When the Roth IRA was created in 1997, it was a small footnote in the world of Pensions and 401(k)s. Fast forward 25 years, and the Roth is on everyone’s mind. The big question: Should I convert my Traditional IRA to a Roth?
There are 4 main questions to ask yourself about conversion. First, when will you need the money? The second involves taxes. Should you convert all at once or spread the conversion over a few years? And, finally, what strategies for Roth IRAs are available.
During this discussion, Tom Gibson, CPA, and David Babinski, a Business Consultant and member of your Family Office Team, examine:
David Babinski: My name is David Babinski, a member of your family office, and I was glad to be invited to this presentation. I’m joined by Tom Gibson, CPA. Tom and I have been working for several years now with clients talking about Roth IRAs, multi-generational wealth creation, and tax-free compounding. After several webinars in a row about potential tax changes, we thought we would join forces and give a nice, consolidated presentation about some of these strategies and do a little bit of a deeper dive. Good morning, Tom. Welcome.
Tom Gibson: Good morning, David.
Babinski: For the next hour or so, we are going to be combining multiple strategies together and taking that year-over-year tax savings and starting to compound it into what we call the TSP effect or the multiplier effect. We will do a quick overview of retirement accounts in general, and then we’re going to peel back the layers on how some of these strategies work.
But I think one of the things that is pressing in on everyone’s mind is the stimulus just passed. Tom, give us a little take on how you see what is happening in Washington and then let’s dive in from there.
Gibson: Congress, after a number of months of doing nothing – and yet another round of COVID-19 relief – at the beginning of this week, finally passed a $1.9 trillion bill. A lot of what was in that bill were just extensions and things from the previous COVID bill. For example, business meals that are purchased in or through a restaurant are 100% deductible now through the end of 2022. Another one that I know all of you all been wondering about: If you bought a racehorse off Amazon while you were locked up, you can depreciate that over three years. So, a lot of things that seem kind of superfluous.
But the one thing that did come out of all of this, if you have spoken to either David or me in the last six months, our expectation is, over the long term, that tax rates are going to rise and that the expected increase in tax rates is really the driving force behind the idea of Roth conversion.
People say, “Well, Tom, how do you know that the tax rates are going to rise?” For one thing, taking this most recent bill into account, over roughly the last 12 months, in inflation-adjusted dollars, the United States has spent more fighting COVID by about 20% than we spent on fighting the Second World War, which lasted four years. After the First World War, the Second World War, the Korean War, we saw the highest tax rates that we have ever seen in the history of this country. Given the makeup of Congress, I can’t think of any reason why we’re not going to go back to higher tax rates.
Now, what does higher mean? Does it mean the 39.6% rates of the Obama administration? I think that’s the best we can hope for. There are folks out there who are calling for significantly higher marginal tax rates for the top bracket. Representatives Ocasio-Cortez and Jan Schakowsky from Illinois have a piece of legislation that’s calling for a 59% top bracket. So, I don’t have any doubt that the rate’s going to be going up. It’s just a question not of when, but of how much.
At this point people always want to have an update on the tax bill and really, we don’t have anything. It’s still proposals. We don’t have legislation to analyze at this point. And so, we’re not going to take up a lot of time with it. I will say, the later in the year that Congress passes the bill, the more likely it is that it will take effect January 1st of 2022, which means there will be a lot of things we can do between now and the end of the year to get ready for that. And certainly, one of the things that’s high on the list for those of you who’ve been working with us since at least 2018 has been this entire issue of Roth conversions.
Babinski: Looking at all the different proposals and even back during the campaign, one thing of note is I didn’t pick up anything about the Roth being adjusted or changed or manipulated in any way.
Gibson: No. There is nothing about doing away with the ability to do a Roth conversion at this point. Part of the Tax Cut and Jobs Act, which passed at the end of 2017, Roth conversions have always been theoretically possible, but like direct contributions to Roth, there were income limits associated with the ability to do those conversions. The Tax Cut and Jobs Act took away the income limitations on conversions, not on direct contributions. Most of our clients are not able to directly contribute to a Roth IRA because their income is too high. But this does give us the opportunity, at least for the foreseeable future – and we’ve not seen anything to lead us to believe at this point that it’s going to change, the ability to take money that’s currently in SEPs, traditional IRAs, 401(k) plans, defined benefit plans, and roll that into a Roth IRA. There are obviously tax consequences now – but we’ll, I’m sure, talk a little bit about why – looking at what the consequences are now may be much, much better than what the consequences would be further down the line.
Babinski: I think this is a good place to take a step back and look at the differences between what we always call traditional retirement accounts and then compare and contrast it to the Roth, so everybody knows where we’re heading.
We talk about traditional IRAs all the time. The one thing I like to remind people is when the Roth legislation came out in 1997, there were strict limitations. And what we forget as the tax code has evolved is the highest tax bracket, 39.6%, which we’ve been flirting with over these last couple of years and is slated to go back, but the marginal bracket started at $135,000. When they limited Roth, you couldn’t make a Roth contribution if you were above a certain level. That was really for people in the highest tax bracket. They didn’t want to allow it.
Now what we have to realize is, even though the highest marginal tax bracket is 37% and it doesn’t sound like that much less, it doesn’t kick in until you’re over $622,000 if you’re married filing joint. We have these massive opportunities. The headline doesn’t say, “Tax rates from 39% to 37%.” But the amount of money that you can convert and move around and fool with before you even get to that is so much greater. That’s why we’re banging the drum on these Roth conversions because we have this perfect storm. They took away the income limit. Even when we could convert it, if someone had a low year, the conversion itself counted towards the income limitation. We were doing $4,800 conversions, $3,700, just to get you right to the line. Now the sky’s the limit and it is becoming more mainstream. It was a footnote in the tax code because it was not very widely used or available, I should say. Now the doors are wide open. We should be jumping through there.
Tom, do you want to mention how a CPA sees a traditional IRA, where it fits, and how now the Roth might be a better option, especially for people who have access to some of our other strategies?
Gibson: Sure, absolutely. The pension industry has done a wonderful job of selling folks on the wisdom of deferring tax or, a better way to put it in a way that David refers to it that I think is a lot more accurate is, not deferring. It’s postponing. Postponing is a more accurate way of describing what’s going to happen.
When IRAs and 401(k)s came into the tax code, the idea of course was to put money into a retirement vehicle, SEPs as well, and get a tax deduction right now for the contribution that made to the plan. The money would grow tax-free, and then, at retirement, be in a lower tax bracket. When my original contribution plus all that growth that has occurred in the intervening years starts to come out in retirement, I’m going to be in a lower tax bracket because I’m going to be living on so much less. And that really is the two bets that you’re making with any type of tax deferred or tax postponed retirement arrangement.
One, you’re betting that your expenses in retirement are going to be less than they are now. Therefore, you’re going to be able to live on less. Well, there’s a certain amount of truth to that. Your kids are going to be through college. Your house is probably going to be paid for. And in theory, yes, it would probably take less money to cover your monthly required living expenses. The problem is you’ve worked for 20, 30, 40 years. No, I don’t have college tuition anymore, but you know what? I’ve always wanted to go to Scotland. And your house is paid for, and you start thinking, “I’ve really always wanted to have a place at the beach or a cabin at the lake.” And so people’s living expenses don’t ever go down to the extent that they think they’re going to do.
I’ve been working in public accounting for over 30 years. I’ve never seen anyone voluntarily live on half of what they were living on before they retired. And notice, I said voluntarily. There are some folks who have to do that because they don’t have any other choice. That’s the first assumption I will live on less.
The second assumption is that the tax rates are going to be lower in retirement. For my parents, my mom just turned 80, she was working during the Johnson-Nixon-Ford administration era, and they retired during the Reagan administration. My dad worked for a company that had a defined benefit. And my parents, both of whom contributed to IRAs and 401Ks, made out like bandits because it really did work that way. Their tax rate dropped, not because they were living on less, but because of the Reagan Tax Act.
For you and me, that’s not nearly as safe a bet. In fact, I think it’s actually a bad bet. And that should change our way of thinking about retirement. But it doesn’t really. The 401(k) plan is probably the most ubiquitous retirement vehicle that we have. When we’ve been working with clients since 2018 on Roth conversions, one of the first things I’ll say is, “Check and see if your existing 401(k) plan allows you to make after-tax contributions.” Many times, the plan will allow that. But folks keep putting money into the pre-tax side of things and they’re just making a problem that they already have worse when they have the ability to put exactly the same amount of money into Roth, where it is going to grow tax-free. The key difference is, in retirement, the original money that was put in, as well as all that growth, comes out tax-free in retirement, which takes that whole issue of what the marginal tax rates are going to be in 20 years completely off the table. You don’t have to think about it anymore. So really, it’s just a change of habit more than anything else.
Babinski: I think you hit the nail on the head when you said, “If we think tax rates are going up and we have this tool available to us that could shift the taxation to the known and pay it now and then be completely tax-advantaged forever, why wouldn’t we want to do that?” When you’re saying you’re taking a bet on tax rates staying the same or lower and you’re going to live on less, well, we could take some of those wild cards or some of those factors out. And I think the point was well made when you talked about the amount of spending and what’s going on is more than the entire series of World Wars. And the punch line there was, taxes ended up skyrocketing after all that money. Somebody’s got to pay the tab. We can’t be buying rounds for the bar and think that there’s no one that’s going to have to pick up this tab.
On this chart you can see World War I. Tax rates were high during the war. Then they had this great period of low tax. And then, boom, they just start going up and up. It’s hard to imagine a marginal 94% tax bracket. To me, all that is, is a mandate from the government to anyone making a lot of money to stop working. Why would you work if you then have a state tax on top of that? We’ve had several decades of very stable and relatively low tax brackets. Talking about paying the tax on your IRAs now when we have this known historically low tax period with the setup that, in the past, has led to higher taxes, is why we’ve dedicated this entire time to this exact thing.
Gibson: You’ve got a great analogy about going into a business deal with someone. Share that because that’s the clearest I’ve ever heard it put.
Babinski: A traditional IRA is where you get the deduction today. You have at it, grow that sucker as fast and as hard as you can, and then, someday, when you take it out, it’s going to be taxed. Here’s the analogy. It’s like going into business with someone, in this case, the government, where you don’t know what the split is of your partnership until you take the money out. So, let’s go into business together, we’ll see how we do, and I’ll decide at the end how much is mine and how much is yours. And you have no say in that whatsoever.
Here’s how I like to frame the conversation on how money is taxed in general. We’re going to take one step back and say, “There’s really only three ways that you can have your money taxed.” And I use the visual of three buckets. They are tax now, tax later, tax never. And this comes under the topic of tax diversification. Everybody knows diversification, especially when it comes to your investments. But what I like to talk about is tax diversification. We need to take a look at how your money is structured and when the taxation comes in.
Bucket 1 is really your taxable bucket. This is where your paycheck goes. This is where your company’s distributions go, your checking and savings, non-qualified investments – a brokerage account at Robinhood or at Fidelity or Vanguard, any collectibles, anything that’s going to, if you transact, create a taxable event. The characteristic of bucket 1 is it’s taxed now. You’re getting ordinary income, capital gains rate. Every year, you get a 1099, a K1. Now, it’s a great place for liquidity, emergency fund. If you know you have a house purchase, a wedding, education, this is a good place for some of that short term. But the problem with long-term accumulation is there’s a leak in the bucket. Every year, when that K1 comes or that 1099, you have got shift money, that could be compounding, into the tax bucket. And of course, they get more and more and more of it. It’s an inefficient way to grow for the future. Everybody intuitively knows that.
The most popular way to save long term in this country is that tax-deferred bucket. This is where you go to your CPA and he says, “If you put in your $6,000, you’re going to save so much money today.” It sounds great, but the problem with that tax-deferred bucket, like Tom said, is it’s the tax postpone bucket. We just don’t know what the share our partner is going to take in the future. The calculation is postponed, and we don’t know the rate. This is the case for all your traditional IRAs, SEPs, 401(k), 403(b), 457, etc.
The other characteristic of bucket 2 is that if you don’t pull the money out, it’s not taxable until you pull it out. But if you don’t pull it out, say you don’t need the money in retirement, the government’s going to force you to start pulling it out through something called required minimum distributions. That’s not because they’re benevolent and they want you to have a great retirement; I think it’s because they want their tax. That’s why they force you to take it out.
