re trying to do a Roth conversion after the age of 72, plus it discusses “Aggregation Rules” that apparently tie into what you mentioned earlier in the show, the technical differences between a Roth conversion and a back door Roth. At this point I’m exhausted with all of this financial jargon, and I’ve said the word “Roth” more in this episode than my entire life, so can you help us understand all of this minutia better?
https://www.forbes.com/sites/jamiehopkins/2020/01/21/3-roth-conversion-traps-to-avoid/?sh=6f1cb9dd12f3
Josh: Michelle, great job as always with the headlines, these are all important pieces of information that impacts those in or near retirement! Listeners – if you have questions around the topics in our headlines of the week, or questions related to your investment strategy or financial plan, you can set an appointment by calling us at 251-327-2124 or by clicking calendy link on our website, gulfcoastfa.com. It’s in the upper right hand corner. It’s a free, no pressure, no obligation meeting.
Alright folks, coming up next : Josh’s Crystal Ball and Big Mouth. What have been some of my predictions? Have I been right? Was I ever wrong? How wrong? What do I think is going to affect investors in the near future? We talk about all of these things and poke a little fun at my big mouth. Stay tuned!
Segment 3 – Josh’s Crystal Ball and Big Mouth:
Welcome back! Your host Josh Null here, along side co-host Michelle Lee. So, I am opinionated, I have strong opinions at times, I would say a radio show host that isn’t probably wouldn’t be very interesting to listen to. And I am paid in my profession to offer professional guidance and opinions to my clients, otherwise what use am I? Sometimes I feel so strongly about something that I talk about it publicly, on the various podcasts and radio shows I’ve had, sometimes I’ll even make predictions, and while I usually proved right, there are times I swing and I miss. Want to hear me beat my chest or maybe…eat a little crow? Then let’s get at with Josh’s Crystal Ball and Big Mouth. Alright Michelle, what’s first?
1. Michelle: Alright Josh, you and several financial industry pundits and commentators once said that when the Department of Labor’s Fiduciary rule went into effect, it would have a huge effect in the financial services industry by forcing most commission-based brokers and insurance salespersons to switch to fee-based compensation or leave the business. This Department of Labor, or DOL for short, started this initiative way back in the Obama administration, and surprisingly, progress was not really held back that much during the Trump administration, finally making it’s way to being implemented during the current Biden administration. OR WAIT, WAS IT? It looks like various lawsuits have held it up, with current news stating that the rule, once called the “Definition of the Term ‘Fiduciary’” to now being re-branded as the “Conflict of Interest in Investment Advice.” So, my question is, did your big mouth nail anything with your opinion, and more importantly, has anything changed at all??
2. Michelle: So Josh on a previous Coasting in Retirement episode we talked about the current potential danger of owning commercial real estate based Real Estate Investment Trusts, or REITs for short. You stated that it was becoming more and more obvious that the work from home phenomenon of Covid was here to stay, plus the carrying costs of the loans on many investment properties were starting to sky rocket because of developers having to re-finance into a much higher interest rate environment. Well according to a recent article by Fortune magazine, quote “Commercial real estate gets even bleaker with $64 billion in property now classified as distressed” end quote. The article goes on to state that the amount of distressed assets rose 10% in the first three months of the 2023, with the potential for another $155 billion of commercial property assets to become trouble this year. Obviously your big mouth was proven correct here, but what does your crystal ball say about investors owning REITs that hold a significant position in commercial real estate?
Josh: Talk about difference in publicly traded and non-traded REITs, make sure to let listeners know how to find old episodes.
https://fortune.com/2023/06/22/commercial-real-estate-distressed-assets-rise/
3. Michelle: Next up Josh, you’ve stated many times both publicly and privately that your opinion on Electric Vehicles, or EVs for short, is this: Our generation, which is Generation X for those keeping score at home, and the previous baby boomer generation would be slow to adopt EVs because, well, as you get older you just don’t like change, and for some folks they don’t like change that they feel is being forced upon them. However, you felt that the generations younger than us – I guess that would be Millennials, Gen Z and apparently something called Gen Alpha, would flock to EV vehicles for many reasons, a simple and primary reason being that they are the first generations used to plugging in devices for their entire lives. Well according to a recent report from Reuters, EV vehicle inventories are stacking up and price cuts are becoming the norm, particularly with industry leader Tesla. So what says your big mouth and crystal ball about the future of EV sales?
https://www.reuters.com/business/autos-transportation/slow-selling-evs-are-auto-industrys-new-headache-2023-07-11/
4. Michelle: Last one Josh, and I have to apologize ahead of time because I already know that your big mouth got way over its skis and unfortunately dragged my sterling reputation down with it. On a VERY recent episode of Coasting in Retirement, you asked the question “Is this as good as it gets in regard to fixed interest investments”? Sadly for both of us, the almost immediate answer has been a big fat NO, and the interest rates and yields being offered on money market accounts and bank CDs rising since our episode published. Care to explain yourself?
Josh: counter back with top MYGA rates now being 5.3 when it was 5.45. But own it on the other stuff, detail the current rates, and explain what you offer.
Well listeners, I hoped you enjoyed a peak behind the curtain on how I form my opinions and predictions, and more importantly, that I’m willing to admit when I am wrong. Which isn’t very often, but still. Now, to our listeners that have more questions the various investments and topics we discussed in this segment, we invite you to reach out to us. Call us anytime at 251-327-2124 to make an appointment or find us at on our website at gulfcoastfa.com.
Folks, that’s it for us this week here at Coasting in Retirement! I want to give a huge thank you to my lovely co-host, Michelle Lee Melton, a thank you to our awesome radio station 106.5, many thanks to the provider of our show music, local band Sloth Racer, and as always my sincere appreciation for all of your out there that have been listening and joining us on this journey. We would love to be a part of your journey as well. Until we talk again next Sunday, have a wonderful and productive week. This has been Coasting in Retirement with Josh Null!
Disclosure:
Advisory products and services offered by Investment Adviser Representatives through Prime Capital Investment Advisors, LLC (“PCIA”), a federally registered investment adviser. PCIA: 6201 College Blvd., Suite#150, Overland Park, KS 66211. PCIA doing business as Prime Capital Wealth Management ("PCWM") and Qualified Plan Advisors (“QPA”). Certain services may be provided by PCIA affiliates. In this format, Josh Null provides general information, not individually targeted personalized advice, and is not liable for the usage of the information provided. Exposure to ideas and financial vehicles should not be considered investment advice or a recommendation to buy or sell any of these financial vehicles. This information should also not be considered tax or legal advice. Past performance is not a guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested.