Take Back Retirement
Episode 20
Women + Roth IRA’s – What Should You Be Aware Of?
In the United States, we can’t talk finances without talking taxes. It shouldn’t come as a surprise that taxes are an inevitable part of our reality and are inescapable. The best (and only) way to go about navigating taxes is to, as Stephanie and Kevin like to say, “be smart about it, know what’s going on, then make your decisions.”
A Roth IRA is a tool that falls under the category of tax planning. So, it’s vital to be aware of exactly what it is and how best to make use of it depending on your circumstances and goals.
“What’s a Roth IRA, anyway?” you may ask. Basically, it’s a special retirement account that was created in 1997 by Senator William Roth as part of one of the tax reform acts that get passed periodically. One of the primary differences between the Roth and the traditional IRA is that, unlike the traditional IRA, you are not taxed on the dividends you earn from the Roth.
Listen in and learn other notable differences between the traditional IRA and the Roth IRA, the rules around taking money out of a Roth, three scenarios in which one would want to open a Roth IRA; and how to prepare your Roth savings for your next of kin.
Check out our previous episodes for more information on this topic.
Please listen and share with your friends who are in the same situation!
Key Topics
“What the heck is a Roth IRA, anyway?” (3:06)
Differences between the traditional IRA and the Roth IRA (5:35)
Can you really take money out of a Roth IRA whenever you want? (14:49)
The five-year clock for IRA accounts (18:40)
Why even open a Roth IRA? (23:05)
Leaving a legacy: Passing on your Roth money to the next generation (32:47)
What is the “deathbed Roth conversion” strategy? (35:22)
Ultimately, what are your priorities? (37:24)
Stephanie McCullough: (00:06)
Welcome to Take Back Retirement, the show for women 50 and better, facing a financial future on their own. I’m Stephanie McCullough. Along with my fellow financial planner, Kevin Gaines, we’re going to tackle the myths and mysteries of “retirement,” so you can make wise decisions toward a sustainable financial future. Through conversations and interviews, you’ll get the information and motivation you need to move forward with confidence. We’ll be sure to have some fun along the way. We’re so glad you’re here. Let’s dive in.
Stephanie McCullough: (00:41)
Coming to you semi live from the beautiful Westlakes Office Park in suburban Philadelphia, this is Stephanie McCullough and Kevin Gaines of Sofia Financial and American Financial Management Group. Say hello, Kevin.
Kevin Gaines: (00:52)
Hello, Kevin.
Stephanie McCullough: (00:54)
We have another scintillating topic for you all today. This is a thing that financial planners, financial advisors get really excited about. And we hope by the end, you’ll find it interesting too. We’re going to talk about Roth IRAs and why in the first place is this even interesting? Like it or not, in the United States of America where we live, if we’re talking finances and money, we’ve got to talk taxes. Taxes are an inevitable part of our reality. They’re inescapable and we have to be smart, like anything. Kevin and I are always saying, be smart about it. Know what’s going on, make informed decisions. A Roth IRA is a tool that falls into the category in our world of tax planning. So, we want to make sure that you’re aware of it.
Stephanie McCullough: (01:40)
Also, you’ve probably heard the term and you might be like, “Oh shoot. I’m supposed to know what that is. What the heck is it again?” So, we’re going to do our best to hit you with the important keys. As Kevin pointed out when we were preparing for this, we could probably talk for three days, but I promise we won’t. This is the benefit and the curse of having someone who is super into this stuff and an Ed Slott Master Elite advisor person like Kevin on stuff because he knows all this stuff, which is great for all of us, so we can turn to him for the information. And when we’re trying to be concise, and informational, and entertaining in something like a podcast, maybe it’s a downfall. So, we’re going to do our best to strike the balance.
Kevin Gaines: (02:24)
I actually have an image of myself right now as one of those over-caffeinated cartoon characters that once they get really amped up, you get the big buggy eyes and they’re literally bouncing off the walls in the cartoons. That’s, again, not saying that I geek out on this stuff or anything, but yes, this is one of those topics. Really excited to be doing this, as well. Unfortunately, you’re not going to be next to me to be able to slap me upside the head to say, “All right, that’s enough. Let’s get onto the next thing.”
Stephanie McCullough: (02:51)
Or kick you under the table.
Kevin Gaines: (02:55)
We don’t have three days to talk about this.
Stephanie McCullough: (02:59
Yes, yes. Maybe I’ll flail my arms because although we are in separate rooms, we are able to see each other as we record. So, I will flail my arms, audience on your behalf. So, the first step is, what the heck is a Roth IRA anyway? And we’re going to go into why we should care, but just the strict definition. I always like to point out because Kevin and I are in Pennsylvania and it actually came from a senator by the name of Roth from Delaware.
Kevin Gaines: (03:21)
Yes. Senator William Roth came up with this back in ’97 as part of one of the many tax reform acts that get passed periodically. It had been something in the works for a while. The idea of being able to save money, post-tax. So, you get your paycheck, you pay your income tax on it, then you put the money into the Roth. It’s already been taxed. And the money that it earns, the growth, doesn’t get taxed either. So, once this money goes in, it’s never taxed. Pretty good deal in many situations.
