The Lange Money Hour: Where Smart Money Talks
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Converting 401(k)s/403(b)s to Roth 401(k)s/403(b)s
Jim Lange, CPA/Attorney & Nicole DeMartino
Please note: Some of the events referenced in our audio archives have already passed. Please check www.retiresecure.com for an updated event schedule.
- Implications of Pending Legislations for Roth Conversions
- Caller Q&A: Steps Every Employee Should Take
- Option to Spread Income to 2011 and 2012
- Encourage Your Employers to Offer Roth Designated Accounts
- Determining How Much to Convert to Roth Accounts
- Roth Conversion is Just One Portion of Well-Developed Retirement Plan
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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
Nicole: Hello, and welcome to the Lange Money Hour, where smart money talks. This is Nicole DeMartino, marketing director for the Lange Financial Group in Squirrel Hill, and I’m here with Jim Lange, CPA/Attorney and nationally recognized Roth IRA expert. Jim is the best selling author of the first and second edition of “Retire Secure!” We are live tonight, and our studio number is 412-333-9385 and you can certainly call in and ask anything you want. Tonight, we’re really excited. We’re going to be talking about some new legislation surrounding Roth IRAs that is on the brink of passing. As a matter of fact, Matt Schwartz, who is another estate planning attorney in our office, he’s been on the show, he’s been watching this very carefully and said it’s probably going to pass pretty soon, so let’s talk about that. This law is talking about employees being able to convert a portion of their 401(k) or 403(b) into a Roth while they’re still working. So, this is really revolutionary, and Jim, I know you can give this more justice than I can, so why don’t you tell us a little bit more about this pending legislation?
Jim: Well, let me tell you one of the problems that a lot of employees have. Let’s say, for discussion’s sake, that you are an employee, that you’ve been working for the same company for a long time, and you have been dutifully contributing to your 401(k) plan, and your employer has been contributing also, so you have a bunch of money in your 401(k) plan, and you’re very interested in getting involved in Roth IRA conversions. But with a Roth IRA conversion, normally, you have to have an IRA to convert. So, if most of your money, or all of your retirement plan money, is in your retirement plan at work, up until now, you haven’t been able to make a Roth IRA conversion, and now, it has not yet passed, I was hoping it was going to pass today and announce it, you know, “Today!”
Jim: But we’re hoping it’s going to be tomorrow or next week. Assuming this legislation passes, what it’s going to allow you to do is you’re going to be able to make a Roth IRA conversion, and you’re going to be able to take your traditional 401(k) plan, pay income taxes on the amount that you’re going to convert, and that will go into a Roth 401(k) that, presumably, will be at the same employer retirement plan. So, an employer will have the ability to offer their employees either a traditional 401(k) or a Roth 401(k). Now, you can also make contributions to a Roth 401(k). We’ll talk about that later. But right now, I’m talking about converting traditional 401(k) money to Roth 401(k) money, and it’s actually fair and it makes sense, because if you’re going to let the public at large make Roth IRA conversions, that is, get income tax-free income for the rest of their lives, the rest of their spouse’s lives, the rest of their children’s lives and the rest of their grandchildren’s lives, why shouldn’t you give the same opportunity to people who are still working? So, I think it’s fair legislation, and the other thing is from a perspective of the working guy who is trying to build up their tax-free portfolio, it is a wonderful mechanism. There’s a couple other bonuses, probably I’ll just concentrate on one, is that there will be a tremendous creditor protection along with this Roth 401(k), and by the way, I’ve said Roth 401(k), it also applies to 403(b) plans. So, if you are an employee of a non-profit organization, or University of Pittsburgh, I don’t want to say UPMC non-profit, I don’t want to get in trouble, but if you are with some type of organization where you don’t have a 401(k) plan, but you have a 403(b) plan, you’ll be able to do the same thing.
Nicole: Now, you’ve talked a lot about the, you know, with 2010, the income restriction lifted. Are there any income restrictions with this? I know now that if you make over $100,000, you can do the conversion. I assume the same goes for this?
Jim: That’s right. There’s no income restriction, which is doubly why 2010 is such a great year for, you know, before, for retirees who are able to do the Roth IRA conversion, or other people who had money in their IRAs to make the conversion. Now, even if you don’t have money in your IRA, but the money is in your 401(k), and you are still working, now you’re going to be able to make a Roth IRA conversion into a Roth 401(k) or a Roth 403(b), assuming, by the way, that your employer offers that plan.
Nicole: Okay. You mentioned the creditor protection that comes along with this. Tell us a little bit why that’s so important.
