Executive Summary

On this episode of Financial Discretion Advised, hosts Abrin and Tyler bring on Craig Joncas to discuss the ever-popular financial strategy of Roth Conversions. Craig is one of the managing partners of Penobscot Financial Advisors and has over a decade of experience in the field.  

Traditional IRA vs Roth IRA  

Abrin starts the show off by describing what the difference is between a Traditional IRA and a Roth IRA. He highlights that in using a Traditional IRA you can put pre-tax dollars in today to grow tax DEFERRED, and once you reach age 59 ½ you can start to take withdrawals of the money. The downsides of this type of account are that if you want to access your money prior to age 59 1/2, you would be subject to a 10% penalty of the withdrawal, as well as owe ordinary income taxes.  

A Roth IRA, as discussed by Tyler and Craig, works a bit differently.  In a Roth IRA you can make an AFTER-tax contribution today, and that money can grow tax-FREE if it is in the account and not accessed prior to age 59 ½. Some other differences with the Roth that Craig points out, are that you always have full access to your principal in the account. This means that any money that you have contributed can be pulled out without incurring any penalties or taxes. However, the earnings will be subject to penalty and taxes if withdrawn from the account before 59 ½. One good thing to remember is that Roth’s operate in a FIFO (First in – First out) fashion, which means that any withdrawal will pull from your principal first.  

What is a Roth Conversion?  

Getting into the discussion, the crew tackles what a Roth Conversion actually is. A Roth Conversion is when you take pre-tax assets in a Traditional IRA and shift them to a Roth IRA. This withdrawal of the assets from the IRA creates a taxable event on the portion of assets being moved but is not subject to the 10% penalty. Those assets are then moved into a Roth IRA to enjoy the benefits of tax-free growth moving forward.   

Does it make sense for me? 

Craig explains that determining if a Roth Conversion makes sense for you depends on a number of different factors. He talks about one big consideration to think about if you are looking to do a conversion, and that is if you believe you will have a higher tax rate in retirement than you do today than it might make a lot of sense for you to convert. 

Tyler highlights that one of the nice differences between a traditional IRA and a Roth is that at age 72, the IRS is going to force you to take a required minimum distribution (RMD). This is effectively the IRS forcing taxation on you for a percentage of your tax deferred assets. This is not the case with the Roth IRA. That means that if you do start to make Roth Conversions prior to age 72 you can reduce the overall value of your traditional IRA (one of the factors in calculating your RMD), as well as allowing yourself to dictate the tax situation in which you made those withdrawals. This also lets you keep this money invested for the rest of your life, which can start to be part of your estate plan.  

Rules for a Roth Conversion  

Craig gives us a good run down on how there are not a ton of rules for Roth Conversions. He does note that we need to get the conversion done by December 31 (year-end). The other big rule is that anything you have converted is subject to the 5-year rule. This means that if you make a conversion, your principal (converted amount) cannot be accessed without tax or penalty until it has been in the account for 5 years.  

Abrin explains that you can make as many conversions as you would like during the year, and how some market movements might help you take advantage of some favorable conversion conditions.  

Strategy on how to do it? 

Tyler discusses with Abrin and Craig about how a lot people believe that the Roth Conversion is just a one-time event with a big tax consequence. This is not the case, and a lot of times a Roth Conversion strategy can be made once someone steps into retirement and done over a number of years. This allows the investor to take small tax bites at the apple and still achieve the overall goal of moving assets into a Roth.  

Tax Bracket Uncertainty 

The guys discuss how today we are in a low tax environment with some current factors (government debt and stimulus spending) that may cause a need tax rates to rise in the future. By working with what we know, tax rates today, we can start to control our taxation but shifting to a tax-free vehicle that would naturalize any tax rate hikes down the road.  

Abrin makes the point that there is always opportunity cost with a Roth Conversion. How this plays into the conversion is that you do need to pay taxes on that conversion, and that money is removed from your investment portfolio and no longer invested. This needs to be included in the calculation when determining if it makes sense to use this strategy. Will the missed opportunity of investing the money that paid the taxes, out weight the benefit of the conversion.

DISCLAIMER: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. 


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Full Transcript

Abrin: Welcome to Financial Discretion Advised. I’m Abrin Berkemeyer.

Tyler: I’m Tyler Hafford. Let’s cue the music.

Tyler: Hey, thanks everyone for joining in. Today, we’re going to be discussing Roth conversions. But we’ve brought a guest onto the show today. Most of you, I’m sure, are tired of listening just to Abrin and I. We decided to reach out and we have Craig Joncas with us today. He is the managing partner here at Penobscot Financial Advisors, going to bring a little bit of expertise to the Roth conversion conversation. But Craig, why don’t you walk us through how you got to where you are today, a little background?

Craig: Yeah. Cool. Thanks for having me on guys. Excited to be back here on the show. You guys are doing an awesome job with this stuff. Yeah, my background, pretty simple. I was one of those rare kids that went to college and knew exactly what he wanted to do and had an interest in this stuff when I was pretty young. Graduated from Orono. While I was there, I got lucky enough to be linked up with Jim Bradley, my now business partner and our fearless leader here. Really, he kind of shepherded me into the industry and the rest is history. Really love doing it and working with clients. Been doing it ever since.

Tyler: I won’t go on too much of a tangent here. Anyone who knows Craig, it was either financial advising or an ice cream truck. That’s a discussion for a different podcast, but we’re glad that you went financial advising. Thanks for joining us.

Craig: I love the ice cream truck too. But I got to say, this is better than slinging ice cream and listening to that song every day.

Tyler: Awesome. Abrin, why don’t you start us off with a discussion about what is a Roth IRA?

Abrin: Sure. Yeah. Roth in general, what a Roth IRA is is an account or any Roth contributions is money that is taxed when you contribute it or before you contributed it. Essentially it’s just a after-tax savings vehicle. The Roth component is based on the fact that you get tax-free growth on that. Any money you put into a Roth IRA or any money you put into, say, a Roth 401k, when you take that money out, you’re not taxed on the amount that you put in, because you’re already taxed when you put it in and you’re not taxed on any of the growth, which is a really powerful tool, overall.

Tyler: Yeah. One of the reasons we tagged that as one of our favorite financial tools in previous podcasts, to the contrast of that is your traditional IRA. In almost all instances, the way you’re using a traditional IRA is you’re putting pre-tax money in today and getting your tax break today. That money is going to sit in that account, grow into your retirement. When you take it out, then you’ll handle the taxes.

Tyler: The tax-free growth part of the Roth is so powerful that Roth conversions can be a good strategy to take money out of that traditional bucket, traditional IRA bucket, and move it into that tax-free growth bucket. Craig, you can walk us through when does that make sense? What are the strategies behind why you would want to do that?

Craig: Yeah, definitely. I think with a lot of things finance, the first thing I like everyone to know when we’re talking about Roth conversions is that does it make sense? Well, that answer is always, “It depends.” We’ve probably got to run some numbers on it, figure it out. It makes sense for a lot of people in a lot of situations, but not for everybody. Not only does it depend, but also it can change over time. If we go into a Roth conversion, we’ve got to know things like tax rates can change, things like your personal goals and spending can change. It might mean that the conversion that we made wasn’t actually a successful one over time. We’ve got to work with the things that we know, understand that there are some things that are assumptions, make educated decision making and go from there. But yeah, there are a lot of good reasons why a Roth conversion makes sense.

Tyler: Yeah. For folks listening, the Roth conversion, Craig’s talking about tax brackets and the reason why we have to pay attention to that. What we’re doing in the Roth conversion is taking that money out of the IRA. We’re going to take a lump sum out of X amount. We’re going to pay taxes on that piece and shift it into the Roth IRA. Knowing what’s going on with the tax situation can make a big impact on when it makes sense to start doing these types of things.

Craig: Yeah, absolutely. Generally, if you talk about some rules of thumbs with Roth conversions, generally what you’ll read about is if you’re in a lower tax bracket today than you expect to be in the future, it can make sense to go ahead and make a conversion, because you’re not saving much by not converting today. In the future you’re shielding a lot of taxes by being able to distribute that to you tax-free. Absolutely.

