#rothira

(This is the third article in a four-part series. Click here to read Part 1 and Part 2.)

By:  Henry VanBuskirk, CFP®, Wealth Manager

Mr. Hill arrived in Texas and is eager to talk to his parents about the Roth Conversion idea that he overheard his boss talking about at work last week. Mr. Hill does not know his parents’ finances and just believes that a Roth Conversion will be a good idea for them and for anyone else their age. This is important to understand that while the recommendations that we give are not gospel, there are very few universal financial planning recommendations that can be given. We will show throughout this article why it is important to go through the financial planning discovery process to understand the household’s unique needs, what assets they have to work with, and how realistic their financial goals are before making a Roth Conversion recommendation.

As Mr. Hill heard over the phone, a Roth Conversion is when someone takes funds from an IRA, pays taxes on the distributed amount, and transfers the distributed amount into a Roth IRA. As long as the person is over age 59.5 and waits 5 years before taking money from the Roth IRA, distributions are tax-free. Mr. Hill knows that his parents do not have an advisor and do all of their financial planning work themselves on their financial planning software. Mr. Hill then proceeds to call his parents and they decide to run the numbers. Here is a summary of their financial plan (which we will call the Base Case):

• Hank and Peggy are 68, live in Texas, and are projected to live to age 100.
• Hank and Peggy are retired, but Hank still works part-time at Strickland Propane earning $5,000 per year. Hank plans to work part-time until age 70.
• Peggy earns a pension of $25,000 per year that grows at 2% per year and will pay out throughout both of their lives¹.
• Hank will receive $46,000 per year in Social Security benefits starting at age 70. Peggy does not receive any Social Security benefits.
• They have $25,000 in cash earning 1.55% per year.
• Hank has an IRA worth $102,000 earning 4.66% per year.
• Peggy has an IRA worth $87,000 earning 4.66% per year.
• Their home is worth $480,000 and there is no debt on the property.  The home value is expected to appreciate by 2.5% per year.
• $3,000 per year for Alamo Beer, indexed to inflation at 2.5%
• $30,000 every 10 years to buy a new truck starting in 2025, indexed to inflation at 2.5%

Hank and Peggy want to see the effect of converting both of their IRAs to Roth IRAs. They run the numbers and get the following result:

Hank and Peggy are pleased to see that their total assets are $229,889 greater ($865,087 vs. $635,198) at age 100 by doing the Roth Conversion this year.  Hank and Peggy understand that by doing a Roth Conversion, they would be treating any amount that they convert from their IRA as ordinary income in the year of the conversion.  Therefore, they run the scenario in their tax planning software and get the following result:

Hank and Peggy like what they see and understand that they can pay $32,126 in taxes this year to have an additional $229,889 at the end of their financial plan since they will not be required to take any RMDs (Required Minimum Distributions) during their lifetimes. Hank and Peggy decide to meet with a local advisor, Mr. Handshake that checks their work and commends them for their plan. Mr. Handshake mentions that they have no problem with their planning. The advisor thanks Hank and Peggy for their time and the meeting concludes. Hank has an uneasy feeling about Mr. Handshake since his handshake was not firm. Hank mentions this uneasy feeling to Peggy about Mr. Handshake’s handshake and says he can’t trust a person who doesn’t have a firm handshake. Peggy rolls her eyes and then obliges Hank’s concern and decides to schedule a meeting with another advisor, Mr. Rock, to get a second opinion.

Mr. Rock meets with Hank and Peggy to review their financial plan and their Roth Conversion scenario. He mentions that while their assumptions are correct, there are a couple of items that he wants to make sure that they are aware of. Hank has been listening intently the entire meeting since Mr. Rock’s handshake at the onset of the meeting was very firm. They have the following conversation:

Mr. Rock: “Hank, Peggy, your plan for a Roth Conversion does help out your financial plan in the long run, but it looks like you missed projections for the Medicare Part B and Part D increase when doing a Roth Conversion. I took the liberty of adding a couple of line items to your report:

Mr. Rock: “If you are going to do the Roth Conversion, you are going to need to pay in 2025 an additional $66 per month in Medicare Part B premiums and $12 in Medicare Part D premiums. This threshold that you passed is called IRMAA and was created to help fund the Medicare program². What if I showed you a financial plan that would allow you to convert your IRAs to Roth IRAs over a 5-year period, increase your ending portfolio value by $36,136, and not have to worry about any increase in Medicare Part B or Part D premiums?