We spend a lot of time in the family office talking about structuring your affairs so that you can get money into bucket 3, but here’s the problem: We can’t just write a check and get into the tax advantaged bucket. There’s always some type of restriction or some type of barrier to entry. There are contribution limits on Roths. You must be healthy to do a permanent life insurance policy. You must have capital gains to get into an opportunity zone. You must have cost basis established for a spend-down. These strict rules need to be paid attention to and that’s why we take so much time to sit down with people one-on-one, to get a clear picture of where we are, and then to see if there’s an opportunity to do a Roth conversion; if you have a health savings account, we’re going to show you how to direct that into an investment account, cash value life insurance, the opportunity zone.
There’s always this barrier to entry and we need to scan the horizon on a one-on-one basis to figure out, is this possible? Do you have an opportunity to move money from bucket 1 into bucket 3? Do you have the chance to move money from bucket 2 into bucket 3? And if we do, how do we pay for it? There are all these different strategies and all these different types of intertwined workings that we have. Saved money currently on your current tax year? Let’s use some of that now, allocate it to fund some of these other strategies.
What we’re trying to do is fill bucket 3 as much as possible. Our primary focus is to take that longer-term view but more importantly, we change the dialogue a little bit to start talking about multi-generational. I don’t really care who’s in bucket 3. Let’s just get the family’s money into bucket 3. Then we start talking about estate planning, and access, and control. At the end of the day, when we’re trying to get people from paying less taxes now, to setting you up so you pay less taxes forever, and then we start talking about retirement. That’s where all these things come into play because retirement is not a net worth problem. We don’t have a number. When I get to X number, I’m going to retire. Retirement is an income problem and the biggest problem with income is taxes. We need to get to and solve for an after-tax retirement income that’s going to keep up with inflation and, of course, make sure you don’t outlive your money. That’s the ultimate goal on top of passing on to the next generation as much as we can without the government taking a piece.
Gibson: That is a great point, David. A couple of other issues.
One, with a Roth IRA you are not required to take distributions. There are no RMDs, required minimum distributions. Every spring, my mom complains because she does not need the money that’s in some of those retirement accounts to live on, but she has to take it out. She doesn’t have any choice. She was super happy when I told her she didn’t have to take her RMDs again for this year. That’s one benefit, particularly if we’re looking at that multi-generational approach.
The other issue – and this was a major moving of the goalposts – David can you explain a little bit about how IRAs used to work when you were passing them to your children and how they work under the current law. Just traditional IRAs.
Babinski: A long time ago, I think it was the ’97 act, we were working with folks, and they would put the great-grandkid as the beneficiary because you could get this massive savings on those required minimum distributions. It was your age plus your beneficiary’s age, and there was some complex formula. Then comes along the unified table where, unless it was a spouse that was more than 10 years younger, you could do a required minimum distribution on the unified table. That was, while you were alive, how we used to manage that required minimum distribution. But they came along with something called the stretch IRA that, if you passed away with a beneficiary that was the next generation, they had their entire lives to take those distributions and basically compound and grow the IRA for another generation. Then there was the 5-year rule when your beneficiary died. Well, the recent Tax Cuts and Jobs Act changed that to where, no matter who the beneficiary is other than a spouse, they have 10 years to draw down that IRA.
Imagine you’ve saved your whole life. We’ve loaded money into the 401(k). We’ve got a $3, $5, $7, $10 million account balance and you’re living very well in retirement, and when you pass away you leave that to your kids or grandkids. They have to draw that down in 10 years. Depending on the size of the account, that guarantees they’re going to be in that highest tax bracket, even if they spread it out over all 10 years. And you’re going to lose a tremendous amount of money to taxation. Now, the Roth doesn’t protect us from the 10-year rule, but it does protect us from the spike in taxation because it would all come out completely tax-free.
I think there’s this kind of trap being set where, all of a sudden, everyone took their eye off the ball with estate planning because the limits were raised to $12, $13, $14 million a person – that’s set to roll back to $5 million – load up all this money in your retirement accounts and you don’t have to take it until you have to take RMDs and you’re the next generation. I wrote a piece when that changed called, “How, with the stroke of a pen, 40 years of retirement planning was thrown out the window.” That stretch IRA was huge because it really added to the story of how tax-deferred compounding works. Now, you hit a wall and fall off a cliff.
Where do the multi-generational strategies converge between the family office and your annual savings? One of the strategies that we use that can further compound with the Roth and multi-generational wealth creation is the scorecard strategy of hiring your kids and taking it one step further. You want to set us up for that and then I’ll go through my case study?