Tyler: Great. There are some other reasons why it would make some sense. I know your traditional IRA is going to force you to take some money out at some point. You’re going to have to make what’s called a required minimum distribution. Not true in the Roth, right?

Craig: Exactly. Yeah. Any pretax retirement plan assets generally at age 72 now, with the passing of the Secure Act, used to be age 71 and a half, or 70 and a half, sorry. At age 72 now, you need to take required minimum distributions from all pre-tax assets. With a Roth IRA, they’re not subject to RMDs, so you can keep it in there and have that top tax-free compounded growth going on forever and use it as an estate planning tool. If you’re passing these assets down to your kids you can allow that tax-free compounding to go through your death and then they inherit an asset that’s actually much more tax friendly for them as well.

Tyler: Yeah.

Abrin: If you think about it, if you are passing down money to children and they’re in their working career, that could be in their highest earning income years. If they inherit something that’s pre-tax and have to withdraw that, then they are going to be paying extra income taxes that could move them up in tax brackets and things of that nature. Then more of your money goes to the government and less of it stays in your family.

Tyler: Right. All good considerations. All right. Let’s say, all right, the Roth does seem to make some sense for me. This is something, a Roth conversion, and this is something I want to do. Rules to that, is it just kind of willy nilly? I’m going to start shifting money around or things that we got to be paying attention to make that happen?

Craig: Yeah, sure. One of the great things about the Roth conversion is it’s pretty flexible and open to use across all demographics. There aren’t a whole lot of rules that we need to be concerned with. The first rule is we’ve got to get the conversion done by December 31st. That is different than making Roth contributions, which can be done up until the tax deadline for the prior year. Your Roth conversions, we are on a deadline of the year end that we need to do that.

Craig: The other big rule with conversions is in order to access the converted principal, not the growth, but the amount that you’ve converted from traditional in the Roth, you need to wait five years. Otherwise it’s not a qualified distribution and you’ll be subject to tax penalties on that if you do so.

Tyler: Which is a big difference from when you’re actually making your contributions to the Roth, right? You can always access the principle of the money that you put into that account the day after you’ve done that. If you want to take what you put in, you can do that. A little different here when you make that conversion.

Craig: Yeah. Exactly. You got it. Yeah. There are these five-year rules with the Roths that you always Google that I think a lot of people tend to switch them up, get them backwards, combine the two or not really understand them. But at the end of the day, with Roth contributions, the five-year rule applies to the growth that occurs and taking that out penalty and tax-free Roth conversion. The five-year rule applies to when you can use the actual converted principle itself. Important to keep that in mind when you’re thinking about conversions versus Roth contributions.

Tyler: Yep. Abrin, I know that you use this a lot in your planning, working with clients. Are we limited to how many times we can do this in a year? You can only do it once? Do we have to take this massive tax bite today? What are the rules around that? When can we do this? How many times can we do this?

Abrin: Yeah. You can do it as many times as you want throughout the year, as long as it’s done before December 31st. If you have a Roth conversion plan in place and say the market dives towards the end of the year, and you already performed a portion of a Roth conversion earlier in the year, when the market’s down might be another good time for another portion of a Roth conversion strategy, because then you’re going to … when that bounces back, you’re going to get that bounce back tax-free. You do have flexibility with how many times you do it throughout the year. But ultimately you’re going to want to stick to the same strategy where you might have an income tax bracket that you’re trying to max out at and take advantage of that at any point throughout the year.

Abrin: But just because something happens in the market or another circumstance changes doesn’t necessarily change your strategy, where you’re going to always want to try to maximize tax savings by getting the predetermined level of tax bracket that you want to be at by the end of the year.

Tyler: Yeah, which I think is important. Maybe you guys can talk to this. I don’t know if your clients, when this comes up in these conversations I’m having, everyone does think it needs to be this one move where we’re just going to take this massive tax bite this year to convert things into the Roth, where the strategy tends to be, “Let’s take small bites of this Apple to get us to where we need to be.” If it takes six, seven years to accomplish that whole goal, then you can do that and just keep yourself, like you said Abrin, underneath that tax bracket.

Abrin: Yeah, exactly.