Hank and Peggy: “We’re listening.”

Mr. Rock: “First off, here is your updated plan with the new strategy for converting your IRAs to Roth IRAs over a 5-year period.

“As you can see, instead of a portfolio ending value of $865,087 from converting everything in 2023, you can instead have a portfolio ending value of $901,223 from the 5-year Roth Conversion strategy.”

Peggy: “Mr. Rock, hold on. I’m reviewing your tax planning projections for the 5-year Roth Conversion strategy and our plan to Roth convert everything in a 5-year period (for those interested in the calculations and assumptions used, please see the Appendix at the end of this article). Just so we understand correctly if we follow the 5-year Roth Conversion plan we would pay the following taxes:

• $4,059 in 2023
• $4,161 in 2024
• $8,971 in 2025
• $8,507 in 2026
• $9,511 in 2027

For a total tax of $35,209

and if we were to instead Roth convert everything in 2023, we would pay the following taxes if we were to Roth convert everything in 2023:

• $32,126 in 2023
• $0 in 2024
• $1,483 in 2025
• $572 in 2026
• $642 in 2027

For a total tax of $34,823

Why would we do the 5-year Roth Conversion plan if we would be projected to pay more in taxes?”

Mr. Rock: “You are right that you would pay more in taxes to the IRS over the next 5 years if you decided to do a Roth Conversion over the next 5 years instead of Roth convert everything in 2023, but you would also avoid any increase in Medicare Part B and Part D premiums by doing the Roth Conversion over a 5-year period. If you did Roth convert everything at once, you would owe an additional $936 in Medicare Part B and Part D premiums, which is the IRMAA discussion that I had with you earlier. You actually would owe less out of pocket over your lifetimes over the 5-year Roth Conversion plan and since you would be spreading that tax liability over a 5-year period, there is less strain on your portfolio and won’t need to withdraw as much in 2023, which leads to a higher ending portfolio value doing the 5-year Roth Conversion plan.”

Hank: “Can you explain that again?”

Mr. Rock: “Think of IRMAA as a tax, just one that is administered by the Social Security Administration, not the IRS. A tax in my book is any money that you need to pay from your earnings to a government entity to receive services from that government entity. Paying additional money each month for Medicare services whether or not you actually use those services is still money out of your pocket. Breaking down Peggy’s numbers from earlier, your total tax bill looks like this:

• 5-year Roth Conversion plan:
  • $4,059 in 2023
  • $4,161 in 2024
  • $8,971 in 2025
  • $8,507 in 2026
  • $9,511 in 2027

For a total tax of $35,209

• Roth convert everything plan:
  • $32,126 in 2023 + $936 IRMAA increase due in 2025 = $33,062
  • $0 in 2024
  • $1,483 in 2025
  • $572 in 2026
  • $642 in 2027

For a total tax of $35,759

You save $550 over this 5-year period by avoiding any Medicare Part B and Part D increases, increase your ending portfolio value by $36,136, and avoid RMDs during your lifetimes since all of your IRA assets would be in Roth IRAs by the time you reach your RMD age of 73.” 

Hank: “That sounds great to me. What do you think Peggy?”

Peggy: “Sounds great to me. Thank you, Mr. Rock.”

Hank: “Thank you, Mr. Rock.”

Mr. Rock: “You’re welcome. Have a good day.”

