Transcript

Wiser Financial Advisor – The Power of Roth Retirement Accounts

Hi Everyone, and welcome to the Wiser Financial advisor podcast with Josh Nelson where we get real, we get honest and we get clear about the financial world and your money. This is Josh Nelson, Certified Financial Planner, founder and CEO of Keystone Financial Services. Let the financial fun begin!

Thank you for joining me. Today we’re talking about Roth Retirement Accounts, the advantages of contributing to a Roth, and also how to convert to a Roth. For those of you who don’t know Finglish, (Financial English), a Roth is a retirement account that works differently than other types of retirement accounts. So grab a cup of coffee or maybe a notebook, because this episode might just inspire you to rethink how you’ve been dealing with your retirement strategy.

Let’s start with the basics. What exactly is a Roth account? Whether it’s an IRA or a 401K, a Roth is a retirement savings account where you contribute money that’s already been taxed. So, these are after-tax contributions. The real magic is what happens down the road. Financial planners are long-range thinkers, right? We’re thinking about many, many years in retirement and possibly passing these assets on to your heirs. Your investments inside a Roth grow tax-free, and when you take the money out in retirement, provided you follow the rules, it’s completely tax-free.

One of those rules is that you need to reach age 59 1/2. That is the magic age when the IRS designates that you have reached retirement eligibility with regard to taking money out of your retirement accounts. Otherwise, if you try to draw money earlier, you will generally be penalized 10% and possibly have tax implications. But overall, imagine the power of having a chunk of your retirement income that isn’t subject to taxes. It’s completely tax-free. That is the Roth advantage.

You want to get as much into the bucket of retirement accounts as possible. There are limitations. For many people, if you’re older and have contributed to a retirement fund before Roth was really a thing, a lot of your contributions may have already gone into a traditional IRA, meaning a pre-tax account. If you’ve got a lot of years until retirement or you’re younger, you might be contributing to a Roth right off the bat.

Let’s talk about the difference between Roth IRA and Roth 401K. A Roth IRA is an individual account and it has nothing to do with your employer. It’s available to anybody with earned income, and there’s no age limit. You could be 95 years old, and as long as you’ve got earned income, you can go ahead and make your Roth contribution. However, there are income limits, and if you make too much money, then you can’t contribute directly. There’s a thing called a backdoor Roth IRA, which gets a little bit beyond the scope of today’s discussion, but just know that there is another way to get money in as a contribution, even if you go over the income limit. In 2024, the limit was $6500 to put into a Roth IRA, and for what’s called a catch-up contribution, the limit was $7500 if you’ve turned 50 or older. You’ll note that every year the IRS puts out the new limits. If there was some kind of adjustment because of inflation, they release that every year right about now. So one of the greatest features of the Roth IRA is that you’re not subject to Required Minimum Distributions (RMD) in retirement. That gives you a lot more flexibility, gives you a lot more of what we call tax diversification, which ultimately just gives you more control over your tax situation and how income is coming out of your retirement plans in retirement.

Number two, a Roth 401K is different than a Roth IRA. It must be sponsored by your employer, so it has to be something your employer offers. You might ask, “What if I’m self-employed; can I open up a Roth 401K for myself?” The answer is probably yes. We’d have to look at your exact situation, but you could look at making a contribution as a self-employed individual. We do have clients doing that right now.

One big advantage of the Roth 401K is that there are no income limits. However, there is still a limit on how much you can put in. In 2024, the maximum contribution was $22,500, or if you were lucky enough to be age 50 or older, the limit was $30,000. Again, those limits go up every year or two because of inflation. The IRS releases those limits. One important note, unlike Roth IRA’s, Roth 401K’s do have required minimum distributions or RMD’s, which currently apply once you reach age 73, unless you roll those funds over into a Roth IRA. When you leave your employer, you have the ability to roll your Roth 401K into a Roth IRA. Also, your employer may allow for what’s called an in-service distribution. Oftentimes. that’s eligible at 59 1/2 or older. If you’re still working, you can still roll your funds from the Roth 401K into a Roth IRA. Same thing is available for the traditional IRA or traditional 401K. Traditional means that those funds are contributed pretax, so you pay taxes in retirement.

