Retirement Answers

Jacob: 00:00

What if I told you that I'm helping a client of mine convert $50,000 to their Roth IRA completely tax free? And here's the thing, they're going to make over $300,000 of earned income this year alone. So how is this possible? That's what we're going to talk about today in this episode of Retirement Answers. And I noticed that a lot of new listeners are listening to the show.

Jacob: 00:18

So if you're new here, welcome. My name is Jacob Duke. I'm the host here. I'm a certified financial planner and the owner of River Tree Wealth, a wealth management firm that specifically helps retirees plan smarter so they can retire better. And Roth conversions are a big topic that comes up in almost every conversation is on pretty much every retirees minds nowadays.

Jacob: 00:34

So as a quick refresher, what is a Roth conversion? Well, the simplest form, it's whenever you move money from a tax deferred traditional IRA to a tax free Roth IRA. So going from pre tax to post tax. In order to do that, you have to pay income taxes on the amount that you convert. Now, are a few different things to know here nuances.

Jacob: 00:52

Some people have questions about, you know, should I withhold the taxes from the conversion amount or should I pay the taxes out of cash that I have on hand? And the best way to pay the taxes on a Roth conversion is with cash that you might have at the bank or something that's not being withheld from the actual conversion amount. Although you can do it from the conversion amount, it is totally possible to it. Although it does take a little bit of the benefit of doing the conversion away because now you have less money growing in the Roth IRA tax free because you had to withhold some money to pay taxes. Now, you do end up withholding taxes from your conversion amount, again, there's another nuance here to where if you are under age 59.5, the amount that you withhold for taxes is actually going to be considered an early distribution since you're under age 59.5 and you would pay that extra 10% penalty on that particular amount.

Jacob: 01:36

Wouldn't pay the 10% penalty on the full conversion amount. You would only pay the 10% penalty on the amount of tax withholdings that you're doing because that money is technically leaving the IRA world. If you're doing a conversion, the money is staying within the IRA world because it's just moving from one IRA to another from traditional to Roth. So just know that if you are under age 59.5, you do not want to withhold the taxes from your conversion amounts. Only think about withholding taxes from a Roth conversion amount if you do that above age 59.5.

Jacob: 02:03

And again, the best way to do this is always to pay it with cash you have on hand. Now, who's a good candidate for Roth conversions and when does it make sense? Well, you maybe you've heard me talk about these gap years before where let's say you retire at 60 and you don't take your Social Security until 67. That six to seven year window, that's a really good opportunity to do Roth conversions and the key there is that you have minimal income, right? So you were working and earning a salary, so you had higher income and so then you stop working and then it goes and falls off a cliff and your earned income is now zero.

Jacob: 02:32

Now, whenever we think about Social Security starting at 67 in this scenario, that income would become taxable at that point, if you have other sources of income as well. So this particular period of time, the six to seven year window, what is called maybe your gap years, this is a great time where we have low income to be able to do Roth conversions most effectively, because the key is we want to be doing Roth conversions whenever we can do those at the lowest potential tax brackets. So think the 10, the 12 and the 22% tax brackets. If we can do our conversions, then that's the most effective time to do that. Because if you remember back to whenever you were saving money into your tax deferred four zero one ks or your IRA, you're probably doing that while you were earning money.

Jacob: 03:10

So you got a tax deduction, right? And typically those are going to be while you are earning more than whatever your tax rate would be whenever you're retired. So your tax rate while you were working and saving into the tax deferred accounts, you were deducting and saving on taxes at a higher percentage than you're going to be paying on taxes whenever you do this conversion during these gap years. So that's way you want to think about this and how to structure it. That's the first component or variable that needs to be in place.

Jacob: 03:33

You need to have lower income. Now, the second component is typically you want to have higher tax deferred account balances. So this means tax deferred four zero one ks's, tax deferred IRAs, TSPs, 403b's, whatever account type you have. If it has not had taxes paid on it yet, it will one day because there's this thing called RMDs required minimum distributions and those have to be distributed out beginning at either age 73 or age 75, depending on your year of birth. So if you have large tax deferred balances right now today, it's almost certain that you will have larger tax deferred balances whenever you get to this point in the future, which means your RMDs will be even greater than they would be based on today's balances.

Jacob: 04:10

So in order to fix this potential tax problem down the road, we want to essentially decide to pay our taxes now, hopefully at a cheaper rate than what we would have in the future. And there is a little bit of guesswork here simply because we don't know what tax rates will be in ten, fifteen, twenty years, but we do know what they are today. And we do know that you know, today they're fairly low in the grand scheme of things in terms of history. So if we think they stayed the same as they are, or perhaps even go up, would make sense if we have opportunities with these low income years to do these Roth conversions at these lower tax brackets. So those are the variables that we want to have in place whenever we're thinking about doing a Roth conversion.