Stephanie McCullough: (03:58)
It’s kind of the inverse of a regular IRA, right? And to back up for a second, big picture. The reason we have these type of retirement plans, IRAs, which are individual retirement accounts, retirement plans at work: 401(k)s 403(b)s, TSAs, whatever you might have. The whole point is that the US government is giving us a tax incentive to save for retirement because they know all too well, Social Security is not going to be enough for most people. “So, how can we get these silly Americans to save more for their future? Oh, let’s give them a tax break.” So, traditional IRAs, you don’t pay tax on the money you put into them. Same with traditional 401(k)s, 403(b)s. In the year you put them in, you get a tax deduction for that amount, and then it grows, grows, grows, hopefully. And then in retirement when you take it out, then you have to pay your income taxes. So, Senator Roth’s innovation was, “What if we flip the script and instead of postponing the day when the IRS gets their money, let’s get the IRS their money up front and then the deal is, as long as you follow the rules,” which we’re going to tell you about, “you don’t pay tax on the money later.”
Kevin Gaines: (05:03)
Right. Yeah. Think about it this way. Your regular IRA or 401(k) or whatever, even though you don’t see it on the account registration, it has a co-owner, Uncle Sam. He owns 20, 25, 30% of that retirement account. He knows he’s going to get it someday. But with a Roth, you own it free and clear. Uncle Sam, you’ve already paid him off. He’s left. Now it’s just your money.
Stephanie McCullough: (05:28)
And that’s really the problem, right? When you’re guessing at what percent you’re going to pay, we don’t know. We don’t know what our future tax rates are going to be. We’ll get into that though, but let’s hit kind of the key characteristics of the Roth, the big differences between a regular IRA and a Roth IRA.
Kevin Gaines: (05:43)
Well, the big one, and we’ve already touched on it, is taxation. To clarify, we’re going to say traditional and Roth.
Stephanie McCullough: (05:49)
Yes.
Kevin Gaines: (05:50)
And when we say Roth, that could be a Roth IRA, that could be a Roth 401(k). When we say traditional, traditional IRA, 401(k), 403(b). Like we said, when you take the money out of a traditional retirement account, you’re going to pay some sort of tax. Typically, whatever your tax rate is. When you take money out of a Roth, you’re not paying any tax. You already paid it going in, free and clear.
Stephanie McCullough: (06:13)
And just a quick note, we’re talking about federal income taxes here. We’re not addressing the states. Different states have different rules, but for federal, which is going to be the biggest bill for most people. You’re going to have some pain if you want to see taxes that way. It’s a matter of, “Do you want to take your lumps now or do you want to take your lumps later?”
Kevin Gaines: (06:30)
Right. Yeah. Uncle Sam’s getting paid, you’re going to pay. When do you want to do it?
Stephanie McCullough: (06:36)
Yep.
Kevin Gaines: (06:37)
And it’s a crapshoot what the rates are going to be. We don’t know. We can make assumptions and we can speculate. And it’s like, “Surely, rates can’t go any lower,” or “Surely, I’m going to earn less money or I’m going to be paying a lower tax rate when I’m older when I don’t have all this income.” Well, newsflash, we don’t know that for sure, and don’t call me Shirley.
Stephanie McCullough: (06:55)
Yeah. The traditional advice was always, oh, you want to defer those taxes because you will obviously be in a lower tax bracket at retirement, because you will be just living on Social Security and your withdrawals from your retirement plan. Well, there’s a lot of problems with those assumptions any more. Number one, you don’t determine the tax rates in the future. Congress does. They can make any changes they want to, anytime they want to. But also, maybe you’re working part-time in retirement. Maybe your spouse or significant other that you file taxes with is still working. Maybe you’ve got other sources of income that are not going to put you in a lower bracket than today.
Kevin Gaines: (07:36)
Or maybe fortune smiles on you and you did a great job of saving both in how much you contributed and that growth rate and the required distributions, even though you may not need all that money, and that’s going to be another thing we’ve got to get to about the differences. In the traditional, you have these required distributions, and if your account’s big enough, you could be in a similar tax bracket to where you were when you were earning.
Stephanie McCullough: (08:03)
Yeah. So, since you brought that up, let’s go there. We call them required minimum distributions or RMDs. So, these really come from the traditional retirement plan world where uncle Sam hasn’t gotten their pound of flesh yet. And they say, “You know what? We’re not going to let you defer this tax forever. There’s a point at which you have to start taking money out and you have to start paying taxes.” And in the old days, not that long ago, they started at age 70.5.
Kevin Gaines: (08:32)
And now it’s 72 under the SECURE Act, which started in 2020. And just to put everybody on alert, there is another bill, and it’s already passed the house, that’s going to ultimately extend that required beginning date to age 75.
Stephanie McCullough: (08:47)
Whoo.
Kevin Gaines: (08:48)
Which is good news. You don’t have to take the money if you don’t want to, but what that will also lead to is bigger, most likely, larger distributions once you have to start taking it because you haven’t taken the money from, say, age 70 to 75. You’ve got a bigger account; you may have bigger distributions.
