Teaching Tax Flow: The Podcast

0:00:04 Intro: Welcome to the Teaching Tax Flow podcast. Where the goal is to empower and educate you to legally and ethically. Minimize taxes paid over your lifetime.

0:00:10 John Tripolsky: Welcome back to the podcast, everybody. Today, episode 67. We are going to jump directly into those Roth can conversions. So we’re going to get into the explanations, definitions, comparisons, and some tips and tricks. But before we do that, as always, let’s take a brief moment and thank our episode sponsor.

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0:00:55 John Tripolsky: Hey everybody. Welcome back to the Teaching Tax Flow podcast. Regardless how you got here, we’re happy to see you or hear you, or you hear us. So today’s topic, as mentioned, we’re going to dive into Roth IRA conversions. Now that’s Roth conversions, not Ross conversions for you friends, fans out there from the tv sitcoms. So get your head out of the gutter.

0:01:27 John Tripolsky: Let’s talk these Roth IRa conversions with none other than Chris Picuro. What’s happening, buddy?

0:01:34 Chris Picciurro: How are you?

0:01:35 John Tripolsky: I’m doing good, man. I’m jazzed up for this one. Good topic. I don’t think we’ve ever touched on, really, in the existence of the podcast. So maybe best place to start with this one. Just give us a little definition. What exactly is a Roth IRA? And then we’ll talk about converting these little puppies.

0:01:54 Chris Picciurro: Yes, Roth Iras and Roth conversions have become much more popular with the Tax Cuts and Jobs act of 2017. The reason for that is that we are in the golden era of tax, in my opinion. So we have the lowest marginal tax rates that we’ve seen, at least in my practicing lifetime, which is over 20 years and quite frankly, the foreseeable future. Now, a Roth IRa or a Roth retirement account. So let’s broaden that scope.

0:02:23 Chris Picciurro: A Roth retirement account is similar to an IRA or 401K in so fact that the account itself is geared towards retirement. The big difference is that with an IRA or a 401, when you contribute money into that account, you receive a deduction on your tax return. So that money is going in what we call free tax. That money is growing within the account, tax deferred. So if you put in $1,000 today and that becomes worth $4,000 in the future, that growth of $3,000 is not being taxed as it grows.

0:03:04 Chris Picciurro: With a Roth IRA, it’s a little different. Or with a traditional IRA or normal 401K plan. Let’s use my example of you put $1,000 in. When you take that $4,000 out, great, you just quadrupled your money, yet that’s all taxable. It is all taxable at whatever your marginal tax rate is, the year you take it out. And for many people, that could be a sneaky high number, because in general, that money comes out at 59 and a half years old or later in life. Again, there are some exceptions.

0:03:45 Chris Picciurro: Yet you might be drawing Social Security, which could be taxable. You could have pensions, et cetera, et cetera. So that’s the traditional or the noble 401K. Here’s how Roth differs. Roth, you put the money in, you do not get a deduction for it. Today, you put the $1,000 in, the $1,000 grows to $4,000. Yay. No tax. It’s still tax deferred. But the trick is when you take the money out as a distribution, it’s tax free, as long as they qualify distribution.

0:04:21 Chris Picciurro: So that is attractive, obviously. And that’s why Roth iras have become more popular, because we feel like marginal tax rates in general are going to go up. It’s been very popular because a lot of business owners and real estate investors have had less taxable income. Because even though they might be making cash flow, one of the three laws of teaching tax flow is cash flow and tax flow are not the same thing.

0:04:48 Chris Picciurro: But they might have a positive cash flow, but they may have used like a cost segregation study or some type of bonus depreciation to reduce their taxable income. So in that case, oh, my taxable income is pretty low this year. I want to put money into the Roth. So that’s the difference between a Roth retirement account in a traditional retirement account, you could say Roth Ira. Traditional IRA. There are Roth components to many employer sponsored retirement accounts, like 403 B’s, 401k plans, 457 plans, depending on where you work.