So which is better of these two options? It really just depends on your situation. If you don’t have a Roth 401K option, then that’s not an option for you. Ideally, if you can access both, you should build both for a tax diversified retirement portfolio. You want to get as much money as you can stomach into a Roth IRA because of the tax-free distributions, the tax-free growth and the tax-free disbursement to your heirs.

Now let’s talk about Roth conversions. This is where things get really interesting. People who contributed a bunch of money to traditional retirement accounts might say, “I don’t have any Roth dollars. What do I do long term if I want to get this money over to a Roth account where it’s tax-free? How do I do that?” There is something called a Roth conversion, which means you have some traditional dollars that are pretax, and you decide you’d rather just go ahead and pay the taxes now to get the growth in the future tax-free. So Roth conversions can be really powerful if your tax rates will be higher in retirement.

There was a tax bill passed in 2017 that lowered tax rates for most taxpayers. That is set to expire after 2025. We probably are going to see those tax cuts get extended. We don’t know that for sure, but for people who are looking at their tax rates and the time horizon to do conversions, you may have more time to do that.

Here are the advantages with the Roth conversion. You get tax-free growth once it’s in there. All the growth is tax-free forever. The earlier you convert, the more time your money has to grow, so there is an advantage there. With tax-free growth, you’re paying the price up front. You’re going to go ahead and pay the taxes today, so to convert that over means you’ve got to part with some money now. The government loves this, right? You’re paying taxes today that you wouldn’t have had to pay until the future. But tax-free withdrawals in retirement are what we’re after. Having a tax-free bucket of money to pull from in retirement can help you manage your overall tax bill. Our clients who did this years and years ago and are now well into retirement, appreciate having different slices of the pie available—such as some traditional pretax dollars as well as Roth dollars and brokerage accounts that are taxable. As your expenses come up, you just take your monthly withdrawals. This gives a lot more flexibility than if you just have it all in a pretax bucket.

Another advantage is avoiding RMD’s (Required Minimum Distributions). Roth IRAs never require a distribution from the owner or the spouse if the spouse inherits it. If you’re not the spouse, you do have to distribute all that money within 10 years of the person’s death. We can help you figure that out and how that applies to you. Just be aware that there is a limitation if you’re inheriting those funds.

Overall, you’re trying to lock in some lower tax rates. If you believe that tax rates are likely to go up in the future, converting to today’s rates could save you money in the long run. We can’t predict the future. Of course things change over time. Tax rates go up and down. If you’ve been around long enough, you know that things change every couple of years, right? My bet, though, is that some big bills will come due at some point for the U.S. government. I think we’ve got like 38 trillion worth of debt right now, which doesn’t even include Medicare and Social Security. Those programs as of right now are scheduled to go insolvent, meaning that they aren’t going to be supported by payroll taxes within just a few years. So, part of the solution probably is going to be higher tax rates. Again, no guarantees, but my guess is that right now we probably have a little bit longer window of time with these lower tax rates. Eventually, tax rates are going up. So you have to think about that for yourself, your own belief about where you think things are going. My guess is that tax rates probably aren’t going to go down a whole lot.

A Roth conversion isn’t for everyone. It’s a strategy that may work best for you if you have cash on hand to pay the taxes now. If you don’t have cash on hand to pay the taxes, this is not gonna work. You’ve got to have money that’s either in the bank, in a CD, in a taxable brokerage account, or maybe just money that you’re saving up throughout the year. If you’re still working and you’re trying to do these Roth conversions, maybe you’ve got money set aside to pay those taxes. If you’re in a lower tax bracket now than you expect to be in retirement, that’s a bet that you would be placing.

My suggestion is to think about this as tax diversification. Would you want to convert all of your traditional dollars to Roth? Maybe not. Consider trying to get the pie evened out between Roth and traditional, so we have the flexibility to adapt to whatever Congress does in the future, however they change the tax code. And then ultimately if you want to leave tax-free inheritance for your heirs, especially if we do your retirement planning, your financial planning, and we figure out that you are not likely to run out of money, more than likely you’re going to have something to leave to your heirs. And Roth dollars are wonderful because your heirs end up gaining that money tax-free as well. Yes, unless it’s a spouse they’ll have to split it out over a 10 year period afterwards, but it would be nice to get a tax-free bucket of money versus one that is taxable.

