Mini-course: Tax Free Roth Strategies

Video Transcript:

Hi folks, it’s Dr. Jeff Camarda, and welcome to my precise guidance on how to wisely convert your taxable IRAs, 401(k)s, TSPs, 403(b)s, what have you, into tax-free Roth accounts. I’m sure you all know the value of that, but the devil is in the details, right?

So I’ve got a couple of programs. I’m going to go through one I call “Roth-ize,” which is a fairly detailed process. My favorite quote about Roth-ize is my own: Roth-ize is the art of using tax arbitrage to convert tax liability in 401(k)s to tax-free retirement income at zero or low tax cost.

And I know you find that very exciting. Roth accounts are tax-free. Traditional retirement accounts—IRAs and so forth, pre-tax accounts—create additional taxable income when you pull the money out, whether you pull it out now or are forced to pull it out through required minimum distributions. Conversions before claiming Social Security can give you more flexibility and save tax on Social Security, plus avoid other problems.

Besides tax on withdrawals, higher total income increases brackets, may reduce deductions, and negatively impact taxation and benefits on Social Security and Medicare. So this is a really complicated game to get right. If you just take a slug of IRA and convert it, and then wait until April to see what the taxes are, it could be devastating—a really bad move.

Converting to Roths tax-efficiently, however, is like creating wealth for free or supercharging investment returns. Avoiding avoidable taxes and turning them into family wealth is like pulling free money out of the air. And remember, future tax policy is pretty likely, regardless of your political affiliation. Under most scenarios, taxes in this country almost certainly need to go up.

So what’s the Roth-ize process, which we do through our affiliate TaxMaster—or maybe you can follow at home or guide your tax preparer? I want to caution you: you need to use a sophisticated tax preparer. These are really complicated calculations and require a deep knowledge of tax law.

Conversions before claiming Social Security again give you more flexibility. Once you start Social Security, you really can’t change that. Done right, this is a multi-year strategy. There are many variables that keep changing year after year, including the law. So think of it as a series of games that you want to play and win each year, rather than one big game. You probably have more flexibility than you or your tax advisor know. So learn what your options are, and use them to your advantage to grow your wealth and avoid taxes. Properly executed, again, it’s like pulling money out of thin air. Tax saved literally is wealth earned.

Conversion later in your life, when various numbers are more certain and safer—when you have more clarity on tax rates, Social Security, pensions, and so forth—typically is safer. And remember the 5-year rule: it’s not tax-free until 5 years after the first Roth contribution or conversion.

So these are my best practices. The Roth beneficiary rules for beneficiaries using trusts require special flexible spending provisions to avoid tax blunders. Spouses of the beneficiary step into your shoes with unlimited tax treatment. But if it goes into a trust without the right provisions, it will accelerate taxation and could backfire. Unlike taxable IRAs, it appears that other beneficiaries can wait 10 years before the first required minimum distribution.

So again, this is best executed with guidance. These are the kind of steps that we go through for our tax clients at TaxMaster, and I advise that you go through with an enlightened tax preparer. You really want somebody who cares about saving you taxes and is well educated on tax law, because there are a lot of moving parts.

It’s a long-term strategy, evaluated annually when conditions are favorable. Some years you don’t want to do it—you just pass on playing the game. Repeat each year until all accounts are completely converted.

The first thing is decide your acceptable conversion tax bracket. For example: “I will pay 25% of taxes and no more,” or 21%, whatever it is. You know what you’re willing to pay.

Remember, IRAs and other tax-deferred accounts have a lien equal to your tax bracket. If you’re in a 40% bracket and have a million dollars in that account, you only own $600,000. The other $400,000 belongs to the IRS. Think of it that way, and minimize the tax bracket to minimize the lien.

Next, estimate your baseline non-adjustable income: salary, Social Security payments, pensions, annuities, and so forth. You don’t have any wiggle room on that. Then look at your variable income to minimize it and look for opportunities to convert to Roths when you don’t have a lot of other income that year.

So what can you defer? Can you defer a W-2? Can you reduce that, switch to 1099, take more money next year instead of this year? Do you have businesses where you can control profitability somewhat? Capital gains? Have you not yet claimed Social Security or pensions? There are a number of variables.

Then estimate potential deductions: business losses, net operating loss carry-forwards, Section 179 accelerated depreciation, bonus depreciation, missed or unclaimed business expenses, home office costs, cost-segregation depreciation. There are a lot of variables.

The objective is to minimize your variable income in a year and maximize potential deductions to drive taxable income down. Then when you add conversion of IRAs to Roth to the mix, increasing your income, it happens at a more favorable bracket.

Do pro-forma taxes on your 1040. Load your tax software. Look at: (1) deductions including income, (2) excluding variable income, (3) maximizing deductions, and (4) estimating additional recognizable income to maximize or clear the target bracket. Convert slightly less than that to Roth.

What does that actually mean? Say that after all adjustments, your minimum income with deductions and business losses and not claiming Social Security and deferring W-2 to next year is down to $40,000. And you’ve got $30,000 left in your acceptable bracket. So you can go to $70,000 and still stay in an acceptable bracket. That’s additional recognizable income. Instead of doing $30,000 and accidentally kicking over $70,000, maybe you do $25,000. That’s the logic.

For risk-based assets—stocks that go up and down—convert those that have dropped in value to leverage tax savings. If you’ve got an IRA stock that’s gone way down but you still believe in it and want to hang on to it, that’s a good candidate to convert at the lower value. You pay tax on a lower conversion value, and hopefully it pops back up tax-free.

And again, repeat in subsequent years until conversion is complete.

I realize that got really technical really fast. There are a lot of moving parts to this, and you want to make sure you get it right to optimize the Roth conversion strategy. Done well, this can be magic, especially if you have some variability.

If you’d like to do it with us and walk through, without charge, a pro-forma Roth conversion procedure to give you insight into how to do it yourself with your tax preparer, go ahead and respond. We’ll be happy to talk to you and see if we can help you out.

Thanks so much for watching. Till next time, this is Dr. Jeff Camarda.