0:05:22 Chris Picciurro: But that’s a 30,000 foot view of the Roth. I will say this in my example. You would say, well, that’s a no brainer. Just put the money into a Roth. That being said, if you’re in the 20% marginal tax bracket, you’ve got to think about if I put $1,000 in a traditional IRA and it grew to 4000, the equivalent of that is only $800 into the Roth. And if that $800 quadruple, what would you rather have $4,000, but you’re going to pay tax on all of it when you take it out, or $3,200 and you don’t pay tax on it at all.

0:05:58 Chris Picciurro: That’s the 30,000 foot view difference between the Roth retirement account and a traditional retirement account. The assets that you own in those accounts is a common question we get in our private Facebook group. Defeating taxes and just in the teaching taxable community is if you want to own ABC mutual fund or I want to do a self directed accountant, buy a piece of vacant land on speculation, you can still do that in a Roth and a traditional.

0:06:26 Chris Picciurro: Think about the IRA. The Roth or traditional as the right. That’s the bread. Rather, what you put in the bread to make a sandwich can be the same. There are just different types of sandwiches, different buckets. A lot of financial advisors talk about buckets that you’re putting money into.

0:06:45 John Tripolsky: And then really just to clarify for our listeners, too, so if we’re looking at, we’ll say traditional versus roth a little bit. So we’ll just use any figure. We’ll say $10,000. So if you put 10,000 into a traditional, it’s tax deferred. You’re not paying until you take everything out at the end or whatever the distribution is at the end. So let’s just make the terrible assumption that taxes don’t increase, they don’t decrease, they stay stagnant. So if we did that, you’re paying tax on the growth of it all at the end versus Roth, you’re paying on what’s going into it initially.

0:07:23 John Tripolsky: So, as you know, every situation is completely different. But is that probably an easy way to compare?

0:07:30 Chris Picciurro: Yes, that’s a very good way to think about it. The Roth gives you more control because one thing to consider, and we’re going to dive deeper in, in a future podcast episode in the near future. Yes. Spoiler alert. So stay subscribed. The traditional IRAs do come with some concept called rmDs. We touched on that a little bit when we were talking about the charitable giving but required minimum distributions. So at some point someone might say, well, I don’t need this money. I’m just going to let it grow until I pass away.

0:08:03 Chris Picciurro: Well, one, your beneficiaries are going to pay tax on it if it’s a traditional IRA, when they inherit it and they take the money out. And two, at some point in your early 70s, depending on the year you were born, the government will force you to take money out of the IRA and pay tax on it. So you do lose a little control. Now, that’s the difference between the Roth and traditional. We’re going to talk now about the Roth. How do you get money into the Roth?

0:08:31 Chris Picciurro: Because unfortunately, the Roth IRA. So individual retirement account comes with some restrictions, which are all indexed for inflation. But the Roth comes with some restrictions on contributions, meaning I’m putting new money into that account based on your income. So if your income is too high, based on your income and filing status, you might be limited in being able to put money into that account.

0:09:04 Chris Picciurro: Also, for a lot of taxpayers, and there’s special rules, if you’re over the age of 50, there’s things called catch up contributions. And again, Roth contributions are going to be a completely different show than Roth conversions. But I’m just letting everyone know that a Roth contribution could be limited by your income. Could be limited by your income plus your filing status. In other words, another factor could be, do you or your spouse, are you covered with an employer sponsored plan on the Roth ira? Now, a Roth 401K, for some reason, does not have an income restriction. So we run into clients that say, I work at XYZ, big corporation.

0:09:43 Chris Picciurro: Man, I would love to contribute to my Roth Ira, but I make too much money. Well, do you have a Roth four and 101k? Yeah, I do. Well, guess what? For some reason, there’s no income limitation. So contribute to your Roth 401K. Awesome.

0:09:59 John Tripolsky: And then, Chris, if I remember right, too, going off memory before we get into the conversion side of it. So a Roth carries with it usually, if not all the time.

0:10:07 Chris Picciurro: Right?