Jim: Well, I think these days, when you have all these different types of lawsuits, everybody wants to sue you, they want to go after your back pocket, and many of us are looking for ways to protect ourselves. It used to be, I think, you know, people like doctors, and people in high risk professions, they were much more creditor protection conscious than the rest of us, but frankly, most of us drive cars, so we can get into an accident. Somebody can get hurt and sue us for more than our insurance coverage. You know, we walk around and we do things that we could get sued, and sometimes, what might happen is, we can potentially lose our assets if we have a judgment against us. IRAs have a fair amount of creditor protection, so let’s say, for discussion’s sake, that all your money is in an IRA, and somebody sues you for something and they win. Well, there’s a pretty good chance that they’re not going to be able to reach your IRA. Your IRA has some natural creditor protection. However, that’s mainly state law. It’s not federal law. And if you are a participant in a retirement plan, like a 401(k) plan or a 403(b) plan, there’s a very good chance that that plan is controlled by laws called ERISA, which is an acronym for something that I don’t know. And those laws basically say money in these types of retirement plans are really pretty much off-limits to creditors for almost any reason, no matter how bad what you did was. So, for example, you might have heard that O.J. Simpson is getting something like $35,000 a month while he is sitting in jail, and doesn’t he have a multimillion dollar judgment against him by the Goldmans and other people, and the answer is yes, he does, but why is he able to get this income? And the reason is because he had an ERISA creditor protected retirement plan, like most people who are working with a big company and have a 401(k) or 403(b). But, the difference is before, if you wanted to make a Roth IRA conversion, it had to come out of the 401(k) or out of the 403(b) and into an IRA, which, admittedly, has good creditor protection, but not as good as the ERISA protected money in a Roth 401(k) or a Roth 403(b). So, this is kind of the best of both where you get the tax-free benefits of having a Roth 401(k) or a Roth 403(b), and you have the ERISA creditor protection of money that is going to stand up in the face of judgments and other problems that you might develop. By the way, there is another thing about ERISA that I actually just learned on the last radio show, and that is, in the event that you do have an ERISA plan, and you are married, you actually need your spouse’s permission to name anybody other than him or her as the primary beneficiary. Even if you have a prenuptial, that federal law trumps the prenuptial, even. So that’s just a little tidbit about ERISA plans.
Nicole: Okay, so I can see why you’re excited, because from my understanding, this allows you to start the tax-free growth much sooner than before.
Jim: Right. It might be in a week or two weeks from now, and the other thing is you’re not going to be limited. You know, there will be cases when somebody has a million dollars in their 401(k) plan, and it’s the strategically correct thing to do to make a million dollar Roth IRA conversion, but instead of being left with a million dollar IRA, they could, if they so choose, have a million dollars in a Roth 401(k) or a Roth 403(b) that will enjoy all the tax attributes of a Roth IRA, but it will enjoy even better creditor protection.
Jim: So this is really big, because there’s certainly a lot of people who can benefit from Roth IRA conversions, but don’t have substantial IRAs, but they do have substantial 401(k)s and 403(b)s.
Nicole: Sure, and this lets them get into them. Really it’s just so exciting is, you can start that process so much earlier now, because in our other shows, when you talk about, when you give out the numbers, and when you do a Roth conversion, how much better your family is off and your children and your grandchildren, those numbers are looking conservative now if you start this when you’re working, right?
Jim: Well, that’s right, because you’re going to have more years, and I think that that’s really a good thing to keep in mind. And by the way, some of the numbers that Nicole is talking about are if you make a $100,000 Roth IRA conversion, and this, by the way, is not assuming the highest tax brackets, so this is assuming more of the middle income tax brackets, for higher income taxpayers, it’s even more favorable, that you yourself will be $50,000 better off in twenty years. So, if you make a $100,000 Roth IRA conversion, or now a $100,000 conversion from your 401(k) to a Roth 401(k), or your 403(b) to a Roth 403(b), you yourself will be better off by $50,000. If you then live twenty years and you and your spouse are gone, and then you leave it to your kids, they would be better off by $608,000, or if you left it to your grandchildren, they’d be better off by $8.9 million. Now, to be fair, that is total dollars. If we say, “Hey Jim, what about if you measure this in 2010 dollars? Tell us the number taking inflation into account.” Well then, you wouldn’t be better off by $50,000, you’d be better off by $28,000. Your kids wouldn’t be better off by $608,000, they’d be better off by $160,000. And your grandchildren wouldn’t be better off by $8.9 million, they’d be better off by $838,000. But now, before, for people to have a lot of money in their IRA, there was a good chance that they would be retired, and a lot of people on the sidelines didn’t even bother learning about Roth IRA conversions because their money was tied up in their 401(k) plan, and most 401(k) plans will not let you take out the majority of your money while you are still working. So, you would have to literally leave your job in order to make a Roth IRA conversion, and people even sometimes ask me, “Should I retire early to make a Roth IRA conversion?” And I said, “No! Keep working!”