Stephanie McCullough: (09:06)
And just not to go down too deep in the details, but the way you figure out how much do I have to take out each year in these required minimum distributions. There’s a table from the IRS and it’s based on life expectancy. So, they say, “If you are age X, you have to take out Y% of your dollars.” And yes, life expectancies are going up, but if we postponed the beginning date, maybe the amounts are taller, or more. So, this is a difference between regular IRAs and Roth IRAs. So, Kevin, are there required distributions in a Roth IRA?
Kevin Gaines: (09:39)
There are not. Period.
Stephanie McCullough: (09:42)
Because you’ve already paid your tax.
Kevin Gaines: (09:46)
Uncle Sam already got paid. He doesn’t care anymore. Just as a quick aside, if you inherit an IRA, a Roth IRA, you still have that required distribution. If it’s an older one, your life expectancy or if it’s a newer inherited IRA, it’s the 10-year rule, but you don’t have to pay tax, but you do have to take the money. Go figure.
Stephanie McCullough: (10:03)
Yeah. So anytime your IRA says BDA or beneficiary or inherited, then there’s different set of rules. Just be aware of that. So, second difference of regular IRAs to Roth, required distributions doesn’t exist in a Roth IRA. So, third difference is eligibility. Yes, the government gives us these tax breaks to put money into retirement accounts, but then they say, “You know what? If you make too much money, you can’t do this.” Or if other conditions apply, and again, we’re not going to go into all the nitty gritty, but just so you get the big picture. First of all, eligibility to make any IRA contributions has to be on earned income.
Kevin Gaines: (10:45)
And earned income is a big… You wouldn’t think it gets tricky, but like any other tax policy, it can get tricky, but bottom line is… Or oversimplification, I guess. If that number appears on your W-2 or if you’re self-employed at 1099 or something along those lines, then it’s earned income. There are some other variations, but keep it simple, focus on that number.
Stephanie McCullough: (11:08)
Right. But then the Congress when they were looking at these Roth IRA rules, they said, “You know what? This is kind of a nice thing, but we’re going to not let everybody make contributions to a Roth IRA.”
Kevin Gaines: (11:20)
Right. So, what they did, they came up with a cap saying, “If you earn less than a certain amount,” and it increases a little bit each year, “you can contribute to a Roth IRA. And if you make over the amount, then you cannot.” And actually in between, there’s a little phase out period where you can contribute some.
Stephanie McCullough: (11:41)
Yeah, but basically if you earn too much money, you are not allowed to make contributions to a Roth IRA.
Kevin Gaines: (11:48)
And this is actually one of the first places people get confused between traditional and Roth accounts is there’s also an income cap for traditional IRAs, but that only applies to the amount that you’re allowed to deduct. No matter how much money you make, you’re always allowed to contribute to a traditional IRA. You just may not be able to deduct the money. With the Roth, the income cap says, “No, you cannot add any more money,” which makes sense because you don’t get a deduction. So, it’s not like they can take that carrot away.
Stephanie McCullough: (12:24)
And just to confuse you even further, you might see the word “Roth” in another situation, which is actually at your 401(k) or 403(b) at work. So, a few years after they created the Roth IRAs, Congress said, “You know what? We’re going to let retirement plan sponsors also allow people to make Roth contributions in their 401(k).” So, it’s employer by employer, whether your plan allows this or not, but the nice thing there is, there is no income cap. So, I’ll meet people and I’ll say… Talking to clients, “Hey, you’ve got a Roth 401(k) option in your plan at work. Have you thought about making those contributions?” And they say, “Oh, I make too much money.” “No, you don’t. No income cap on a Roth 401(k) contribution.”
Kevin Gaines: (13:06)
I think we should probably stop it there as far as discussing the differences because, usual caveat, this could be a whole episode just talking about the differences.
Stephanie McCullough: (13:15)
There’s one other thing to talk about though, which is, there’s another way to get money into a Roth IRA. Besides making a contribution, you can also… And this also came back a few years, so I remember this because I actually started as a financial advisor in 1997, the year the Roth IRA was invented. So, a few years after that, they decided, “You know what? We’re going to let people convert money they might have in a traditional IRA,” (remember that’s the usual kind that’s tax deferred, taxed later) “into a Roth IRA.” And there was an income cap and then they got rid of that too. So, now you could choose to, if you’ve got a pot of money in your regular traditional IRA or traditional 401(k) plan, you could in any given year convert some or all of it to a Roth and the pain is, you’ve got to pay the tax on the amount that you convert in any given year.
Kevin Gaines: (14:09)
Right. But it’s not an all or nothing. Like you just said, Stephanie, it’s not an all or nothing. You can choose to say, “I’m going to convert $10,000 each year,” or random year because of whatever. For example, in 2020, a lot of people were laid off or earned less money because of COVID. We actually saw an increase in people doing conversions because they had lower income so they could get more in at a lower tax bracket. So, it’s something to be aware of and it could be really powerful because again, no income limit.
Stephanie McCullough: (14:44)
Yep.
Kevin Gaines: (14:45)
Which is a big get for a lot of us.
Stephanie McCullough: (14:48)
Yep. So, we’re definitely going to get to the question of, why the heck would we want a Roth anyway? But the next key piece to understand… And again, remember, this is a government program, so the rules are not simple, but we want to talk about taking money out of a Roth because there are specific rules around that too.