0:10:08 John Tripolsky: I believe it’s called the five year rule. And that has to do with basically any withdrawals from a Roth within five years of the initial deposit, if we will. So that’s kind of question a. And then as we jump into conversions, does that also apply to a conversion within that five?

0:10:26 Chris Picciurro: John, you’re. Wow, you actually listened to somebody at some point about. Yeah, so a couple of things. Let’s talk about Roth contributions. There is not a five year rule on Roth contributions. They could be distributed immediately. And actually, the nice thing about Roth contributions is that you could always take out the contribution portion of your Roth tax free. So let me paint a picture, John. You’re a responsible parent. Well, at least you play one on tv. Your wife’s very responsible, as we know.

0:11:00 John Tripolsky: Touche.

0:11:01 Chris Picciurro: So, hopefully very true. And we know Stacey and Holly don’t listen to these podcasts unless we tell them, hey, don’t listen to this episode. And then they will beeline it to.

0:11:09 John Tripolsky: The we give them the highlights reel of all the great things we say about them. We condense.

0:11:13 Chris Picciurro: Yeah. Stacy is much more responsible when it comes to parenting. At least that’s my opinion, anyway. Not that you’re great. No, you’re great. But let’s say you set up a Roth Ira and you’ve contributed $20,000 over the years, and it’s grown to 40. Well, let’s say your daughter decides that she wants to be a Michigan state spartan. I don’t know if that would go well in your household, but that’s all right.

0:11:38 John Tripolsky: I don’t want to find out. Actually, I think we’ll be all right either way.

0:11:42 Chris Picciurro: Is it good? So, at that point, even though the Roth is up to 40,000 of value, you could take 20 grand out, which is what your original contributions are, tax free from the Roth IRA account. And the rest of the 20, there would be penalties if you took that out, but that can continue to grow tax deferred and be tax free to you when you take it as a qualified distribution. So that kind of hits on that five year rule. But great pointing out the five year rule, the five year rule says, is to qualify for tax free withdrawals of converted amounts and earnings, the Roth IRA must be open for at least five years, and each conversion has a five year rule, as well. So, for instance, if I convert on June 1, 2024, Roth money to my Roth IRA, that money will be available.

0:12:38 Chris Picciurro: So, typically, that five year rule starts ticking January 1 of the year of the conversion. So January 1, 2029, I can now take that money out, assuming I’m 59 years or older or have a qualified distribution. So the point is, Roth conversions, once that money goes into, once the money is converted from another retirement account, which we’re going to explain that in a moment, it’s got to stay in there for five years. The five year clock will start ticking the first day of the year. So it’s not like, oh, you did it June 1. It’s got to be June 1. No, it’s going to be that first day of the year.

0:13:14 Chris Picciurro: So that’s something to consider. Each conversion has an autonomous five year rule, if that makes sense.

0:13:24 John Tripolsky: And then really, with those conversions, too, I mean, are we talking a. What is a conversion? A little bit. And then, really, we kind of know why somebody would want to do it based off of what we’re just discussing. But then what would be the purpose, we should say for there to be more than one conversion? Like you mentioned, that five year role restarts. What are some scenarios where that may be the case.

0:13:51 Chris Picciurro: Well, you know, John, in teaching taxflow, right, we’ve got a four step process. Diagnose, prescribe, IQ test, implement. So what that means is that when does it make sense to make a Roth conversion? It makes sense if you are a green diagnosis, meaning you’re to lower marginal tax rate than you, than 25% in general, or you think your marginal tax rate is going to be significantly higher in the future than it is right now.

0:14:21 Chris Picciurro: And that could be based on your income, your assets, or what you think is going to happen with tax law. Two, you are a gold diagnosis. We believe in the gold diagnosis, and that means you’re looking for tax free income and growth. And you could typically be two of our four diagnosis at any time. Side note, if you’re wondering, what the heck’s green gold or red green? Purple gold. Good. That means you just started listening to the show.