Hank and Peggy decide to follow Mr. Rock’s advice and decide to have Mr. Rock manage their finances. There’s only one additional mistake that Hank and Peggy made. They didn’t ask how Mr. Rock was compensated. Luckily, Mr. Rock is a fee-only advisor, and his full title is Mr. Dwayne Rock, CFP®. A CFP® professional has a fiduciary duty, meaning that they strive to put their client’s interest ahead of their own at all times. Further, to be called a fee-only advisor, the advisor must adhere to the following rules (by the CFP Board’s definition)³: (a) the CFP® professional and the CFP® professional’s firm receive no sales-related compensation; and (b) related parties receive no sales-related compensation in connection with any professional services the CFP® professional or the CFP® professional’s firm provides to the client. It is important to note that just because an advisor can earn commissions, doesn’t make them nefarious. However, it is important to know how an advisor gets paid to understand whether or not they actually do have your best interest in their heart at all times when making a recommendation⁴. Tune in next week to see what potential issues can arise if you work with an advisor that puts their bank account ahead of your needs.

Footnotes:

1. This pension benefit was awarded to her for winning “Substitute Teacher of the Year” three years in a row.
2. You can find the IRMAA brackets here https://www.medicareadvantage.com/costs/medicare-irmaa
3. https://www.cfp.net/-/media/files/cfp-board/standards-and-ethics/compliance-resources/cfp-board-guidance-for-fee-only-advisors.pdf
4. BFSG is a fee-only Registered Investment Advisor.

Appendix:

Assumptions used in the tax calculations in the 5-year Roth Conversion plan:

• The pension income increases by 2% compounded interest each year
• The assumed values of the IRA values and the Roth Conversion amounts assume that Hank and Peggy’s IRA balances total $189,000 and increase by 4.66% per year.  The Roth Conversion amount increases by 2.5% per year until the final year has the full remaining balance of $48,627.15 in Traditional IRAs be converted into their Roth IRAs.  Here is the balance in a spreadsheet:

• Hank’s wages increase by 2.5% per year and stop at 2025
• Taxable interest increases by 1.55% per year
• Social Security starts in 2025 and increases by 1.5% per year
• The standard deduction does not sunset back to the proposed 2017 values (adjusted for inflation)

Assumptions used in the ‘Roth convert everything’ plan:

• The pension income increases by 2% compounded interest each year
• The entire combined IRA balance of $189,000 is converted into Roth IRAs in 2023
• Hank’s wages increase by 2.5% per year and stop at 2025
• Taxable interest increases by 1.55% per year
• Social Security starts in 2025 and increases by 1.5% per year
• The standard deduction does not sunset back to the proposed 2017 values (adjusted for inflation)

Disclosures:

Past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk.  Therefore, there can be no assurance that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Benefit Financial Services Group [“BFSG”]), or any consulting services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  BFSG is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, you should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from BFSG. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.bfsg.com. The scope of the services to be provided depends upon the needs and requests of the client and the terms of the engagement. Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.

By:  Paul Horn, CFP®, CPWA®, Senior Financial Planner

As parents we always want to see our kids succeed and do better than we did. This means many times we want to invest in their future for various things. Most of the time parents want to save for education, but there could be other reasons to save.  For example, helping them buy their first home, seed money to start their business venture, or to pay for a wedding. Below are the most common account types and when it may be the best choice based on your goals for the money. Some may notice that the Coverdell (Educational IRA) is not listed and that is because it is no longer relevant given recent changes to the 529 Plan.

529 Plan: Best account for saving for education

• Best used if you 100% know that the beneficiary is going to use the funds for college, post-secondary education, or private school.
• For 2022, the max that can be contributed in one year is $16,000 per person per beneficiary (or $32,000 with gift splitting).  There is also an option to superfund a 529 where 5 years of contributions are made in one year.
• Contributions grow tax-free and distributions can be tax-free as long as they are used for qualified education expenses.  Qualified education expenses include (but are not limited to) items like room and board, tuition, and books.
• Contributions can be deductible at the state level depending on your state.
• If the distribution is not for qualified education expenses, the earnings on the distribution are subjected to ordinary income taxes and a 10% withdrawal penalty.
• You can switch the beneficiary at any time. Let’s assume you have money left over after the oldest child graduates; you can transfer this money to the next kid in college.

UTMA/UGMA (custodial account): Best account if you want your kid to have the money at 18 or 21 without any limitations

• In 2022, this is an account where the custodian can contribute $16,000 per year to an investment account for a minor child.  At the age or majority (usually age 18 but can be increased to age 21 or 25 in some circumstances), the minor child then becomes the owner of the account.
• While the minor child is still listed on the UTMA (Uniform Transfer to Minors Act) account or UGMA (Uniform Gift to Minors Act) account, the earnings are subject to capital gains at the following schedule:
  • The first $1,100 of unearned income is free from tax,
  • The next $1,100 is taxed at the minor’s tax rate,
  • Earnings above $2,200 are taxed at the parent’s tax rate.