Gibson: Absolutely. The crux of the scorecard is taking dollars that you’re going to spend regardless, deductible or non-deductible, and by adding a step, maybe two steps, to the process and the proper documentation, we can convert some of those expenses into legitimate business expenses and get some traction on your tax bill.
Hiring the children definitely fits the bill for that. Kids are crazy expensive to raise and anything we can do to convert even a portion of that is certainly a step in the right direction. If we’re paying the children up to the amount of the standard deduction for a single person, which for this year is $12,550, that money is being shifted from mom and dad’s 37% tax rate down to effectively a 0% tax rate at the level of the child’s return.
When we talk about the different ways you can use that money, the guiding principle is any expenditures need to be for things that are in the child’s best interest. You can set aside money for college. You can use some of that for the things that children are involved in that go a little bit above and beyond food, clothing, and shelter, like dance lessons and music lessons and football camps. But there’s another thing that we have been talking with our clients about. The child has earned income at this point. It’s not subject to income tax if we stay below that $12,550 limit. But it is earned income and that is the requirement for funding a Roth IRA. You have to have earned income. And certainly, setting money aside in a Roth IRA would fit the bill for being in the child’s best interest. David, let’s talk about what happens when you do this.
Babinski: We just talked about the three buckets. We’re constantly scanning the horizon, trying to find a way to kick some money into bucket 3 and along comes this great current year tax-saving strategy that creates, as a byproduct, a taxpayer underneath the Roth contribution limits. I look at this and I say, “Wait a second, why aren’t we setting up or why wouldn’t you immediately take some of that $12,550 and put it into a Roth?” The max for Roth is $6,000 in that age bracket. And now we have access to the Roth. And at 18, it becomes the child’s property. When you look at these numbers and you look at the opportunity to create multi-generational wealth in bucket 3, which is the tax-free, tax advantage, long-term compounding bucket, it just starts to become startling.
Let me go through a case study of taking the hire your kids to save that couple of thousand dollars a year and show you what happens when you put it into a Roth. We’ve got a three-year-old corporate model. We’re pulling out the full standard deduction for an individual and we’re going to take about half of that and make that Roth contribution. Now, there’s a couple of things that we need to look at. $6,000 a year is $500 a month, and we’re going to take this and we’re going to say that child model is going to work until he can work on his own. And I’m going to say until he’s 38, he’s still going to be eligible for the Roth contribution. I ran it out and I’m going to show you how that $500 per month turns into $22 million.
We’re putting in $500 a month and we’re assuming a 7% long-term consistent interest rate. And we’re actually going to start pulling income out at age 62. That’s $245,000 a year in income for putting in $500 a month. And oh, by the way, it’s tax-free. So let me show you the big pieces and then we’ll jump into the numbers.
Taking out 5% of the account value in income, we’ll start with $20,000 a month and increase, tax-free, totaling $12 million. And there is still going to be $10 million of account value at life expectancy. We’re using 98. If you look at the life insurance tables, they’re saying that a newborn female right now has a life expectancy of 106. So let that sink in for a minute. People are going to be living longer, working longer, and their money needs to work for them.
I’m a numbers guy. Let me show you where these numbers come from and where the backup is.
At age three, year one, we’re going to put in $6,000 and it’s earning 7% a year. We’re only going to compound it once a year. At year 10, the account value is $55,000. We add the $6,000 and then it grows and then we have our end of year account value of almost $66,000.
As you move into the end of the period when he can make those contributions, I said contribution stop at year 38, age 40, that’s when they become a tax-free millionaire. I always like to point that out.
How would you like your grandkid, if you can hire the grandkids, to be a tax-free millionaire?
Back to the example. At age 41, no more contributions, but we are going to just let that account grow every year. He’s no longer eligible for this particular strategy according to current laws.
Now let’s get to retirement age. That account has grown from that $1 million through the miracle of compounding to $4.9 million. A negative contribution is a withdrawal; that’s where we see that $20,000 a month, or $240,000 a year, coming out. It’s still growing at 7% and we’re taking out 5% so the account itself is still accumulating and that’s what allows us to give you a bigger check. You want to have an increasing check in retirement because of a sneaky little thing called inflation.
So, we are taking an increasing check throughout the retirement years and, as we get close to life expectancy, that $1 million account at age 40 and that $5 million account at age 62 is now a $10 million account at age 98 and now he’s taking $40,000 a month to live on. And again, with inflation, that might be enough to pay the cable bill. Who knows? But that seems like a lot of money. And then there’s still the $10 million left for the grandkids or the great grandkids.