0:14:48 Chris Picciurro: Please go back and we have episodes on each of the color coded diagnosis, or jump in our community and we’ll talk to you about that. But green means lower marginal tax rate or expected higher marginal tax rate in the future, and then gold, tax free income and growth. So when you’re one of those two diagnosis, that’s when a Roth conversion starts making sense. What is a Roth conversion? Well, what a Roth conversion does is it takes money in your retirement account. That’s pretax. So that could be an IRA.

0:15:15 Chris Picciurro: Four hundred and one k, four fifty seven plan, and moves it to a Roth account. So, John, let’s say you had $10,000 in your traditional IRA, and you thought, well, I’m going to win the lotto in two years. So I’m going to have a lot of assets, a lot of income, and I want to get that into my Roth so it grows tax free. You could then take the 10,000 and convert it from that traditional IRA to a Roth. That means that the money doesn’t come into your pocket. You’re working with a financial advisor or a financial institution to, say, convert that $10,000 to a Roth.

0:15:52 Chris Picciurro: That $10,000 will be taxable in the year you did the conversion. Now, the good news is there’s no 10% early distribution penalty. There are some penalties for taking money out of retirement accounts early. You’re exempt from that. So if your tax rate today, John’s 12%, and it’s for whatever reason, let’s say, who knows? You could have sold a rental property at a $200,000 loss. So you made a mistake. So you have little taxable income. That’s when you’d say, all right, let’s convert, let’s convert that money to a Roth. Now that $10,000 and you’re a young guy is going to grow tax free.

0:16:34 Chris Picciurro: So let’s use a real example. Let’s say you’re in a 20% marginal tax bracket. You convert $10,000 from a traditional IRA to a Roth IRA, it’s going to cost you $2,000. That’s gone. But if that $10,000 doubles four times before you retire, that would be 1020 40, 8160 thousand dollars tax free. And you could take that out for medical expenses or home improvements or travel or whatever the heck you want at that point. So that’s why the Roth IRA conversion is very popular. The scenario one is when it’s popular if you have a taxpayer in a very low marginal tax bracket temporarily.

0:17:17 Chris Picciurro: Let me use one quick example that is very popular for a lot of people. You have someone that’s worked in corporate America for 30 years. They’re relatively young. Let’s say they’re 61 years old, and they get a buyout and they’re going to be retired. They’re not going to have full time employment. They’re going to not draw Social Security yet. And let’s say they have a lot of assets accumulated. I can live on my savings for two years pretty easily, not taking money out of my, can not worry about tabing my pension.

0:17:54 Chris Picciurro: I’m going to take some of that money in the, convert it to a Roth. So what we do with a lot of early retirees or younger retirees is we look at their marginal tax rates and we try to figure out how much income could they still absorb in that 12% marginal tax bracket and convert that to a Roth.

0:18:13 John Tripolsky: And then we mentioned too, multiple times a little bit earlier on, and then just a moment ago, too, talking about penalties. So, without going into a lot of detail on it, I mean, are these something that are kind of standard penalties for specific actions? Is this something that is the IRS saying, nope, we’re going to act on these penalties that are out there because we don’t want you taking the money now. It’s obviously for future use.

0:18:39 John Tripolsky: Who really, we should say, decides on what those penalties are as well as kind of a question looking back, have those changed over the years with everything that’s happened, Covid, et cetera, have those changed or have those always kind of been in place for that same purpose?

0:18:56 Chris Picciurro: Well, you hit on another law, teaching tax agencies are involuntary business parties so the Congress really sets what the penalty is in general. And this has been like this for a long time, at least as long as I’ve practiced. If you make an early distribution from a retirement account, meaning in those rules are vast. Right. But let’s just use iras. If, let’s say it’s a traditional IRA and you’re under the age of 59 and a half, and you take money out of it, you pay tax on that and a 10% early distribution penalty, that could happen with a Roth as well. It could be. You could be penalized. There are some exceptions to the penalties, but the rule of thumb is going to be 10%.