Nicole: More money.
Jim: More money. I mean, if they can afford to retire, and they want to, that’s another thing, but you don’t retire early to be eligible to make a Roth IRA conversion. So this is going to allow them to have their cake and eat it too.
Nicole: Well, now, you know, it seems to me that in the last year, this opens up the opportunity for everyone to be able to do this. No matter what you make, it opens it up for people working, people not working, under a hundred, over a hundred, I mean, are there any things that are stopping anyone from making a conversion? Is there anything left?
Jim: Well, yeah. I mean, frankly, Roth IRA conversions are not for everybody. I’ll give you the perfect example: let’s say, you’re 65 years old and you’re at the height of your earning power. You’re earning $200,000 a year, and you’re not a great spender, so you could afford to put the maximum into your Roth 401(k), and you could afford to pay the taxes on a very substantial Roth IRA conversion. Well, the problem with that is if you already have a high income, and then you’re adding additional income with a Roth IRA conversion, it’s going to push you into a higher tax bracket. So, the tax on the Roth IRA conversion is going to be very expensive for you. So, what you’re probably better off doing is waiting until after you retire. So, let’s say you’re planning to retire at age 67 or 68, wait until you’re 67 or 68. Then, you’re not going to have your income from your business, you’re not going to have your income from your minimum required distribution of your IRA, you may or may not have income from Social Security, but if you really wanted to hit the triple header in terms of reduced income, you would hold off on your Social Security. Now your income’s really low, and then you could make substantial Roth IRA conversions at a much lower rate. So, there will certainly be people who should not make Roth IRA conversions immediately. There’ll be other people who don’t have the money to pay the taxes on the conversion. There are some exceptions where we think that that’s okay to make the conversion if you don’t have the money to pay the tax on the conversion. In this case, with a 401(k) to a Roth 401(k), probably would not make the most sense. There will be other situations where it’s not appropriate. I’ll give you one situation. Maybe if you are very old and you’re thinking about your estate, and your children are in a much lower tax bracket than you are, and then if you die, you save taxes, not at your rate, but their rate, so that might not be 100%. Actually, I don’t want to say that everybody should make a Roth IRA conversion, or that everybody should go from this traditional 401(k) to a Roth 401(k), but what it does do is it opens up possibilities which, frankly, for some people, it’s going to be bad news because now they have to think about it. Before, with the old law, if all your money or most of your money from your retirement plan was in a 401(k) or a 403(b), you weren’t faced with the issue of should I make a conversion, because you just weren’t allowed to do it. So, you just didn’t have a choice.
Nicole: Sure, sure.
Jim: Now you have a choice, so I think, in a way, it’s going to be a little bit of a burden. Now, I look at that as an opportunity. And it is possible that somebody’s going to do some legwork, you know, maybe read my book or a portion of my book or come to a workshop, which I think is going to fill now, because it should, it certainly should, because now, there’s a whole new entire range of people who are eligible for this Roth IRA conversion, and I think a lot of people should take the time to figure out, well, is this thing for me? And that’s what we do at the workshop, so I think it’s going to give people, almost, the burden of choice, and frankly, a lot of advisors are not really up on these issues, and particularly, advisors to people who make more than $100,000, because up until this year, they were never allowed to make Roth IRA conversions, and there was no choice at all.
Nicole: Okay. I think this is a good time for us to take a quick break. We will be right back. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back. We’re certainly talking about smart money this evening. We are actually talking about a new law that’s pending. It’s going to pass very soon, and we’re talking about the ability for people that are still working to be able to take a portion of their 401(k) and move it over to a Roth designated account while they’re still working. And we are live tonight so you can certainly feel free to call your questions in to the studio. The number is 412-333-9385, and I see we have a caller Jim, so is it okay if we take a little break from this and see who’s on the line?
Jim: That’s fine.
Nicole: We have Nick from Pleasant Hills out there in the South Hills. Nick, are you there?
Nick: I am, I am. Good show, and…
Nicole: Thank you.
Nick: This is an interesting new law. I hope it comes to fruition. Jim, my question to you is, I have already invested in Roth. In fact, I made my contribution my maximum outside of my 401(k). I do know my company has a 401(k) Roth. Up to now, I thought because I made my contribution for the year, I wouldn’t be able to take advantage of the 401(k) Roth. Could you tell me if I’m right or wrong about that?
Jim: Alright, well, let’s take a look at everything that an employee should do from ground one. Alright? So, this will be a little bit more of a comprehensive answer than you might have been looking for. Alright, the first thing is, if your employer offers any type of matching program, always, always, always take advantage of the employer match. So, even if it’s not dollar for dollar, even if it’s, for example, they’ll contribute a dollar for every two dollars you contribute. You should always do that. Alright, then, in general, subject to the exception, like the exception of the 65-year old who’s going to be in a lower tax bracket soon, I do like the idea of you maximizing your Roth IRA or tax-free opportunity. So hear the old opportunities, and then hear the new ones. If your income was, and I believe it’s somewhere around $170,000 or less, you qualify to make a Roth IRA contribution of $6,000 if, or maybe I shouldn’t ask you. Are you 50, or younger than 50?