I hate to hedge my bets too much here, but one thing you should be aware of is that once you’re Medicare eligible (which for most people is age 65), there are premiums for that. The only free part about Medicare is Part A. That’s your hospital and hospice coverage. But Part B and Part D and whatever other coverage you get has premiums to pay. People will pay a higher amount if they exceed income limits. So keep in mind, if you’re doing some really big Roth conversions, you may end up having to pay higher amounts for your Medicare premiums in your retirement years as a result. It’s a two year look-back. So if you did a huge Roth conversion this year, you’re going to get a letter from Medicare in a couple of years and they’ll say your level of income means we’re going to charge you more in premiums. Some people are willing to pay those premiums for a couple of years to get this money into a tax-free bucket.

The other thing I’ll tell you is just my belief: Because of how it’s already set up, I think it’s a road map for the future with Medicare and Social Security benefits. My crystal ball tells me that in the future one of the ways these programs could be paid for is that they might make the income limits lower and start charging you more for Medicare at much lower limits. I think that’s likely the same thing with Social Security, and that idea has been floated out there before, that over a certain income level they start cutting your Social Security benefits or taxing them more heavily. They’ll probably just tax them more heavily because it doesn’t sound good to cut Social Security benefits. But I think it’s pretty likely that if you make over a certain amount of money in the future, you may not get the full amount of Social Security that you’ve been promised up until this point. Better to be conservative with something we can’t control.

Before you run out and convert your entire IRA, let’s talk about strategy. It all depends on your situation and beliefs. Some people really hate paying the taxes today, and decide not to do this. Paying a bunch of taxes to convert this to a Roth IRA is something you have to stomach. Somebody’s gonna write the check, and that would be you, right? Or if I convert mine, it’s going to be me. You are going to write a check to the IRS and to your State. Unless you’ve got some kind of an exemption or you live in a tax-free State, you are going to be paying some State income taxes as well. So, you really have to be thinking long term. It might make sense to do it gradually, because if you did it all in one year and you had a really big Traditional IRA, it could be really expensive but still could pay off in the long run. Maybe there’s an opportunity to spread it out over a number of years instead of doing it all at once. Therefore, working with a professional is a good idea on this.

There are large consequences, good and bad, for any of these decisions. So I would highly suggest that you not make this a DIY project. Not to disparage people that like to self-direct their stuff and manage their own money. Maybe that’s your hobby and you enjoy doing that. That’s great, but at some point you might decide you don’t want to do that anymore. Or maybe you’ve got a spouse who thinks it’s a good idea to start getting some help. I always recommend that you work with a Certified Financial Planner. At Keystone Financial Services, all of our financial advisors are Certified Financial Planners (CFP). That’s the gold standard in our industry. There’s no reason not to work with a CFP. That means we have a lot more education and experience. We’ve had to go through more hoops. There are a lot of advantages to working with the CFP, but also your tax professional. If you’ve got a CPA, if you’ve got a tax advisor that you work with, it’s important to talk with them as well, so you understand the implications. We’ve got some great software that can help with gaining some optics and then giving you an idea of what you might be looking at as far as the tax bill upon conversion. We’ve got great tools, and tax advisors have great tools. It’s a good idea to get some counsel on this because it could be a very good thing for you long term, but you do need to understand the implications.

I’ve been doing this 25 years now and I still love what I’m doing. But as you can imagine, I’ve had thousands and thousands of conversations with people about their money and strategy. I also have a lot of experience seeing what’s worked for people and what has not worked for people. It all comes down to decisions and habits along the way, and that’s our job as your advisor and fiduciary—to guide you and give you advice that’s in your best interest based on our experience, education and so forth.

With that, I’m gonna wrap up. I think this is a great topic for everybody to explore. If you’re planning for retirement, you’ve got retirement funds. It’s important to look at. And the younger you are, I highly encourage you to look at Roth IRAs and Roth 401K’s. If you’ve got a long time horizon, this will probably work to your advantage. I can’t say guarantee, but I think it’ll probably work to your advantage to have many years of tax-free growth by making the contributions that way.

As always, we want to hear feedback. So e-mail me at josh@keystonefinancial.com with any feedback you may have, especially if you have any topics or things that you want addressed in the future. Also help us get the word out by doing two things. Number one, rate us five stars on whichever service or directory that you’re pulling this up on, whether Apple or Google, whatever it is. Number two, if you subscribe, that helps us out as well and it also helps you out because it gives you the updates when new episodes come out. Thank you so much. I appreciate you taking the time to be with me, and God bless.