Kevin Gaines: (15:08)
So, one of the things everybody hears about the Roth and it’s one of those things is you hear it and you may have heard it accurately or you may not. So, we’re going to give you the accurate version. It is true that you can take money out of your Roth whenever you want. And some of it will be exempt from penalties and taxes. And when I say “whenever you want,” we’re saying under the age of 59½ because with all IRAs, once you get over 59½, you can take the money out and you never have to worry about paying the 10% penalties for whatever reasons.
Stephanie McCullough: (15:49)
Right. And we’ll point you back to our episode on IRAs [Episode 12] to get into those details.
Kevin Gaines: (15:54)
Right. But with a Roth, you can take the money out before 59½ without the penalty, but only certain dollars. And when we get to one of the next complicated issues about Roth with something that’s called ordering rules. So, what they’ve come out with is, there are three classifications of Roth dollars. There’s contributions, conversions, and earnings-and-growth. And I just gave it to you in the order in which the money comes out as far as the IRS is concerned. So, the first dollars you would take out are dollars that you contribute and that money you can take whenever you want, and you don’t have to worry about penalties. You don’t have to worry about income taxes or anything. You contribute $5,000 today, you can take that $5,000 out tomorrow and nobody’s going to care.
Kevin Gaines: (16:54)
Then there’s the conversion dollars. Now, we start getting to something a little bit interesting called the five-year clock, which we’ll get to that in a moment. But I just want to finish the ordering thought. After you take out your contributions, after you take out your converted dollars, then you take out your earnings and those earnings are going to be subject to penalties and all that fun stuff.
Stephanie McCullough: (17:20)
So, 10% penalty if you’re under 59½.
Kevin Gaines: (17:23)
Correct. But those are the last dollars taken. Bottom line, recordkeeping is important with Roths.
Stephanie McCullough: (17:31)
Yeah. If you forget everything else, remember that you’ve got to keep track every year of how much you put in and how much you converted.
Kevin Gaines: (17:39)
Right. Fortunately, you’d have to tell the IRS this every year. So, worst comes to worse…
Stephanie McCullough: (17:44)
It’s in your tax return.
Kevin Gaines: (17:45)
Just go check your old tax returns and you’ll see what these numbers are and you’ll be able to work backwards to figure out how much you can take without having to worry about penalties.
Stephanie McCullough: (17:53)
So, Kevin, the ordering rules mean you can’t decide, “Hey, I’m going to take out earnings.”
Kevin Gaines: (17:58)
Right.
Stephanie McCullough: (17:59)
The IRS says, as many dollars as are coming out, they’re all contributions until you reach the amount you’ve contributed. And then the next dollar is conversions, right?
Kevin Gaines: (18:07)
Right.
Stephanie McCullough: (18:08)
That’s what the ordering means?
Kevin Gaines: (18:10)
Yes. And this is in the taxpayer… This is in the saver’s advantage because the IRS is saying the stuff that is most advantageous for you to take first, we’re going to say, “You’re taking that first.”
Stephanie McCullough: (18:20)
That’s nice.
Kevin Gaines: (18:21)
You don’t have to worry about this.
Stephanie McCullough: (18:25)
Yeah.
Kevin Gaines: (18:26)
They’ve already decided for you in your favor. So, take the win.
Stephanie McCullough: (18:29)
All right. So, that’s kind of a little bit in the weeds, but the key point is, keep track.
Kevin Gaines: (18:34)
Yes.
Stephanie McCullough: (18:35)
And then you mentioned this five-year clock. What the heck is that? Why are we talking about clocks?
Kevin Gaines: (18:41)
Here’s the thing. So, back in ’97, quick little history lesson, when they first came out with the Roth and allowed the Roth conversions, it didn’t take them more than a few weeks to figure out, “We didn’t add enough lines to the tax code,” because people would immediately convert their IRA into a Roth and then they would take the money. And Congress said, “Well, wait a second. This isn’t our intent.”
Stephanie McCullough: (19:06)
Oh, you mean before 59½?
Kevin Gaines: (19:10)
Before 59½, you converted into a Roth to bypass the 10% penalty. Still paid the income tax, but you bypass that 10% penalty.
Stephanie McCullough: (19:16)
That’s pretty good.
Kevin Gaines: (19:18)
And if it’s a sizeable enough IRA, 10% is a number. Or if you’re cheap like me, even 10% on $100 is a number. But that’s aside. So, they quickly added a little tweak to the Roth law saying five years. If you convert money from IRA into a Roth, you have to wait five years before you can take that money without penalty. Now, again, you’ve already paid the tax, they’re not going to tax you again on that money, but if you do a Roth conversion and then four years later, you take those conversion dollars, you’re going to pay a 10% penalty.
Stephanie McCullough: (19:57)
But no tax, right?
Kevin Gaines: (20:00)
But no tax.
Stephanie McCullough: (20:02)
Because the contributions, you’ve already paid tax on, right? Because you did not get a deduction when you put them in. The conversion dollars, you’ve already paid taxes on because you paid tax in the year that you converted that amount. So, as Kevin pointed out, you converted $10,000, that’s $10,000 more dollars of amount you’ve already paid tax on. And then the growth and earnings, you don’t pay tax on as long as you follow these rules. Kevin, is that all?