0:19:40 Chris Picciurro: Again, there are some exceptions. There’s a form 53 29 if you really want to get fancy and check out all the exceptions. There was a special provision during the pandemic that you were able to take money out of retirement account and spread that income over three years. That was in 2020, and you wouldn’t be subject to the 10% penalty. So if someone was self employed or let’s say someone got downsized and they had money in their retirement account, they could take that out up to $100,000 and spread the income over three years.

0:20:13 Chris Picciurro: They also could pay it back. We had several taxpayers take the money, invest it, then pay it back. But that’s a once in a generation situation like that. Hopefully we don’t have another huge pandemic and we don’t have a need to have those special situations. I do want to start wrapping up with one other situation, that the Roth Conversion makes a lot of sense. Unlike Roth contributions, Roth conversions don’t have an income threshold.

0:20:43 Chris Picciurro: So let’s say someone is self employed. They have maybe a simple IRA plan or something at their job, but it’s very limited what they could put into the retirement accounts. There is no limit on Roth conversions. You can convert as much Roth as you want, no matter what your income is. So for that, those taxpayers, a lot of times they like to do the Roth conversions, and we like to pair the Roth conversions, just like a fine wine and cheese, with other tax advantaged strategies. So if you’ve got someone, let’s say that we add Heidi on Heidi Henderson from ETS.

0:21:26 Chris Picciurro: Let’s say we have a taxpayer that has $300,000 worth of income. They invest in real estate, and they have a $400,000 deduction from a cost segregation study. Now, they have a minus $100,000 of net income. Let’s convert the Roth. So let’s say you have very little income, or let’s say you’re phased out of Roth contributions. That’s where Roth conversions can make a lot of sense. And this is an implementation tool that we use very frequently, but typically the last month of the year. Because what we’re trying to do is we’re trying to really stay in a certain marginal tax rate situation.

0:22:05 Chris Picciurro: But, yeah, it’s a real powerful tool. One more thing I’m going to mention. So let’s look at a fact pattern where you’ve got a married couple. Let’s say their income is $400,000. They put money into a 401, but they want to start putting money into their Roth. They make too much money to put money into a Roth IRA. They could do something called a backdoor Roth conversion. Now, again, don’t try this at home, if you make sure that you work with a professional. But what happens is you make a non deductible traditional IRA contribution and you immediately convert that to a Roth.

0:22:47 Chris Picciurro: Essentially, you’ve been able to put the money into a Roth IRA and work around the income limitations. And I want to repeat myself, this is a really good strategy we use with a lot of people in the teaching tax flow community, but let’s make sure we’re working with the proper team, our proper board of directors, as we like to say. But, yeah, so really, the Roth conversion is a tool that we see taxpayers at all ages using, at all income levels using.

0:23:16 Chris Picciurro: It just comes down to, let’s diagnose you. Let’s look at this as a potential prescription. Let’s make sure it makes sense for you. Johnny made a great point. If someone’s a pre or early retiree and they’re 62, we have to keep in mind the five year clock. But also we keep in mind that any money they put into the Roth or convert to the Roth won’t be subject to those required minimum distributions. So that’s why this is a great tool.

0:23:44 Chris Picciurro: And we wanted to do this episode because it applies to many different income levels, many different ages, many different situations.

0:23:50 John Tripolsky: Excellent, as always. And to put out the disclaimer out there that no financial advisors or tax professionals were injured during the making of this podcast that we know of. However, Chris, you did answer my last and final question for you. Obviously, last and final being the same thing, if somebody did have more questions on this, obviously there’s an abundance of resources out there. We have information within the teaching tax flow community and the ecosystem as a whole.

0:24:18 John Tripolsky: But you also did mention that the backdoor conversion is not a DIY or suggested as a DIY. Attempt just a conversion in general, is that ever something that somebody can do on their own? Obviously, it’s always best to consult a professional, but is that something that could be an option?

0:24:36 Chris Picciurro: DIY, you could, yes, you could do a Roth conversion on your own. It’s just when you start doing the backdoor Roth conversion, you definitely want to work with somebody. Definitely. Because there’s a lot of paperwork, a lot of timing issues. You could have unintended consequences if you so, but you could convert. What you’re going to want help with, at a minimum, is someone to talk to about how much to convert and come up with that strategy.