Nick: Yes. Yeah, I’m in that range right there, and yes, I made that contribution this year. That was my question.
Jim: Okay, alright, so that’s fine. So, let’s say it’s $6,000 for you. You can also, by the way, contribute $6,000 for your spouse. Alright?
Nick: Right. She has that right.
Jim: Alright. If your employer is wise enough to offer you a Roth 401(k) plan, and by the way, if we have any employers here, this is a no-brainer. This is a benefit that you can give to your employees that doesn’t cost you any money. So, if you are an employer, and you have a 401(k) plan or a 403(b) plan, I’m going to very strongly recommend that you implement the Roth 401(k) and the Roth 403(b) options. But anyway, you mentioned that your employer does have that option, so you could be contributing. Now, this is new money. I’m not talking about converting money. You could have up to $22,000 withheld from your pay that would go directly into this Roth 401(k) account. Alright, so it’s $6,000 for you, $6,000 for your spouse, $22,000 into the contribution of the Roth 401(k). Now, the new law says if you’re even interested in getting more money into the tax-free environment, that what you could do is you can take some of your existing 401(k) money, pay taxes on it now, and we haven’t talked about the option of paying taxes in 2011 and 2012. That’s another issue. You could actually pay taxes on, let’s say, a portion of that now, and then have that money grow income tax free, again, for the rest of your life, the rest of your spouse’s life, and then, ultimately, your children and grandchildren’s lives. So that can be a great way to get money into the Roth environment.
Nick: My next question is, and it’s kind of unrelated, but related. I have a brother-in-law who just recently was furloughed. He’s unemployed. He doesn’t know if he’s going to be returning to work, but he might very well have a Roth 401(k) already. Would it be sensible, if he could afford to pay the taxes, to do it now while he’s still in the 401(k) before he decides to roll it over into, say, an IRA or, actually, you had said before, a Roth. If he wasn’t sure if he was coming back or not, would this be a good idea for him if he could afford to pay the taxes to make that conversion within the 401(k), providing the law does pass?
Jim: Well, first, the answer is I like the idea of him doing some type of Roth conversion, because let’s assume, for discussion’s sake, that he’s been out of work all year, and normally, he makes anywhere from $50,000 to $200,000, and normally, his income tax bracket is much higher than now, but because he has not been working, his income is much lower. That means if he make a Roth IRA conversion, he’ll be paying taxes at a lower rate. So, the general idea is, I do like, this sounds like a, you know, without knowing anything more about the situation, this sounds like a good year for him to make a Roth IRA conversion. Now, depending on his exact work status, I don’t know if he has access to his traditional 401(k). If he does, he might actually prefer the investment choices of the IRA world in general, because let’s say he goes out to Vanguard or a money manager, etc. He’s going to have a lot more options than the 401(k) plan at work. Let’s say, for discussion’s sake, he likes the 401(k) plan at work, or the creditor protection is very important to him, and he could then, assuming his employer does have this Roth 401(k), this might be a good year for him to make a Roth 401(k) or, we don’t even have the terminology now for it, because it’s so new, but a Roth IRA conversion of a portion of his 401(k).
Nick: Sounds like he should be giving a person like you a call, maybe. Thank you. I appreciate your time tonight, and you got a good show.Jim: Alright, thanks for calling, Nick.
Nicole: Alrighty, you know, Jim, when you were talking to Nick, you said something, and I think we should definitely address this, is about paying the taxes. If the employee does decide to take a portion, convert it to the Roth designated account, you were talking about paying taxes in 2011 and 2012. Tell me a little bit about that. Is that allowing you to spread that out?
Jim: Well, yeah. Just like a regular Roth IRA conversion, 2010 is a special year. You have a choice of paying the taxes on the income in tax year 2010. So, let’s say, you make a Roth IRA conversion, and I’ve been using $100,000 because it’s a nice, round number. Let’s say, you make a Roth IRA conversion of $100,000, and you add that to your income in 2010. That would be just like every other year where you make a conversion and you add that income to your income for the year. But 2010 is a special year. If you want, you could recognize 50%, or $50,000, in 2011, and 50% in 2012. So, you’re paying taxes on the same amount of income, and you are not spreading the taxes. You are spreading the income, and there’s a difference.