• When the account transfers to the minor child due to the minor child reaching the age of majority, earnings and distributions are taxed at capital gains tax rates.

2. Put money into a taxable account in your name – Best option for anything not education specific

• There are no limits on how much you put into the account or how the money is used.
• You maintain full control of the assets and determine when and how much they receive.
• This is a taxable account, so it would be subject to regular taxes (i.e., interest income, capital gains, dividends, etc.)
• If your kid(s) were to inherit the taxable account, the securities in the taxable account get a step up in basis to virtually eliminate any tax implications for them.
• A taxable account has less impact on financial aid for your kid(s) than a UTMA/UGMA.
• Money can be invested however you choose.
• When you give the money to them it is considered a gift and limited to $16,000 per person or $32,000 for a married couple per year (2022). Any amount over this is reported on a gift tax return (no taxes are paid but it reduces your estate tax exemption).
• If the money is used to pay tuition for a school directly or directly to medical bills, then the $16,000 limit does not apply.

Roth IRA: Best if saving for their retirement

• Contributions to a Roth IRA can be made for a minor child as long as the minor child has earned income from working.
• For 2022, contributions are limited to $6,000 or the amount of earned income (whichever is lower). Assume they make $3,000 from a summer job, then you are limited to contributing $3,000.
• A parent can put money into the Roth IRA for the kids to allow the kids to keep their income they earned.
• Contributions grow tax-free and distributions can be tax-free if the owner (the minor child) is at least age 59.5 and the contributions have been in the account for at least 5 years.  If not, earnings on the distributions are subject to ordinary income tax and subject to a 10% early withdrawal penalty.  There are some instances where the 10% early withdrawal penalty can be waived that include (but are not limited to): buying your first home (up to $10k), college tuition, or permanent disability.

As you can see, there are many options available to you and the best account depends on what your goals are. You can reach us at financialplanning@bfsg.com if you would like to have a complimentary call to discuss your specific situation.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

By:  Henry VanBuskirk, CFP®, Wealth Manager

Investing is a broad concept that has a wide array of definitions that differ depending on whom you ask.  If you ask a recent college graduate, parents in their early 40s with two young children, and an elderly retired couple to define what investing means to them, you will probably get three wildly different answers. They all have different goals, and their investment accounts need to match those goals. My goal with this article is to help define some of these different investment accounts and why they would be used. There are many different types of investment accounts, and it may be overwhelming to keep tabs on the goals and rules for each account type. While I’m not going to go through every single investment account type in existence, I am going to help define some of the more common and lesser-known investment account types and why they would be used in each stage of life. Let’s start with the recent college graduate.

College graduate:

Say you are a recent college graduate of 24 and you started working for ABC Company. You probably aren’t thinking much about your retirement (…that’s 40 years from now…). You probably are thinking about making sure you can pay rent on time and hoping your date on Friday night goes well. The recent college graduate would probably answer, “I have a 401(k) at work, social security when I’m older, and I’ll be fine. There are a few stocks I like, and I follow the market, but I don’t have enough money to set aside to focus on investing. I don’t need to focus on investing right now.” The sentiment towards investing is understandable, but there are a lot of things that this college graduate can do now. This could be the prime time in this person’s life to start thinking about investing. Assume that ABC Company offers a match of 4%, you make $50,000, your salary never increases, and you contribute 10% to the 401(k).  Below is how much you would have at your projected retirement at age 65 assuming a 7% rate of return.   

Now compare this to someone at ABC Company who is 40 years old, makes $100,000 per year, their salary increases by 5% per year, and contributes 10% to the 401(k) each year. We will use the same 7% rate of return assumption.

The college graduate (24-year-old), who makes half as much as the 40-year-old, would have more saved in retirement. This is due to what Einstein calls “The Eighth Wonder of the World”, compound interest. 