Craig: Yeah. Most of the time I find that clients accumulate more pre-tax assets than they accumulate Roth assets. When we start talking about Roth conversions, we might already have a big sum of money that’s built up in pre-tax assets. To get that into Roth definitely has to happen in small nibbles over time, otherwise it’s probably just working counterintuitive to the strategy. Because one big conversion’s going to drive you up the tax brackets. We’re no longer convinced that over the long run, you’re going to be able to distribute those at better tax brackets than at the rate you converted. Definitely usually part of it.

Craig: Also, because people oftentimes have a lot of money built up in pre-tax assets, it’s one of the reasons that I like Roth conversions and improving a financial position through Roth conversions, because we don’t know what the future holds. Today we’re sitting here and we do have some known quantities. We know we’re in a relatively low tax environment today after TCGJA. [inaudible 00:11:06] We know that we are burdened with a whole lot of debt in this country today and that there might come a point down the road where one of the ways we need to fund it is through higher tax policy. Giving yourself some flexibility by adding Roth assets to your overall picture, so we can deal with those unknowns in the future as they come with the right type of asset, that’s a huge advantage for a financial planning situation.

Abrin: That really compounds with required minimum distributions. Once you’re later in retirement, if they do move tax brackets up and they’re making you take money out of your accounts, if you planned for that earlier on by doing a Roth conversion that can take your pre-tax assets away and help lower your required minimum distributions, that’s another way where it can help you. It can benefit you over the long run.

Tyler: Yeah, definitely.

Craig: Yeah. I think it goes back to the idea of having more control of your financial plan. Anything that’s giving you a little bit more control on when I’m taking taxes, how much I have to take, those types of things, tend to help the plan because you you haven’t … Like you said, there’s less unknown out there.

Abrin: This can really coordinate with a Social Security strategy too, because Social Security, obviously that’s going to be more income coming into you. If you’ve got a strategy where you’re retiring at age 65 and you’re delaying until age 70, that’s 5 years where you have lower income. You might decide to pay more in income taxes by doing a Roth conversion during that time period, when you don’t have the Social Security income coming in that’s going to be taxed to you.

Craig: Yeah, exactly. Then the other thing that benefits you on later is the tax ability of your Social Security itself depends on total income and your Medicare premiums depend on total income. If you go through that conversion, during that five-year period, Social Security kicks in. You might be in a position where now you’re showing lower income and Medicare premiums at that time [crosstalk 00:12:57] lower as a result too.

Abrin: Yeah. Push it down the road.

Craig: There’s all these little things that you can put on a scale and it can teeter either way, where performing conversions at the wrong time, too, can make your Medicare premiums way, way, way too high. We always want to be evaluating what’s going on in your current situation today, what we expect for the future, and considering it all.

Tyler: Yeah. I think if you are doing any type of financial planning, whether you’re working with someone or doing your own, if you’re not exploring this or having a conversation of, “Can a Roth conversion benefit me,” at least vetting that out, I think you’re doing yourself a disservice. I think it can be a powerful part of the plan. I think it is something to at least venture into and say, “Is this going to benefit me down the road?” Because all the little things that you mentioned can be so powerful for someone’s plan and really make a difference. For someone, I know sometimes we’ll run plans for clients and we’ll see massive improvements in their probability of success just by incorporating a Roth conversion somewhere along the way. Yeah, definitely think that it’s worth having that conversation.

Tyler: Now. It is not as easy as saying, “All right, my tax brackets are this today, and this is what I think there’ll be down the road.” We do have to pay taxes. That’s money that we probably would have invested instead of paying taxes. That’ll factor into the conversation. Abrin, I don’t know if you want to get actuarial on us and talk to us about that?

Abrin: Sure.

Tyler: But definitely something to consider.

Craig: I’m sweating there, thinking you were going to ask me. I was like, “He’s the numbers guy.”

Tyler: Yeah, yeah. Craig paid me before the podcast. Only easy questions went to Craig. Anything that was math had to go to you.

Abrin: Yeah, it really all comes back to two words and that’s just opportunity cost. Pretty much every financial planning decision that you make has opportunity costs associated with it. Whether it’s purchasing a long-term care policy, you’ve got the opportunity costs of if you didn’t pay for the premiums and instead left that invested, that you would have a pool of money that could go towards long-term care costs later on. Same thing with a Roth conversion. You’re taking money out of your overall plan to pay the taxes to the government. You’re not getting that money back. That’s your opportunity cost.