Kevin Gaines: (20:25)
I wish I was Marisa Tomei, so I could say, “No, there’s more,” but I can’t do that voice very well. My Cousin Vinny reference for you younger listeners out there. The federal government and all their wisdom decided to make multiple five-year clocks just to confuse the hell out of everybody. So, to take a quick step back, there’s an overall five-year clock for an IRA account. So, the moment you open a Roth IRA, a five-year clock is started and what this clock covers is the earnings. So, you can always take your contributions out. Like I said, even the very next day, but you have to wait five years before you can take the earnings out without any penalties or tax, and you have to be over 59½.
Stephanie McCullough: (21:21)
So, five years and 59½. So, if I start my account when I’m 58…
Kevin Gaines: (21:25)
You still have to go to five years.
Stephanie McCullough: (21:27)
So, I’ve got to wait till I’m 63.
Kevin Gaines: (21:29)
Yes.
Stephanie McCullough: (21:29)
Or five years from the date I opened it.
Kevin Gaines: (21:30)
Correct.
Stephanie McCullough: (21:30)
Okay.
Kevin Gaines: (21:31)
Now, a little quick hint. The five-year clock starts the moment you open your first Roth IRA. Open a Roth the moment you can. You’re 16, you just got your first paycheck, open a Roth, put a dollar in it and don’t worry about it for the next how many years before you can start contributing bigger. But that five-year clock has already started. You’re in.
Stephanie McCullough: (21:49)
Yeah.
Kevin Gaines: (21:50)
So, it’s a one and done type deal.
Stephanie McCullough: (21:52)
The five-year clock on the account or all of your Roth accounts is for the contributions. And then the conversions is what you were talking about, right?
Kevin Gaines: (22:06)
Correct.
Stephanie McCullough: (22:07)
To get people out of that loophole.
Kevin Gaines: (22:09)
Right.
Stephanie McCullough: (22:09)
Now…
Kevin Gaines: (22:10)
Aha. There’s more.
Stephanie McCullough: (22:12)
There’s more.
Kevin Gaines: (22:14)
Each conversion has its own five-year clock. So, you got a five-year clock within a five-year clock…
Stephanie McCullough: (22:21)
Oh my gosh.
Kevin Gaines: (22:22)
… to worry about. You make five Roth conversions; years one, two, three, four, and five. You’ve got five five-year clocks to worry about. So, that just covers the conversion dollars.
Stephanie McCullough: (22:33)
Recordkeeping.
Kevin Gaines: (22:34)
Now, you get through all the conversions, you take out all the money from the conversions, you’ve satisfied the five-year clocks. As the calendar works out, you could then take the earnings, assuming you’re over 59½, because that was covered by the initial IRA five-year clock. It’s confusing. It gets back to what we said earlier. Record keeping is important or just don’t touch the money, which was the original design of these accounts anyway.
Stephanie McCullough: (23:04)
Right. So, that brings us to the whole next point. We just went through all the boring rules, why the heck would you want to have one of these things? And we’ve kind of thought through maybe four scenarios in which having a Roth makes sense. We are not here as salespeople for Roth IRAs. We’re just trying to give you the info so you can make decisions, but like anything, we’re always wanting people to go in eyes wide open, understanding the pros and cons. There are pros and cons of everything in the financial world. You just want to know what they are so you can make good decisions.
Stephanie McCullough: (23:38)
So, scenario number one is, as we’ve mentioned a couple of times, a younger person. So, a younger person we are going to presume is in a lower tax bracket, they’re earning less money than they might sometime in the future. They are below the earnings limit, so they’re eligible to make Roth IRA contributions. Also, when you’re in a lower tax bracket, giving up that tax deduction that you would get from a regular IRA contribution, it doesn’t hurt as much. I’m not picking tax brackets here. I’m just using numbers, right? If I’m in a 20% tax bracket versus a 40% tax bracket, the deduction is more valuable to me when I’m in a higher tax bracket if that makes sense. So, a younger person earning less, giving up the deduction doesn’t cost as much, but then the other piece is the time.
Stephanie McCullough: (24:34)
The time horizon. So, if I’m a younger person and this is my future long-term money, maybe even for retirement, remember, I’m going to pay tax on that. Let’s say I put in $2,000, but I’m, if I follow all the rules, never going to pay tax on that growth. So, if I start it when I’m, I don’t know, 20, and I don’t take it out until I’m 70, that’s 50 years of growth on that $2,000 that I’m never going to owe tax on.
Kevin Gaines: (24:59)
Right. And to even put a bigger explanation point on this, especially if you just started working, go back to the 16-year-old with a part-time job, your tax rate might be virtually zero.
Stephanie McCullough: (25:14)
Yeah.
Kevin Gaines: (25:15)
And you get that money into a Roth and it’s growing. Your tax rate when you’re retired is virtually guaranteed – I know I’m going to irritate compliance by saying it that way – you’re going to have a higher tax bracket. So, especially if you’re earning minimum wage or really small amount, the Roth is… I don’t want to say a no-brainer. It makes an awful lot of sense from a tax bracket perspective.