A Traditional 401(k) also would offer tax-deductible contributions that would lower your pre-tax income, would you lower your tax bill, and the investments would grow tax deferred. The catch is that you would be required to take distributions in retirement starting at age 72. This is called the required minimum distribution (RMD). The college graduate is probably not thinking about RMDs right now, but what they are thinking of is getting a break on their taxes and saving for their future retirement. There is also a Roth 401(k)that does not allow for tax-deductible contributions, the earnings would grow tax-deferred, but you would not be required to take any distributions ever (not all plans offer this option).

Now assume that ABC Company offers a High Deductible Health Plan. Since you are a 24-year-old, you probably are in good health and would be okay signing up for a high deductible health plan.  Doing so would give you access to a lesser-known account, a Health Savings Account (HSA). This account type offers the trifecta of tax savings:

• Tax-deductible contributions
• Tax-free growth
• Tax-free distributions when used for qualified health expenses

Think of this account as a Traditional 401(k) where you don’t have required distributions. If you don’t use it for qualified health expenses, then distributions are taxed at ordinary income tax rates. There is also a limit to how much you can contribute to an HSA in any given year (for 2022, $3,650 for individual coverage and $7,300 for family coverage). As we illustrated before, time is your friend when it comes to investing.

Parents in their early 40s with two young children:

Now assume that you are a 43-year-old parent with two young children, ages 5 and 6. You may be thinking about what’s best for your children. Fortunately, there are investment accounts that you can consider for their goals as well. Some investment account types that would fit this bill are Uniform Transfer to Minors Act (UTMA) accounts, Uniform Gift to Minors Act (UGMA) accounts, and Roth IRAs.

Uniform Transfers to Minors Act (UTMA) accounts or Uniform Gifts to Minors Act (UGMA) accounts are accounts where you can set aside money each year to invest for a minor. The adult family member is the custodian (person in charge of the account) and when the child reaches the age of majority (normally 18 but can be as high as 25 in some states), the account legally changes ownership to the child. There are very few differences between a UTMA and a UGMA, which is why I lump them together and will refer to them as a custodial accounts. A custodial account is taxed with the following schedule:

• The first $1,100 of unearned income is free from tax
• The next $1,100 is taxed at the minor’s tax rate
• Earnings above $2,200 are taxed at the parent’s tax rate

It generally would require filing a tax return to report any gains or losses attributed to the investment account’s performance. The taxation in a custodial account is not dependent on whether or not the child or grandchild uses it for qualified education expenses. The UTMA or UGMA account after the child or grandchild reaches the age of majority becomes a non-qualified investment account. This means that it is taxed at the more favorable capital gains tax rates.

One account that can help pay for future college expenses is a 529 plan. 529 Plans (sometimes referred to as college savings plans) are a great investment vehicle if your child goes to college or a private school. This is because the earnings are tax-free, and distributions are tax-free as long as the funds are used for qualified education expenses. The downside is if the distribution is not for qualified education expenses, then the earnings are taxed at ordinary income tax rates and a 10% penalty is assessed. If your child has goals of wanting to be an astronaut, doctor, or another profession that requires post-secondary education, it may be a good opportunity to talk to them about what needs to happen to realize that goal. Maybe during Christmas, you have the child open a letter that has a $100 check made out to a 529 plan. The kid would naturally have questions. You could then give them the same gift every Christmas and show them the 529 plan statement on how you are working together to make that goal a reality.

Another way to save for a minor child would be a Roth IRA. Roth IRAs are available to anyone that has an earned income below $144k for single taxpayers or $214k for married filing jointly. This isn’t just for people 16 and older that work part-time after school. You can have even younger people than that contribute (with the parent’s help as custodian) to a Roth IRA provided that they have earned income.  Earnings on a Roth IRA are tax-free, as long as it has been longer than 5 years since you first contributed to a Roth IRA account, and you have reached age 59.5. There is a 10% early withdrawal penalty if funds are withdrawn before age 59.5 and it is possible that you would owe ordinary income taxes on the earnings received. Your basis in the Roth IRA is never subject to taxation.