Jim: Alright? So, I’ll give you an example. A perfect person who would benefit from that provision is a guy who’s at the top of his game in 2010. He’s making a lot of money, but he’s planning on retiring before the end of 2010. So now, he’s going to have very low income in 2011 and 2012. He should make, and let’s say he’s still working and he doesn’t have access to his retirement plan. He should consider a 401(k) conversion to his Roth 401(k). Then, he should elect, actually, the default, if you will, is you’ll be taxed in 2011 and 2012 on that conversion when his income will be much lower. Now, let’s say somebody else in a, let’s say, a more typical situation might say, “Well, gee, should I, you know, usually, it’s better to pay taxes later. Should I pay taxes in 2010 or should I defer it until 2011 or 2012?” Interestingly enough, because some of the tax increases that we have already scheduled, and it depends on each situation, but in, I would say, most of the situations that we have given advice on that issue, we have actually told people to pay the tax in 2010, which is a little bit counterintuitive to what you might think from CPAs who, for years and years and years have always been saying pay taxes later, and that’s true, but if you have to pay more taxes, you might be better off now.
Jim: This, by the way, is the essence of a Roth IRA conversion. You are paying taxes now in order to get tax-free growth. By the way, the name that I came up with, we’ve always wanted to call it “The Roth Revolution,” but the name I came up with the other day is “Pay Taxes Once and Never Again,” because that really describes the Roth. You’re paying taxes on the Roth IRA conversion, and then after that, it grows income tax free, again, for your life, your spouse’s life, your children’s lives and your grandchildren’s lives.
Nicole: Okay. You mentioned your book, a new book coming out. I think I said that back on one of our shows in July. Actually, I think it’s written, but are you going to be able to sneak this information we’re talking about tonight into it?
Jim: Well, I have to.
Jim: You know, the book has actually already been submitted to the publisher, and this, by the way, happened the last time.
Nicole: I’ll bet they love you. A major revision!
Jim: It did, and after I submitted it before, and the publisher was Wiley, which is a big place and they’re not like a small, flexible press, and then they changed the tax law, and by the way, I’ll tell you what the change was. The change was that, even though this was back in 2006, the change was that in 2010, they were going to let people make Roth IRA conversions regardless of their income, and I couldn’t, you know, get a book out that didn’t have that. So, I made a whole bunch of changes, and I guess they dealt with it because they did it. They might not have liked it. So I’m going to do that again. I’m saying, you know, the movie “Stop the Press!”
Jim: So, we kind of said “Stop the press,” so we’re kind of revamping a number of sections, and then, there will be a dedicated section on people who are still working and have 401(k) plans and whether they should make a Roth IRA conversion to a Roth 401(k), or if you work in the public sector, going from the traditional 403(b) to the Roth 403(b).
Nicole: Okay. And since this is so new and the book is so timely, this is perfect timing. Really, it is.
Jim: Yeah, it really is. Before, I was kicking myself that I didn’t get the book out on January 1st, but now, it’s a better book anyway because I spent a lot more time on it. That’s what I’ve been doing on evenings and weekends for a couple of months now, but now, it will have the new law, which I think will be even more significant, and it will now apply to a lot more people, because before, it was more for people who had substantial IRAs or people who were retired, but now, the book will be just as relevant for people who are still working and have money in their 401(k) or 403(b) plans.
Nicole: Just as a reminder, we are live. Jim is here right in the studio. We can take your calls. The number is 412-333-9385. Now, I want to just clarify a little bit so our listeners out there are crystal clear. So, you have a 401(k) or 403(b), and I assume it works for 457 governmental employees too?
Jim: That’s correct.
Nicole: Okay. So, you have that plan and you’re working. You’re converting to a Roth 401(k)? Is that the right terminology? You’re moving it to a Roth, because I’m using the term Roth designated account, is there a difference there?
Jim: No, a Roth designated account is actually part of the language in the statute, and I’ve referred to it as a Roth 401(k) or a Roth 403(b) because I think people have a better chance of knowing what that is. The language in the statute says Roth designated account.
Jim: If you have a 401(k), the Roth designated account is a Roth 401(k). If you have a 403(b), the designated account is a Roth 403(b). Alright, the important thing for a lot of people though, is that you might not have access to this opportunity if your employer doesn’t offer a Roth 403(b) or a Roth 401(k), and there’s unfortunately quite a few fairly large companies, and I think eventually that most of them are going to come around and offer it, but there are some substantial companies, both in the private and in the public sectors, that have not gotten on board to offer their employees this option. And again, it doesn’t cost the company any money. So this, to me, is an opportunity for a company to give their employees the best chance to accumulate money for their retirement.
Nicole: Okay, so if an employer is listening, and this passes, which it sounds like it’s going to, what should he or she do?
Jim: Well, first of all, I think they should do this whether this passes or not.
Nicole: Offer the Roth 401(k)?