As you pointed out Tom, that’s going to be tax free as well. You almost have to ask yourself, “How do we not find $500 a month that would have gone to the government anyway if we didn’t do the hire the kids strategy and put it away for that secured retirement that everyone is looking for?”
In summary, we’ve drawn out $12.7 million in retirement income through those tax-free withdrawals, 5% of the account value. We still have $10 million left as a legacy for the grandkids or great grandkids, tax free, and they have 10 years to draw that out. Put a pencil to 38 years at $500 a month, we’ve only put in $228,000 of total contributions, and that’s money, again, that would have normally gone to the government if we didn’t have the first part of the scorecard strategy.
That’s why we call it the multiplier effect. We’re taking monies that are tax savings and we’re throwing it into the future in a tax advantaged manner. That’s when you start to see the planets align and all these strategies start coming into effect.
Gibson: There are a lot of questions I regularly get on this topic.
Is there a maximum or a minimum age that we can start hiring our children?
There is not a maximum age. My rule of thumb is if you’re still coming out of pocket to support your child financially, I would much prefer that you do that through a job in your business. It’s more tax advantaged for you. Normally, the child, even on through college and graduate school, is going to be in a lower tax bracket than the parents. So even if the child’s paying 10%, 12%, if mom and dad are paying 37%, 35%, the math still works.
As far as a minimum age, that is more governed by federal labor law. Some states have state laws that are a little bit more restrictive than the federal law, but for the three-year-old David was talking about, a job that’s absolutely suitable for a three-year-old child is corporate modeling. It is not something that is going to interfere with their education. It is not a prohibited type of activity. And so that would be a good fit. Now, the salary does depend on location. In Orange County, California, Manhattan, $12,550 for modeling is not at all unheard of. In Oklahoma City, we won’t be able to pay them quite as much for modeling because it’s dependent on where the modelling’s being done. But I’ve not seen any situation where we couldn’t at least pay the child $6,200, $6,300, which still gives us the ability to utilize this strategy.
If you invest in this program with after tax dollars, when you convert to a Roth, aren’t you taxed a second time on those dollars?
The answer is no because what we’re doing is taking money that you’ve invested into some type of pre-tax retirement plan – a traditional IRA, a traditional 401(k) plan, a SEP – those types of arrangements where you’re getting a deduction when you make the contribution. So, you’ve got your deduction, we’re going to roll it to a Roth, and we’re going to deal with the tax consequences right now. But it’s not a situation where that money and the growth on that money is going to be taxed any further in the future.
Just an aside to this. The government looks at all those billions of dollars that are sitting in tax deferred plans as their money. And to a certain extent it is because they gave you something when you funded that plan. They gave you a tax deduction when you put the money in that plan, and as we saw with the elimination of the stretch IRA, they can change the rules any time they please. A huge part of the COVID-19 bill that just passed went to shore up mismanaged union retirement plans. And if you think that’s bad, Google how many state retirement plans are insolvent right now. They’re looking at this money, and it’s been floated that we’ll just have a national retirement plan. The government will take all this private money and fold it in with these government pension plans. That’s a horrible scenario, but it’s something that’s been brought up as a possibility. We’re not going to put you in a situation where you’re going to pay tax on the same money twice.
“How long does the money have to be in the Roth before I can start using it to pay for my child’s education?”
That’s something we didn’t really talk about. We were focused in on the retirement side of things. But generally, when you open a Roth, the money has to be in the Roth for five years if you are of retirement age.
If the child’s making $12,550, you should have plenty of money to fund the Roth fully and still put aside another chunk of money for college down the road as well. But if you had to, there are three or four reasons you can get into the funds of even the traditional IRA prior to retirement: first-time home purchase, medical expenses, and college education. Obviously, it would be in the child’s best interest to leave that money alone if there’s any possible way that you can and just let it grow. But that is a possibility.
But there’s nothing that makes me happier when we’re starting to work on Roth conversion with a client than hear them say, “Right after I got out of medical school, right after I got out of dental school, I opened a Roth IRA because I could, and I put a $1,000 in it. And it just been sitting there.” That’s great, because we’ve got an IRA that’s more than five years old, we can use to roll funds into.