If you’re doing a $50,000 Roth conversion, we’ll just say there’s a 20% tax bracket for easy math. that’s 10% in taxes that you’re paying this year. That’s your opportunity costs. If you left that invested, we have to compare, let’s just call it the 40,000 that you get with the Roth conversion, assuming that you paid for it out of your conversion amount, versus the 50,000 in the pre-tax environment that you would have had, if you didn’t pay the taxes. That’s the level playing field, because you’re accounting for that 10,000 that you’re paying in taxes as the opportunity cost.

You could either lump that in with the original pretax balance, or if you wanted to keep it off to the side as a separate calculation, it can be this extra pool of money so that you can compare and contrast and just make sure that you’re really comparing apples to apples. You can’t just say, “There’s that 10,000 in taxes and I wouldn’t have done anything with it anyway.” There’s always an opportunity cost whether you left it in cash or had it invested. You need to compare that to what you’re going to end up with later on. That’s where Roth conversions definitely benefits you, if you can leave the money in the Roth for a longer period of time.

Some of the conversations I have with clients if we’re doing Roth conversions right at the beginning of retirement, say in their 60s, is like, “Think of this money as money that you might be using in your 80s, or maybe even longevity, if you make it to your 90s. The longer time that you have for compound growth to do its work, the more it’s going to benefit you over time.” That’s where the opportunity cost gets settled out because now you’re getting tax-free compound growth for a longer period.

Tyler: Craig, I’ll let you talk soon. Abrin just hit something. Starting this process in retirement, it may not make sense … Sorry, your Roth conversion in your higher earning years when you’re in this massive tax bracket and doing that. But there’s probably some folks that are in retirement thinking, “I’ve never contributed to a Roth. Did I miss out on this?” Retirement might be the best time to start this process.

Craig: Yeah, absolutely can be. One of the beautiful things about retirement is typically there is a decline in income. Abrin mentioned earlier alongside that, if you’re doing a delay strategy on your Social Security, there could be a substantial decline in income for a period of time. It’s usually years with lower income where a Roth conversion is most appropriate. You can perform a Roth conversion at any time. It’s never too late. One of the great things, too, is if you get past age 59 and a half, if you perform a Roth conversion, the five-year rule is a moot point, because you’re already old enough to take out your distributions penalty free. You can start accessing that capital right away. Absolutely it can be done in retirement, just like every other demographic, a person needs to put some numbers to paper, think about now, think about later, what we know and what we don’t know, but definitely can work.

Tyler: Yep. Yeah. Yeah. I think it’s good. If you are sitting, newly retired, looking at tax, your income today saying, “Gee, this is low, lower than it’s ever been in my life.” Do we think tax brackets are going to go up in the future? I know we talked a little bit on that, but there’s a good argument on why taxes may increase down the road. Maybe the Roth conversion is something we explore around this time. But yeah, I think that’s all good things to consider. Anything out there that you guys in the planning piece of this think is important to consider?

Craig: Yeah, I’ve got one. I think today we positioned this as something where you generally want to convert if you’re in a lower tax bracket than you will be in the future. But a lot of times it can even make sense to perform conversions even if you’re going to be in a lower tax bracket in the future than you are today. A lot of different reasons that might occur, some of those Social Security, Medicare reasons, some of your goals and legacy planning might have something to do with it. I don’t want to position this as something that’s only appropriate when you think tax rates are going up, even though that’s a big reason.

Craig: Another big thing for me, I’m big on control of assets in a financial planning picture. Roth assets are always more controllable. You can use principal at any time, for any reason. Roth assets give you a few reasons for taking out even earnings prior to age 59 and a half, like first time home buying expenses or college expenses. They are a more flexible tool. We can make more decisions with them when goals change, without having to eat penalties or taxes or costs. Even if we’re on the fence, a lot of times I prefer a conversion. I prefer to have Roth assets. Even sometimes when we’re a little in the court of, “Keep it in pre-tax accounts,” sometimes it might make sense just to even out a financial picture to perform some conversions.