0:25:07 Chris Picciurro: Because there’s a lot of things, John, there’s a lot of things that get fake. We’ve talked about marginal tax rates, how marginal tax rates are different than tax brackets. So what if you convert an extra $500 and now you’re phased out of your entire child tax credit, or you’re phased out of the continuing education credit. You have one child in college and now you just phased yourself out of a $2,500 credit.

0:25:29 Chris Picciurro: So definitely work with someone on calculating that amount. If you want to execute it on your own, at least a simple conversion, then you can. And now you can convert money from 401 ks, 557. It doesn’t have to be just a Roth IRA. So a lot of opportunities out there.

0:25:45 John Tripolsky: And that’s a great place to close at, too. Chris, you mentioned a couple of things there. A couple of examples you mentioned about phasing out a lot of taxpayers. I’d probably say 99.99% of them probably don’t know what those limitations are or issues like that. And that’s why you guys are obviously tax pros and financial pros. So let’s close out on that. We don’t want to get too far into the weeds on some other stuff. I know we can always go on this forever and ever, but as we mentioned, teaching tax flow is your place to jump into if you have not done so yet.

0:26:15 John Tripolsky: Plenty of resources, plenty of contacts. We’re always here to reach out. So new topic coming up next week, completely unrelated to this, but somehow tied in. So until then, as we always like to say in my radio voice, same time, same place next week back here on the teaching Taxable podcast. Have a great week, everybody. Thanks for hanging out with us here on this episode with Chris and myself diving into those Roth conversions, definitions, implementations, et cetera.

0:26:54 John Tripolsky: So as we always like to mention here at teaching tax flow, there are opportunities out there, as Chris had mentioned multiple times, to really defeat taxes. That’s right. That’s something we talk about every once in a while. Defeating taxes. That’s actually the name of our private Facebook group, defeating taxes. Be sure to join that. And Chris mentioned something really interesting to me right out of the gate in this show. He referred to it for currently current time as the golden era of I believe it was one of the first things he said in there. So I want you to think about that as we really do these episodes on a weekly basis.

0:27:32 John Tripolsky: And the reason being is that a lot of the information we give you, it’s not a secret, it’s not something that we just made up, and we’re doing it for clients and recommending that everybody does this. It’s not that at all. In fact, we are basically just outlining and simplifying these tidbits or these little knowledge nuggets, if we will, on how you can really own your tax situation. So really taking the mystery, a lot of the worry, if we can, out of taxes and really just putting the ball in your court as far as for owning that relationship with the IRS. So a lot of us are bred and raised to kind of fear the IRS in a sense, thinking that they walk around with firearms and badges and they’re going to come lock. Yep, sure, Al Capone had a different experience.

0:28:20 John Tripolsky: Hopefully you guys don’t experience the same. But again, our goal here is really just to simplify and get as much knowledge as we can in front of you to consume and do with it as you will. We always mention as well, you really lean on your order directors. It’s another show we’ve done earlier on. We reference a good bit, but really your tax professionals or if you are a DIY individual when it comes to taxes, our goal is to really make you the smartest Diyer out there.

0:28:52 John Tripolsky: So think of us as your tax professional. So enough about this one. I know I went on a little bit of a tangent here, but all with good intention. So we will see everybody back here next week. Little teaser, we are actually going to talk about the IRS, so be sure to subscribe to the podcast if you haven’t yet, and we’ll see you right back here next week.

0:29:17 Disclaimer: The content provided is for educational purposes only. We encourage you to seek personalized investment advice from your financial professional. For all tax and legal advice, please consult your CPA or attorney. Investment advisory services are offered through Cabin Advisors, a registered investment advisor. Securities are offered through Cabin Securities, a registered broker dealer. The content of this podcast does not constitute an offer of securities offerings can only be made through an offering memorandum, and you should carefully examine the risk factors and other information containing the memorandum.