Babinski: And then the rest of that is, even in the child’s name, the $6000-a-year contributions are eligible for withdrawal with no penalty because you’ve already paid the tax on it. Now there are strict rules to get the growth, and it really is designed for retirement. But you can build up some basis in there and if you needed to you can take it, but you can’t put it back in. And that ruins the uninterrupted compounding. But it’s there. It’s a source of funds. If you needed the growth, you’ve never paid tax on it. There is a penalty to take it out, and then it is taxable. So that part of it, you really want to be a last resort.
Gibson: One more thing before we shift gears, David. Quickly talk about a nondeductible IRA contribution.
Babinski: That’s a great strategy, too. Like I said before, the Roth is starting to come into focus. People are starting to talk about it. We’re all starting to hear the terms backdoor Roth. Simply a backdoor Roth is what Tom just mentioned: everyone that works and has income is eligible to make an IRA contribution. I’m going to say that again. Everyone is eligible to make an IRA contribution. It’s the deductibility of that contribution that phases out as you earn more income and as you participate in other plans. But you can still make the contribution. It’s not deductible. So, what did we just set up? We just set up what we call a MEC. We set up an account where your money’s been taxed going in, the growth is deferred, but you’re going to pay tax on the growth. Now, enter us and our strategy and we say, “Let’s convert that to a Roth.” What are the rules? Well, you have money in a traditional IRA. There’s no income limitation to do the conversion, so we do the conversion. Your basis is the $6,000 you just put in. There’s no taxation. We’ve basically just made a Roth IRA contribution for a high-income earner through the backdoor.
Now there’s a rub. If you have other IRAs and we haven’t transitioned them yet or converted them yet to a Roth, you have to take a proportional amount of that. So, it’s a stairstep process that we get you to. But eventually, it’s another way that we have access to bucket 3 after we’ve cleaned out all your regular IRAs into conversions or there’s 10 strategies to do that. But there’s extra money that we could get into that third bucket and have this uninterrupted compounding. It’s through the backdoor. There are a lot of different strategies, but it all starts with the converting of the traditional IRAs that are there.
And Tom, said it. You have to pay the tax. What if we could pay that tax at a discount? Let me quickly go through this strategy, because you’re sitting there saying, “Unfortunately, my parents or grandparents didn’t have the wherewithal to set me up to be a tax-free billionaire. How do I get access to the Roth?” This is how we’re doing it for the people that can’t qualify to make the contribution. It’s called the Roth conversion. And we coined the term the double discount method.
We want to get money into a Roth, but we don’t want to pay 37% or 40% or 45% with state tax. We want to get it in there as tax efficiently as possible, and this is how that works. If you have a traditional IRA, a SEP, a simple 401(k), it’s at what’s called the custodian. You don’t have access or control over your IRA money. It’s with Fidelity, Vanguard. Some custodian is holding your IRA. For our double discount method, we’ve got to get that money into an alternative custodian, sometimes called self-directed. We identify how much you want to convert this year, it’s going to be a taxable event, and we move it over to that alternative custodian. Why? Because we need to put it into our investment.
Gibson: There definitely will be a taxable event but rolling it out of the 401(k) to a self-directed traditional IRA, that’s not where the taxable event occurs because that’s just a rollover and there aren’t really any tax consequences at this point.
Babinski: You’re going from custodian to custodian through what’s called the direct transfer. And because you don’t take possession of the money, it’s a non-taxable event. We’re leading to with taxable event. We’re going to do it very methodically and purposefully, but it’s a little further down the line here.
Once we make that investment – let’s use $100,000 so we can do some math – into a real estate project that we’re sponsors of, you’re still in the traditional IRA. But here’s the rub. Once you’re in that alternative custodian, the one requirement that we’re taking advantage of is that custodian is required, once a year, to supply the IRS with what’s called the fair market value. And this is where the whole term alternative comes in and why this is important. If you’re with Fidelity or Vanguard or Robinhood, every day at 4:01 PM, we know what that stock account is worth. It’s a liquid market, and we have our valuation. When you get into the alternative side and you’re buying an apartment complex or you’re buying gold bars– we just had someone buy a case of whiskey, believe it or not. You can’t drink it – the custodian needs to know the value. You need to tell the IRS once a year the fair market value of this account. Well, we can’t supply that, so we go out and we call for an appraisal.