Jim: Right, because there’s still Roth 401(k) contributions, which is new money, not conversions. So, to me, there’s no real downside, maybe there’s a slight accounting difference, but I don’t think that that’s really significant. They should be contacting their plan administrator, depending on the size of company that you have, we’re basically a ten person company, so what we do is we hire out, in effect, those services where somebody is a plan administrator and they take care of all the details of the withholdings and investing the accounts, etc. You should be getting hold of your plan administrator and saying, “Hey, we would like to add the Roth 401(k) or, if you’re in the public sector, the Roth 403(b) option.” And that will give your employees the opportunities to not only contribute to the Roth 401(k) or the Roth 403(b), but also to do this new conversion.
Nicole: Sure, and I guess if you’re an employee then, you can certainly go to the right person to ask and tell them, because you said this doesn’t cost the company anything to offer it.
Jim: No, but this might come as a terrible shock to you, but some people who own companies don’t like to be told what to do. Now I certainly would never do that!
Nicole: Oh, well, I don’t know anyone like that!
Jim: Who has their own headstrong ideas, even if they’re wrong, and there might be some political issues there too, but in terms of doing the right thing, and to me, let’s say somebody says, “Oh, I hate Roths. Why would I want to pay the taxes now?” Well, that’s fine. You can do that, but at least give your employees the option.
Jim: Because I know that there are some people out there, despite my best efforts, who don’t quite see the light, and they think Roth IRA conversions are bad for everybody, and that, I truly believe, is dead wrong. I actually think the right way to do it is to make projections and determine where you would be with a conversion and without a conversion, and in many cases, if not most cases, people would be better off converting at least a portion of their IRA, or now, a portion of their 401(k) or a portion of their 403(b) to a Roth IRA or a Roth 401(k) or a Roth 403(b). And typically, it’s hard to generalize, but what we tend to prefer, and after we’re done with all the analysis, we don’t tend to make a recommendation of one huge Roth IRA conversion for most of our middle income taxpayers. We tend to say, “Well, convert a smaller portion, but do it every year in order to stay in lower tax brackets,” and you can also do this with this new 401(k) to Roth 401(k) conversion.
Nicole: Alright, well, we’re going to take a quick break right now, but I think when we come back, I think I want to go more on that point and ask you, Jim, this will give you a minute to think, how people should determine how much they should convert in this 401(k), and we’ll talk about that when we get back. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back. You’re listening to Jim Lange, and we’re talking about a new law that’s pending and it will hopefully be passed any day now. It lets people still working to convert 401(k) dollars and put them into a Roth account while they’re still working to start that tax-free growth even earlier than we’ve been doing it now. When we left off, I wanted to ask you, Jim, so say we have a listener, they’re sitting there, and they’re thinking about their 401(k), they think this is a pretty good idea, do you have any ideas of how they determine how much they should do that? Now, I know that back in our office, we have a lot of people come in, more retirees that come in, and you call it running the numbers to figure out what is most appropriate for them. Do you still recommend that for people still working, or do they take a guess, or what should they do?
Jim: Well first, in defense of Steve Kohman, he doesn’t like running the numbers.
Nicole: I know he doesn’t like that!
Jim: He says a monkey can run numbers. We’re doing deep financial projections that take into account a client’s entire situation…
Nicole: I’m going to be in trouble tomorrow, I know!
Jim: …where we do an in-depth analysis, and Steve’s actually, I believe Steve is one of the top guys in the country to do this Roth IRA analysis, and one of the reasons is, in fact, two companies, and I’d prefer not to mention their names, but they’re both relatively household names in the software and IRA world, have approached us and talked about us training their software buyers how to use their software and how to figure out the optimal amount to make a Roth IRA conversion. And the problem with any software program, and I don’t care how good it is, is if you don’t really understand the underlying principles, you’re not going to get a good result. So, it’s almost like, and I would even say the same thing for our tax software, we have what we think is the best tax software, when I say tax software, I’m talking about tax preparation software, I think we have the best tax preparation software around, and most of the media and larger companies have pretty good tax preparation software, but you can’t take somebody off the street and say, “Okay, here’s this great tax software. Go prepare tax returns.” You really have to know what you’re doing. We actually calculate long-term Roth IRA conversion plans, so sometimes we have come up with a recommendation of making multiple conversions over a number of years. Sometimes, we’ve said, “Hey, convert them all.” Sometimes, we have encouraged people to do what we call a Roth launcher, which is to separate the IRAs and Roth IRAs into different accounts, do multiple conversions, and then later on, see how they do and keep, or recharacterize or undo, some of them. And of course, we touch on this in the workshop, and I have two entire sections in the book, and if anybody’s interested, what you would do is just go to www.rothira.com and sign up for the newsletter, because we’ll certainly be announcing that, and we’re probably going to have some promotions with free chapters, etc. But, there is a strategic way to determine how much to convert. Now, interestingly enough, we not only use what we think is the best Roth IRA conversion software to determine that, but we actually use 1040 software, plain old tax preparation software, because what happens is, when you add income to your existing income for a Roth IRA conversion, sometimes you get unexpected results. So, for example, if you are retired and you make a Roth IRA conversion and you have been collecting Social Security and your Social Security hasn’t been taxable because of your income tax bracket, it is possible doing the Roth IRA conversion will kick in taxes for your Social Security even to the extent that it’s not worth it to make a small conversion. Sometimes, though, if you make a larger conversion, you might be in a high tax bracket for a portion of it, and it still makes sense to do a larger amount. We actually have some pretty extensive analysis in the book on that, and then we also talk about some of those issues at the workshop, but here’s the simple answer to your question, Nicole. It’s really going to come down to comparing your current tax bracket with what you think your future tax bracket is going to be.