Stephanie McCullough: (25:39)
Yeah. And starting that five-year clock, too. And here’s the point, too. My son worked at the Giant grocery store over the winter time doing checkout and decided that maybe he didn’t want to work at Giant his whole life, which I appreciated. But the point is, he can still keep the dollars he earned. The fact that he’s got earned income this year makes him eligible to open a Roth IRA, but I could fund that Roth IRA for him, right? He doesn’t have to use his dollars, which are going to gas for the car and whatever else he’s spending money on, who knows, as a 19-year-old boy, right? But just the fact that he has earned income makes him eligible, but it doesn’t have to be those same dollars.
Kevin Gaines: (26:21)
Right. IRS does not care where the dollars come from just as long as those are earned dollars. So, if you wanted to encourage your kids or grandkids or neighbors to save for the future-
Stephanie McCullough: (26:36)
Nieces and nephews, right? Give them a little taste.
Kevin Gaines: (26:40)
Right. Give them a birthday present instead of giving them $100 or whatever. Throw it in a Roth for them. As long as they have earned income, I can’t stress that part enough, and then that way they can take their own dollars and do whatever they’re going to do with them. But it’s a great way to encourage and get them to start thinking about saving. And especially when you throw in compounding and younger people start seeing, “Hey, this is growing without me doing anything.”
Stephanie McCullough: (27:08)
Yeah.
Kevin Gaines: (27:09)
It creates a favorable attitude towards responsibility.
Stephanie McCullough: (27:12)
Instilling those good habits young. Okay. So, scenario number one, young people. Scenario number two where Roth IRAs are popular and might make sense is for needs that you might have before retirement. Whether they be college planning for children or starting a business, buying a lake house, whatever it might be. Now, we’re not saying it’s necessarily the best option, but this is another way people use Roth IRAs.
Kevin Gaines: (27:39)
Right. Remember what we said, contributions, you can take them out whenever you want without penalty or tax.
Stephanie McCullough: (27:48)
Not even that five-year clock?
Kevin Gaines: (27:52)
Not even the five-year clock. Does not apply to contributions. It only applies to the earnings of those contributions and conversions. So, you can take that money whenever you need, whether it’s, “Oh my gosh, I need this. I’ve got a sudden need for cash. I don’t have anywhere else to go.” Again, going back to people just starting out. You don’t necessarily have the dollars to build up an emergency savings account, to set up a retirement account, to-
Stephanie McCullough: (28:16)
Save for a house down payment.
Kevin Gaines: (28:20)
… save for a house and down payment. The Roth does allow… Again, we’re not saying this is the best use of the money or advisable, but it does give you an option of being able to pull some money out if you need it.
Stephanie McCullough: (28:29)
Whereas a regular IRA, you don’t have that flexibility. So, if it’s, “Yeah, I’m pretty sure this is long-term money, but I might need it for something else.” A Roth is not a bad option.
Kevin Gaines: (28:40)
And Stephanie, you know a couple of clients that I have said that they are using this as their college savings plan for their kids. Again, not necessarily the best option for a variety of reasons, but it is an option. So, yeah, it works on college planning. You put $6,500 in a year and hopefully as it continues to go up, which it does, you get more and more saved and then you can take all those contribution dollars out to help pay for college or… Again, the IRS doesn’t care what you’re taking the money out for, but if you don’t want to create a 529 or some other college savings plan because… Let’s think optimistically. Your child is gifted, intelligent or athletically inclined. Maybe they just get a full ride scholarship and then you don’t necessarily… You’ve got that money locked up in a college savings plan. So, you don’t want to necessarily tie it up exclusively for college. The Roth does give you some flexibility. So, that’s a point to consider.
Stephanie McCullough: (29:47)
Okay. Then let’s get to the big use that most people think about using a Roth IRA for which is retirement. And Kevin mentioned this before. When you get to retirement, you’re looking at your retirement monies. Let’s say you’ve got a regular 401(k) and a regular IRA and then you have some things with Roth on it. So, maybe you have some Roth money in your 401(k), maybe some Roth money in your IRA. You own 100% of that Roth money. It’s all yours because you’ve already paid your taxes. You owe some, as yet to be determined, percentage of the traditional 401(k), traditional IRA to the government. So, you want Roth money in retirement.
Kevin Gaines: (30:32)
Yeah. You’ve prepaid the expense. If nothing else, you’ve prepaid that expense and now this money is free and clear. So, when you’re thinking, “I have $500,000 saved for retirement,” you really have $500,000 saved for retirement.
Stephanie McCullough: (30:48)
If it’s all in a Roth.
Kevin Gaines: (30:50)
If it’s all in a Roth. If it’s all in a traditional account, you don’t have 500,000 saved for retirement. You have 500,000 less whatever federal taxes are going to be, and maybe state taxes. It’s not 500,000.
Stephanie McCullough: (31:06)
Yep.
Kevin Gaines: (31:07)
Might only be 400 or less, but it’s not 500.