Jacob: 04:45

We want to have low income from other sources, whether it be earned or anything like that. Typically people with higher tax deferred account balances such as those traditional IRAs or 401ks, those are going to make more sense for Roth conversions because again, you're going to have that RMD problem down the road and we want to start fixing that now if we can and planning way ahead so you're not caught off guard by a $200,000 RMD in year one of that time period and you pay taxes on $200,000 that you otherwise simply don't need. So that's a Roth conversion in its simplest form. Now, whenever I talk about this example here where I'm working with a client and we're going to be able to do a Roth conversion completely tax free. Jacob, how's that possible?

Jacob: 05:19

Sounds like this is normal Roth conversion so far. We know we got to pay tax on it. Well, if we add another element in, it actually creates the opportunity to deduct the same amount of money as we converted in order to pay no tax on the conversion. So here's what I'm talking about. It's a donor advised fund.

Jacob: 05:36

Now, what is a donor advised fund? This is simply an opportunity for you to create a fund for yourself that you can then use to donate money from that fund to charities. And now the benefit of this type of account is that you can gift as much as you want in one particular year, and we're going to talk about deduction limits here in just a moment, but you could contribute as much as you would like in one single year, and then you could not take all that money and give it to different churches or charities or whatever you see that you want to give to. You can give that over the rest of your lifetime. But the key is the tax deduction.

Jacob: 06:09

Whenever you receive the tax deduction from the gift that can all happen in that same one year. So hypothetically, let's say you wanted to give $200,000 over the next ten years to your favorite charity. So that's $20,000 a year. Well, instead of giving $20,000 a year, every single year for the next ten years, what you could do is you could take $200,000 of your money that you have right now today cash or appreciated holdings or whatever it is. You could take that and contribute that to a donor advised fund.

Jacob: 06:36

And now you just created a tax deduction in the current tax year up to certain amounts of that $200,000 and then you get to offset your income in this particular tax year by doing that. The key is, is once that money is in the donor advised fund, then you can have that money invested over the next ten years and you can actually give more than $200,000 to that charity that you want to give to because it hopefully has grown over that ten year period, and you can still give your $20,000 per year out of the donor advised fund to that charity that you want to give, and then you can fulfill your charitable obligations that you desire to give. And also you can save on taxes this single year. So it's called bunching, you're putting all of your charitable gifts into one tax year to offset other income you might have, especially if you have a higher income year. So this is a big one for business owners who are charitable and they sell a business in any particular year.

Jacob: 07:24

They likely want to put a large sum of money into a donor advised fund in that particular year, especially if they know they're going to be charitable moving forward. They want to offset as much of the taxes from their business sales they possibly can. So that's a great opportunity to do that. So if you've got a large income year and you're like, this is out of the ordinary, this is not normal, but I also give and I'm charitable in different ways. Should I take a portion of this income or whatever it is you have from that year and put that into a donor advised fund so that you don't have to pay taxes on that particular money that year at those really high tax rates because you earn so much money that year.

Jacob: 07:56

And then you can gift out of that donor advised fund to the charity that you'd like to moving forward year after year. The key though is that the tax deduction happens in the year in which you give to the donor advised fund, not the year in which you actually give to the charity. So that's Roth conversions and that's donor advised funds. Now, how do we pair these things together in order to not pay taxes on the Roth conversion? Well, we want to do a conversion and the donor advised fund in the same year to off offset each other.

Jacob: 08:20

So back to my client's example where we're converting $50,000 this year. We just did this the other day because of the market cycle and the opportunities that are there were down 20% at the time. And so we were able to convert from traditional to Roth, which we were planning on doing later this year, but we sped that timeline up because the opportunities that were given to us with account balances going down, it created a good opportunity to do a conversion. So that's what we did. But here's the key.

Jacob: 08:42

She's going to be making a donor advised fund contribution of $50,000 also this year because she has charitable obligations to where she typically gives anywhere from 15 to $20,000 a year to different charities. And so she wants to front load that just a little bit for the next couple of years. So she's going to donate $50,000 of cash to her donor advised fund. And what that's going to do is that's going be able to offset all of her Roth conversion of $50,000 that we did as well. So she's not going to pay any taxes on that $50,000 conversion.

Jacob: 09:10

And she's also going to be able to fulfill her charitable obligations and desires as well. Now, are a few different kind of nuances here around this donor advised fund regarding deductibility. So a few things that you need to know here are that cash donations. If you take cash from your bank account or money marker or something like that, and you put that into the donor advised fund, you're eligible for an income tax deduction up to 60% of your adjusted gross income if you donate cash. If you donate long term appreciated assets, you know, stocks, restricted stock, company stock from like a brokerage account.