Jim: So, when I mention that 65 year old, who had a high income, that next year was going to be in a low income, I wanted him to do the conversion in the following years when his income was low. If he was the opposite situation, and sometimes we see that, where people are going to be making as much or more money when they are retired as when they are working. This is particularly true for people that have very large IRAs, so let’s say you have a two or three million dollar IRA. It’s possible that your minimum required distribution and your Social Security and your other income might exceed what your income is now. So, sometimes it might make more sense to convert early. So, I would say, you know, like a lawyer, it depends, but I would say what the factors are current and future tax brackets, and also, for people who are older and they’re planning their estates, we sometimes look at the tax brackets of their heirs. So, sometimes, what we have determined is it makes more sense, I hate to be this grim about it, but it makes more sense to have the person die with, for example, a traditional 401(k), and their heirs make the Roth IRA conversion of the inherited Roth IRA and pay it at their income taxes rather than dad’s income tax rate or income tax bracket that was substantially higher.
Nicole: Right, that makes perfect sense. The key is really to make the conversion when your tax bracket is lowest.
Jim: That’s right.
Nicole: If you can figure that out, that helps with figuring out the timing.
Jim: Right, and typically, what we find the best strategy is, is not one conversion of a small, or even a large, amount, but multiple year conversions. So, we might develop a three or five-year plan of a certain amount to convert, and that’s what we are commonly doing, and for our assets under management clients, we’re looking at that issue for every one of them, and then, even after developing a long-term conversion plan, then we look again every year and we tweak it and adjust for whatever’s happened during the year.
Nicole: Alrighty, we have about ten minutes left in the show. If you do have a question, you can give us a call at 412-333-9385, and I also like to throw out there, if you have any questions and you want to give us a call in our office, you can certainly do that too. We’re located in Squirrel Hill right outside of Pittsburgh, and the number’s 412-521-2732. You can give us a call or come to a workshop.
Jim: The other thing that I wanted to mention, and I think it’s going to be a really interesting area, now we’re probably going back to our retired listeners and we certainly want to have great information for you guys, and again, it’s something that is a little bit counterintuitive, the Roth IRA conversion where you’re paying taxes to the government before you have to, that doesn’t sound too appealing. And by the way, I actually have clients who say “I don’t want to do a Roth IRA conversion,” or sometimes, they cite somebody that I think is a joke, and they say, “Well, that person says I don’t want to do a Roth IRA conversion, so I’m not going to do a Roth IRA conversion.” And I say, “That’s fine. We can do lots of great strategies without Roth IRA conversions.” This year, we’ve done a lot of shows on Roth IRA conversions, even more than previous years, and I think we’ll do much less next year, but this year’s the hottest year, which is one of the reasons why I’ve kind of emphasized it and that we’ve done so many shows on Roth IRA conversions. In reality though, Roth IRA conversions are just one portion of a well-developed retirement and estate plan. So, for example, when I talked about making financial projections, and so, let’s say for example, we would do multiple scenarios, and by the way, it’s more of a manual process than you might think. It’s not just you put a bunch of numbers in a computer and hit optimize and it comes out and tells you how much to do it. It’s more like interpolating, where you’re making educated guesses for reasons that we have to make these guesses, and then, testing to see which ones. Well yes, which year and when to convert are going to be one issue, but for example, gifting might be another issue. Life insurance might be another issue. What types of investments you have might be another issue. Should you be transferring money from one spouse to another, that could be another issue. So, what happens in the real world is that Roth IRA conversions are just one portion of the entire integrated retirement and estate plan that I think sometimes we lose control of and lose consciousness of, and one of the things that I try to do in “The Roth Revolution: Pay Taxes Once and Never Again” is I try to recognize hey, Roth IRAs are not just an issue in and of themselves that have nothing to do with the rest of your plan. So, for example, you would never go to the doctor and say “Doctor, I want you to look at my right hand, and only my right hand, and whatever you do, you know, it’s not going to affect the rest of my body, just worry about my right hand.” So, we’re not the type of firm, and I don’t think any good firm is, that we’ll say, “Alright, all we’re going to do is look at Roth IRA conversions. We’re not going to take a look at anything else.” We would much prefer to do a more overall holistic, if you will, or taking into account all the factors.