Stephanie McCullough: (31:10)
And really when we look at people’s retirement income planning, it’s nice to have both types of money and some money that’s not in a retirement plan, but that’s another topic for another day. But if you’ve got some that you know you’re going to pay tax on and some you know you’re not going to pay tax on, you can adjust year by year depending on where your tax brackets are going to fall. So, you don’t end up in other issues. And Kevin, don’t you dare talk about IRMAA today. That’s a topic for another podcast. I can see it on his face. He was dying to go there, people. I’m not letting him go there. We’re confusing people enough already. There are reasons in retirement that you want to keep an eye on your taxable income amount. How’s that?
Kevin Gaines: (31:51)
Although as a shameless plug, on AFMG’s YouTube channel, we do have a video talking about IRMAA and how Roth can help you avoid the… As a Medicare surcharge.
Stephanie McCullough: (32:03)
Yes.
Kevin Gaines: (32:03)
Enough said. Although again, shameless plug number two, when we in our previous podcast about Social Security-
Stephanie McCullough: (32:10)
Episode 15.
Kevin Gaines: (32:11)
… we talked about how you can pay tax on some of your Social Security benefits. People get trapped when they have to take these RMDs out of their traditional IRAs. Remember, with Roth IRAs, not only do you not have RMDs, but any money you take out is not considered taxable income, so it doesn’t count against those earning limits for any other government program. I am shutting up now, Stephanie. We’re skipping over those rabbit holes that I so want to go down.
Stephanie McCullough: (32:41)
If you want to talk about them in depth, give Kevin a call. He’ll be so excited. So, retirement. It’s good to have Roth money in retirement, but guess what? If we’re talking legacy and inheritance, your kids want that Roth money. So, if they’re looking at, “Okay. I could either inherit mom and dad’s regular IRA or their Roth IRA.” They want the Roth IRA. Tell them why, Kevin.
Kevin Gaines: (33:07)
Well, here’s the thing. So, remember what we said, you don’t have the RMDs if you’re the original owner of the Roth account, but if you inherit the Roth account, you still have to take an RMD. If you inherited it before 2020, you take it over your life expectancy. If you’ve inherited it more recently, you have a 10-year window to take it over, but you’re still not paying tax. You inherit a regular or you pass to your… Whoever; kids, grandkids, friends, nieces, nephews, a regular IRA, they’re going to have to pay income tax. And especially if they’re a higher earning tax bracket, they’re really not going to want this concentrated bulk of income on top of their regular salary or earnings, I should say, but the Roth, “Okay, it’s fine. I got to take it out and within 10 years. Fine. I’ll take it out within the 10 years. It’s not going to make a hill of beans difference.”
Stephanie McCullough: (33:59)
Right. Roth money, you own 100% of it. You pass it on to an heir, they own 100% of it. Uncle Sam owns 0%. So, they get more dollars, but also Kevin’s point about the timing, right? Because again, government program, government rules. When you inherit an IRA, and you can go back to our episode number 12 on IRA rules, you’ve got now… If someone passes away 2020 or later, they have to vacate, empty that IRA account within 10 years. If your people who are inheriting are in their prime earning years, they’re going to be in a higher bracket than maybe later in their life, and they’re going to be forced to take that money out in those high earning years. So, even more of a dilution from taxes.
Kevin Gaines: (34:46)
We don’t have the technologies set up at the moment, but we should probably set up a user poll since we have just done, what? Three plugs in the last five minutes. Do you want us to have a little bell as a sound effect each time we plug something else that we have done or about to record in the future?
Stephanie McCullough: (35:08)
Or each time Kevin goes too far down the rabbit hole, I should have a sound effect noise for that.
Kevin Gaines: (35:12)
That would have to be Elmer Fudd.
Stephanie McCullough: (35:15)
Oh yeah.
Kevin Gaines: (35:16)
Some Elmer Fudd quote for that-
Stephanie McCullough: (35:19)
Kill the rabbit?
Kevin Gaines: (35:22)
Kill the rabbit. Oh yeah. That screams Elmer Fudd right there.
Stephanie McCullough: (35:28)
I like it. I like it.
Kevin Gaines: (35:29)
There is one more advantage of Roth that I want to bring up as we get into legacy. It doesn’t have the most cheery name, but it’s called a deathbed conversion.
Stephanie McCullough: (35:36)
Ahhh!
Kevin Gaines: (35:36)
Yeah! Hey, there’s a silver lining everywhere if you look hard enough. If you’re going to have a larger estate, that’s going to put you into the cross hairs of the IRS with the estate tax. And this also will impact your estate taxes that you can do… Like I said, they call it a deathbed conversion just because the thing is, you no longer care about taxes if you’re about to die. You don’t care about your income tax. Then you convert your entire retirement account into a Roth. And that’s going to create possibly a very large tax bill depending on the size of your IRA. But here’s the advantage. That income tax-
Stephanie McCullough: (36:20)
Obligation.
Kevin Gaines: (36:21)
… obligation, thank you, was created before you died. Therefore, that payment of said tax is not included in your estate. You’re taking that money out of your estate. Say, you’ve got a $50 million IRA, why not? And that ends up creating a tax bill of five million, 10 million, whatever. That 10 million is out of your estate. So, now you’ve reduced your estate by $10 million, so you’re going to pay less tax or may even drop you below the-
Stephanie McCullough: (36:59)
Exemption.
Kevin Gaines: (37:00)
… exemption amount.
Stephanie McCullough: (37:01)
Yeah.