In our projects, at a certain time, when we call for the appraisal, we’ve experienced the discount. Think about it. We buy a piece of land, we hire an architect, we hire an engineer, we pay impact fees, but the assisted living facility is not built yet. But an appraiser has to come out and tell us what it’s worth. Well, invariably, we’re going to have that fair market value come in at a discount. Think about it. You put $100,000 in, a project’s ongoing, we’re required to report to the custodian what it’s worth. We call for an appraisal. Now we have a $60,000 fair market value inside your IRA, not because the project’s lost money, but because if you had to liquidate and you have an incomplete project, market forces tell us that it’s fair to say you’re not going to get 100 cents on the dollar. That’s the point where we’d convert it to the Roth. That’s the taxable event. But the taxable event is now at a significant discount to what you put in. Once the project’s complete and the funds are repaid with interest, now it’s inside your Roth IRA, you have a taxable event, say $60,000 if we get a 40% discount.
Then we have a whole scorecard of other strategies that we can use and advance strategies we can use to pay tax on the discounted taxable event. So, $100,000 goes in. You owe tax on $60,000, $60,000 hits your AGI. Now we could whittle that down from there. We have multiple strategies, but where are we? We’re a year, year and a half later. All your money is now in a Roth that we’ve converted. It’s going to be tax-free compounding until retirement, and it’s going to be tax-free income until the next generation.
Gibson: When we’re working with a client, absent the Roth conversion, it’s not at all uncommon for us to get your average or your effective tax rate well below 25%. Sometimes it’s barely above the 20% long-term capital gains rate. With this, when you couple the effect of the discount that you’re getting based on the valuation and then utilize some of the other advanced strategies to mitigate those consequences even further, David, you’ve been seeing actual effective conversion rates on the Roth of 15%.
Babinski: Yes. Let’s think about the numbers big picture. If you’re going to convert $100,000 to Roth, and you’re in the highest tax bracket, federally that’s 37%, but we can get a 40% discount on that, we’re basically cutting that almost in half. Now that money hits your AGI on your tax return, and we have other strategies that might be able to cut that in half again. So, just round numbers, 37% goes just to 19% or 20%. And then that 20% can then be whittled down again, not by half, but say by a third.
We’ve had people convert who would have written a check for $37,000, and now you’re spending with all the different strategies $14,000 to $16,000 thousand. Now, that $100,000 in the Roth growing, it could double to $200,000, double to $400,000 and you’ll never pay tax again. If you can pay $14,000 or $15,000 today to have $400,000 or $500,000 thousand tax-free in retirement? This is our focus for the rest of this year, especially until we know specifically what’s going to happen out of Washington. The door is wide open here, and the opportunity is apparent.
Just to summarize, tax diversification is now more important than ever. As much money as we can send into the future, where it will never be taxed again, the better. It gives you total flexibility in retirement and in your estate planning. It’s a prudent thing to do. We’re constantly monitoring the proposed legislative changes from Washington. We don’t know what the changes are going to be, but we do know there are going to be changes so stay tuned. The Roth IRA has one of the lowest barriers to entry right now. And finally, the strategies compound off one another. We’re here to give you the glimpse into you hired the kids, the money has been sitting there, you’ve been buying the iPad, you’ve been paying for jeans and sneakers, but let’s take that and elevate that strategy to a longer-term perspective and build some real multi-generational wealth. The opportunity here is to take the early part of the year before we get hectic with our year-end planning and really map out how these strategies can help you in the future.
Gibson: We’re working on this year’s tax bill. And we want to get it as low as we legally and ethically can. But that doesn’t mean we’re going stop at that point. The work that is done by the family office is going to impact your tax bill, and not just your tax bill, your children’s tax bill, and their financial legacy 10, 20, 30, 40 years down the road and even beyond that potentially.
Another thing that you have heard me say a lot: taxes can’t ever become the tail that wags the dog. And I’m afraid when we’re thinking about, “Oh, if you’ll put this much into your pension plan, it’ll give you this much of a deduction. It will save you this much on your taxes.” That is an incredibly short-sighted way to look at what is a much, much more complex situation than just, “What deduction am I going to get this year?”
Babinski: Thanks, everyone.
To learn more about how TSP Family Office can help you with your family office needs, give us a call today at (772) 257-7888.