Nicole: Well, that’s absolutely the right way to go, and the medical analogy is right on. You know, you have to look at all of those parts to make sure you have a well functioning plan.
Jim: Right, and we have noticed certain patterns, if you will, of people, now, our clients, in real life, tend to be a little bit older, probably sixty or older, and quite a few who are on the brink of or are already retired, I think actually this new law is going to make Roth IRA conversions much more attractive and now possible for a whole new set of people, so frankly, I’m expecting a lot of people in their mid-fifties and older to attend the workshop to find out what needs to happen. And by the way, it’s not because I don’t tell people, you know, there’s no law that says hey, if you’re in your thirties or forties, you can’t come to these workshops, but I’ve been doing these for years and years, and younger people don’t seem to come.
Nicole: And it’s a shame, because I’m in that age bracket, and maybe because I’ve been in the industry, and the earlier people start, you know, I always say you don’t necessarily have to work as long and as hard as you think you do if you do the right planning upfront and you plan smart.
Jim: Well, I’ll tell you what I think is one of the great ironies is, so let’s say, most of my clients have a little bit of this depression-era mentality, and they’re really better at saving than spending, and that’s just the way they are, and you can’t get a leopard to change its spots. The one area that I’ve managed to loosen people up a little bit is I’ve managed to talk some people into doing a family vacation, where they pay for the whole family to get together every year or every couple of years, and that’s actually been a nice thing. But most people, frankly, aren’t going to change their spending, so let’s say that you have somebody who has an estate between one and three million dollars and maybe they have a pension, and maybe they have Social Security, and they continue to spend, like, $60,000 or $70,000, and that’s just the way they are and they can’t change it. Maybe I can talk some of them into a gifting program if it’s appropriate, but let’s assume there’s moderate or no gifts. And then they complain about their kids. They complain that their kids don’t have nearly as much money, have a nicer house, have a bigger kitchen, drive newer cars, but don’t have nearly as much money, alright? So, there’s a lot of guys out there in their thirties and forties that have bigger houses, newer cars, and they do all kinds of spending and not saving, and frankly given, let’s say, the natural course of things just if they were on their own, they would have some problems when they’re in their seventies or sixties, and they want to retire and they don’t have enough money to, but what I think is going to happen is that their parents, who are savers, and who always kind of resented a little bit how much their kids paid for all these things like the new kitchen and the new house and the new cars and everything else, because they’re not spending it.
Nicole: They’re kind of going to bail the kids out?
Jim: They’re going to bail the kids out, not on purpose, but they’re going to die and yes, you know, they’re going to leave some money to charity, but most people leave most of it to their family, so the kids are going to get bailed out. So, it’s kind of ironic that you have this situation where you can have, you know, children who are kind of, I won’t say irresponsible, but I’ll just say who are spending more than is appropriate given their income and their resources, and they are ultimately going to get bailed out by their parents, and a lot of my clients, they might tell their kids what the will says, but they don’t necessarily want to tell the kids how much money they have, because they’re, and I think justifiably, afraid that it’s going to reduce their children’s motivation because if a child says, “Oh, you know, mom and dad have $2,000,000 and there’s just two of us, and when they die, and they’re savers, they’ll probably grow the estate and not shrink it, when they die, we’ll each have $1,000,000, so I don’t have to work as hard.”
Nicole: Right! Well, that is certainly true.
Jim: So that issue is certainly part of the kind of paradox, if you will, of the child who is spending too much, the parent who is resenting the child who spends too much, but the parent ultimately, not on purpose, but just the way of things, will end up bailing the child out.
Nicole: Well, you know then, who’s really going to be the bad position are the children of the spenders. They’re not going to have anything, because they’re not going to have their grandparent’s money, their parents are just going to spend it all.
Jim: Well, we do have clients who are making provisions for their grandchildren. By the way, one of the best things that you could leave a grandchild is an inherited Roth IRA or an inherited Roth 401(k) or an inherited Roth 403(b).
Nicole: Alrighty, well, I think we’re at the end of our hour. Thanks for listening. Have a great evening. You’ve been listening to the Lange Money Hour, Where Smart Money Talks.
James Lange, CPA/Attorney
Jim is a nationally-recognized tax, retirement and estate planning attorney with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, will and trust preparation and intricate beneficiary designations for IRAs and other retirement plans. Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.
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