Tyler: Right. Yeah. Yeah. All things I think are worth exploring. It can be a powerful tool for folks. It is kind of a tough topic, I think. It’s not something that just comes up. When we did our Thanksgiving podcast, I don’t get Roth conversion questions all that often, because I think it sounds complex and a difficult thing to do. But reach out to professionals, obviously one way to do it. Always on this podcast, we’re happy to answer some questions. If you go on our website, we all have emails. Feel free to shoot us emails. We’re happy to to address those things or give some guidance.

Tyler: The last thing I had on the agenda, Abrin, we haven’t done in a few weeks, is the stock pick. I thought we would bring Craig in on this a little bit this week and see if he could beat us. I’m sure he could. It’s not that difficult, but what do you got? Anything good?

Abrin: I mean, the talk of the land has been Tesla. I mean, they’ve just been on a tear of a run for a long time now.

Tyler: You’re thinking that’s still moves up?

Abrin: I mean, …

Craig: What is the timeframe of the stock picking game?

Tyler: Two weeks.

Abrin: Until the next podcast.

Craig: Until the next podcast…

Abrin: Yeah.

Craig: Okay, got it.

Abrin: Just short enough where it could move up or down 10 or 20%. I mean, yeah. It’s one of those stocks. It just seems to break all the norms and just not care about any negativity at all. It’s just like, “We’re going to keep plugging away. We’re going to keep going up.”

Tyler: Yep. All right. Going with Tesla, pulling at my heartstrings. It’s always been a favorite of mine. I’m going to go with Roku this week.

Abrin: Nice.

Tyler: I want to remind everyone, this is just a game. This is not financial advice. This is just something fun. But I’m going to go with Roku. The reason I’m doing that is pre pandemic, there was a company called Quibi out there. They were going to make these 10 second, or not 10 second, 10 minute shows for folks who were in the cities who were going to jump on the subway and they just had 10 minutes and you could watch 10 minutes worth of content and they would break it up. They thought this would be a thing.

Tyler: Pandemic hit, no one was on the subway anymore. This company went bankrupt. But what happened is … or they’re selling themselves. Roku is buying all of the content that they were putting together and putting it on their own platforms and in a world where content is king and Roku is in everyone’s TV, seems like an interesting story. This week I’m going to go with Roku.

Craig: Nice, nice. You guys are really leaving Bitcoin up for the grabs?

Tyler: I was wondering, when he said Tesla, I immediately started thinking Bitcoin.

Craig: I feel like in this game that lasts two weeks, you’re either going to win or you’re going to lose. You better pick the thing that can definitely go up faster than everything else and that seems to be Bitcoin. But I actually have a different one for you today. I’m going to go with Genworth. Genworth is an insurance company, one that doesn’t necessarily do all that well anymore these days. They’ve spun off a lot of their divisions. I wouldn’t think of them as a good long-term company. But they bounce between $2 and $5 pretty consistently over the last few years, because they’re trying to be purchased by China Oceanwide. Just this week, they dropped another 40% because the deal with China Oceanwide got delayed and kicked down the road, always seems to happen. Right now, I think you can buy it. I think when some favorable news comes out about China Oceanwide, it’ll be going back up again. We’ll see.

Tyler: Well …

Craig: Maybe even more than Bitcoin.

Abrin: You got two weeks for good news.

Tyler: Let’s hope that happens in about three weeks.

Craig: All right.

Tyler: Awesome. Well, I want to thank everyone for listening today. I’ll throw my little tidbit in to anyone. If you’re interested in more content that we’re putting out, find us on any podcatcher out there, Apple, Google, Spotify. We’re on YouTube. If you are listening to this and you want to just relive it all again in video, find us on YouTube.

Abrin: Yeah. You can see what I look like. You can see what Tyler looks like. See what Craig looks like.

Tyler: We’re working on just putting a picture of Abrin in there so we don’t have to see him live. But awesome. Thank you, Craig, for coming on. This was great.

Craig: Thanks for having me. Appreciate it.

Tyler: Really great conversation today. Next time you might even get your own headphones.

Craig: I’d appreciate that.

Tyler: Let’s get out of here. Let’s get some ice cream.

Abrin: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Thank you.