Jacob: 09:41

If you donate that to a donor advised fund, you're only eligible for up to 30% of your adjusted gross income as a tax deduction. So here's an example of this not working out exactly how you would hope is, let's say you have no income. Okay, and you want to do $100,000 Roth conversion, but you also have a $100,000 of appreciated stock that you can donate to your donor advised fund so that you can give from the fund in the future. Well, if you donate a $100,000 of your appreciated stock to the fund, you cannot use 100% of that appreciated stock as a deduction against the $100,000 of the conversion. In fact, if you have a $100,000 conversion, 30% of that amount is 30,000.

Jacob: 10:24

So the dollars don't work exactly right all the time. So you have to pay attention to deductibility limits. And again, I'll just reiterate this really fast. If you make a cash donation to a donor advised fund, you're eligible to deduct up to 60% of your adjusted gross income with that cash donation. So let's say, let's say you do a cash donation and you donate $60,000 from cash into that into that donor advised fund.

Jacob: 10:48

And then you also have a $100,000 of other income that's taxable. So you have AGI of a $100,000. That means that that full $60,000 is eligible to be deducted out of that 100. So your taxes will only be paid on 40 in that particular year. Now in that same scenario, again, 30% is what you can deduct if you donate appreciated securities or stocks.

Jacob: 11:08

So again, if we have a $100,000 of adjusted gross income, that means only 30,000 is what you can deduct off of that 100,000, which leaves 70,000 left over that you actually have to pay taxes on. But the key on the appreciated stock giftings is that you can potentially eliminate all the capital gains that are built in that you otherwise are not going to have to pay taxes on the future. So yes, you only get a 30% deduction off your AGI or up to that 30% deduction of AGI by gifting appreciated securities, but you also have to remember there's an extra amount of tax from capital gains that you're not going to be paying that also adds on to that. So, is a little bit of benefit there. So, think like maybe a total 45% is what you could be actually benefiting from a tax perspective instead of just 30%.

Jacob: 11:49

So that's a few different rules there around deductibility of donor advised funds. These accounts are amazing. They're super powerful because you can gift money to the account right now, not give that money out of the account to a church or a charity for another ten years, and so you can grow that money over that ten year period. Now, there might be some annual minimum amounts that you have to distribute out like a couple $100 that have to be taken out of the account because that's a requirement. But in general, you can keep most of those funds in that donor advised fund account, and you can grow that and double it over the next ten years.

Jacob: 12:19

That way you can give more to that charity or church that you want to give to. So, in the key there is that, you know, once it's in that account, it's irrevocable. So, it's not your money technically anymore, which means it's not going to be taxable to you ever again. And you cannot take that money back out of the donor advised fund and take that for yourself. Once it's there, it's viewed as it's been gifted and it's no longer in your possession.

Jacob: 12:39

It's an irrevocable gift. So, whenever we're thinking about this $50,000 conversion for my client, guess what? They're making over $300,000 So whenever we gift $50,000 of cash to their donor advised fund, that's completely within that 60 percent of AGI range. And we're also doing this $50,000 conversion. And so now we're going to get to convert that money completely tax free because again, that donor advised fund gift is going to be offsetting that completely.

Jacob: 13:04

Because of that, we're going to get to accomplish all the goals that we're trying to accomplish. We get to convert the money that we want to convert up to a certain tax bracket that we were targeting. Get to lower our tax deferred account balances. So in the future, don't have as large RMDs because they will have pensions and other income as well. So it's going to be even more detrimental for them because of those fixed income sources those RMDs could create from a tax standpoint.

Jacob: 13:25

So we want to eliminate that if possible and also to their charitable every single year. They want to give the different churches and charities around town. And so they value that and they can use this donor advised fund to do just that. So all those things are getting accomplished and no taxes are going to be paid. So that's the that's the best way.

Jacob: 13:41

That's the most optimal way to do a Roth conversion and pay no taxes. Even when you have high income. In fact, high income is required to be able to benefit fully from the Roth conversion and the donor advised fund gifting at the same time. So think about this as you evaluate your Roth conversion strategy and whether you're charitable or not. If you're not charitable, don't just create a donor device fund to give a bunch of money to it to save money on taxes.

Jacob: 14:00

That's not why you need to do that. But if you are already charitable, would encourage you to look at this option and say, I know I need to be doing conversions, but I also am charitable. What if I do this just in a different order in a different way compared to how I have been doing it and it could save me thousands and thousands and thousand dollars of taxes. So, hopefully this is helpful. Gives you a new perspective maybe on how to think about Roth conversions and some different ways to, I guess, navigate the tax code and tax system giving your specific situations.

Jacob: 14:25

So with that, thanks so much for tuning in. I look forward to talking with you again here on Friday with our next Friday Q and A.

Jacob: 14:34

Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.