Kevin Gaines: (37:01)
And what’s estate tax? 40%?
Stephanie McCullough: (37:03)
Yeah. 40%.
Kevin Gaines: (37:04)
So, if you can get below that threshold, now you’re going to save 40%? Yeah.
Stephanie McCullough: (37:10)
We will do a future episode on gift and estate taxes. We’ll try to make it sound less dry than it actually is.
Kevin Gaines: (37:18)
And depressing.
Stephanie McCullough: (37:19)
I promise.
Kevin Gaines: (37:20)
Oh wait. Ding.
Stephanie McCullough: (37:24)
Yeah. So, all this stuff about Roth IRAs, hopefully we haven’t put you all to sleep by now, but one of the risks in retirement, one of the things that can come along to kind of blow up your planning is taxes, right? If tax rates do something different than expected. We always talk to our clients about, what are your priorities? What is most important to you? What are you trying to create? We’ve just laid out a bunch of different scenarios. We’re not recommending any particular one because it always depends on the client, on their goals and priorities and their situation, but if you decide that you might like to have some Roth dollars in your nest egg, so to speak, here’s the things to look at.
Stephanie McCullough: (38:08)
Number one. If you work at a place that has a retirement plan, a 401(k), 403(b), is there a Roth option in there? Can you swap your ongoing contributions from the pre-tax to the Roth? Your take-home pay will go down a bit because you’re paying more tax today, but you’ve already made that decision that that’s okay with you. So, that’s kind of the most painless way, would you say, Kevin, to start making contributions?
Kevin Gaines: (38:29)
Yeah, definitely the easiest way to get started.
Stephanie McCullough: (38:33)
You don’t have to go open a new account and figure all that stuff out. You don’t have to figure out if you’re below the income limits and all that stuff. So, that would be option number one. Option number two, if you still want to make some Roth contributions is, are you eligible to make ongoing contributions to a Roth IRA based on your earned income? So, you have to have earned income and then you have to be below the income limit. And then if you are, you can make a contribution each year up to a maximum of $6,000 in 2021. And then there’s a catch-up if you’re old like us and you’re over 50, you can do an extra $1,000, so $7,000 per year. So, that’s kind of option number two.
Stephanie McCullough: (39:10)
And then option number three, we would say, and we would kind of put them in this order. These are the things to investigate. Should you do some conversions? And this involves a conversation with your accountant, with your financial advisor, for sure. But if you’ve got a pot of money, either in your 401(k) or in your IRA, can you convert it to a Roth? How much should you convert and what year? What’s going to be the tax implications? There’s a lot of pieces to it. What does that five-year clock going to get you to in your life, right? But that’s kind of the other way of getting some money into a Roth bucket.
Kevin Gaines: (39:39)
And let me emphasize a point that you just made, Stephanie, that a lot of people overlook in the conversion conversation. If your plan allows for a Roth, you can convert. It doesn’t have to be just a straight contribution into your wallet. You can convert some of your existing dollars into a Roth. Typically, when people are talking Roth conversions, they’re thinking IRAs or that’s the subject, but 401(k)s are eligible for conversion.
Stephanie McCullough: (40:04)
Yes. Yep. And a lot of people are talking about, are tax rates going to go up soon? So, 2021 is not a bad year to be thinking about these things because we know what the tax rates are this year. Maybe they’re headed upward. Does it make sense to look if you have any room in your bracket to do some conversions at a relatively lower rate versus what you may be facing in the future?
Kevin Gaines: (40:28)
Right. It’s the old cliche about the devil you know that’s coming to mind. That’s indeed this particular point that we’re discussing here. And yet another quick aside, you see the Roth that we’re talking about Roths, a lot of people have heard the phrase mega backdoor Roth conversions. We’re not covering that here. Again, there’s the mother of all rabbit holes when it comes to Roths is having those conversations. There are strategies and tricks or whatever you want to call them that you can work with, but this, we’re not covering. In fact, Stephanie, just rolled her eyes the moment I said the word “backdoor”.
Stephanie McCullough: (41:09)
Not that it’s not a valuable thing. And Kevin does have a video on this as well, which we’ll link to in the show notes for some more details about that. Yeah. That is another way you can get money into a Roth, even if you’re over the income limit. So, like I said, we’re already out of time. Hopefully, you’re still awake. If you are, will you send us a note? Will you let us know? Was this entirely too dry for your liking? Or was this useful information? We would love to hear from you. Please check us out, takebackretirement.com or our various websites which will be linked to in the show notes. I think that’s all for now. Thanks for being with us. We’ll talk to you next time. It’s goodbye from me…
Kevin Gaines: (41:45)
And it’s goodbye from her.
Stephanie McCullough: (41:48)
Be sure to subscribe to the show and please share it with your friends. Show notes and more information available at takebackretirement.com. Huge thanks for the original music by the one and only, Raymond Loewy through New Math in New York. See you next time.
Disclaimer: (42:03)
Investment advice offered through Private Advisor Group LLC, a registered investment advisor. Private Advisor Group, American Financial Management Group, and Sofia Financial are separate entities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. This information is not intended to be substitute for individualized tax advice. Please consult your tax advisor regarding your specific situation.