For example, I worked with a client who owned an educational toy company, and her 2-year-old was a ‘toy tester’. She gave the 2-year-old a salary, and then matched that salary in the form of a Roth IRA. Think outside the box, but also make sure everything is well documented since you are reporting all of this to the IRS. We are all about tax saving strategies at BFSG, but we will never recommend illegal tax avoidance strategies.

An elderly retired couple:

The elderly couple isn’t thinking about accumulating and is instead thinking about maintaining their lifestyle and passing on their successes to future generations in their household. This is also the time when you are taking required minimum distributions (RMDs) from your Traditional 401(k) or Individual Retirement Account (IRA).

This elderly retired couple has a sizable estate and are concerned about making sure their grandchildren can attend college. They can put the RMD funds (net of taxes) into a 529 Plan that would grow tax-free and withdrawals can be tax-free if the funds withdrawn from a 529 Plan are used for qualified educational expenses. With a 529 plan, you can build an educational legacy for your grandchild while taking advantage of tax and estate planning benefits.  

What some of our clients do when they don’t need the money from their RMDs (not a bad problem to have) is that they journal the net distribution from their Traditional 401(k) or IRA to their brokerage investment account.  The brokerage investment account is non-qualified (no favorable tax treatment) that can be used for any purpose.

However, don’t let Lloyd Christmas have that chance at your estate. Make sure the brokerage investment account is titled properly – preferably in the name of your Living Trust.

Upon the elderly retired couples passing, the brokerage investment account would pass to their heirs (as dictated in the Trust), and they would receive a step-up in cost basis at death. For example, assume you put $100,000 into a brokerage investment account and it grows to $150,000 10 years later. If you close out the brokerage investment account, you would owe long-term capital gains taxes on the $50,000 gain and you would receive $150,000 minus what was paid in long-term capital gains taxes. If you instead leave the account open and pass away with the $150,000 brokerage investment account, your heirs would receive the account and can choose to take the $150,000 tax-free.

Conclusion:

Regardless of what demographic group you are a part of, there are investment accounts for you and a team of CERTIFIED FINANCIAL PLANNERS^TM at BFSG that can help you along your life journey.  Let us know what we can do to help. 

Sources:

1. https://www.bankrate.com/retirement/401-k-calculator/
2. https://www.fidelity.com/viewpoints/wealth-management/hsas-and-your-retirement
3. https://www.nerdwallet.com/article/investing/utma-ugma
4. https://www.bankrate.com/loans/student-loans/roth-ira-for-college/
5. https://www.savingforcollege.com/article/can-i-pay-my-mortgage-with-529-plan-money
6. https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022
7. https://www.courts.ca.gov/partners/documents/probguide-eng.pdf

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

One silver lining in the current bear market is that this could be a good time to convert assets from a traditional IRA to a Roth IRA. Converted assets are subject to federal income tax in the year of conversion, which might be a substantial tax bill. However, if assets in your traditional IRA have lost value, you will pay taxes on a lower asset base when you convert. If all conditions are met, the Roth account will incur no further income tax liability for you or your designated beneficiaries, no matter how much growth the account experiences.

Tax Trade-Off

The logic behind deferring taxes on retirement savings is that you may be in a lower tax bracket when you retire, so a current tax deduction might be more appealing than tax-free income in retirement. However, lower rates set by the Tax Cuts and Jobs Act (set to expire after 2025) may have changed that calculation for you. A cost-benefit analysis could help determine whether it would be beneficial to pay taxes on some of your IRA assets now rather than later. One strategy is to “fill your tax bracket,” meaning you would convert an asset value that would keep you in the same tax bracket. This requires projecting your income for 2022.

Lower Values, More Shares

As long as your traditional and Roth IRAs are with the same custodian, you can typically transfer shares from one account to the other. Thus, when share prices are lower, you could theoretically convert more shares for each taxable dollar and would have more shares in your Roth account to pursue tax-free growth. Of course, there is also a risk that the converted assets will go down in value. You may have the option to take taxes directly out of your converted assets, but this is generally not wise.

Two Time Tests

Roth accounts are subject to two different five-year holding requirements: one related to withdrawals of earnings and the other related to conversions. For a tax-free and penalty-free withdrawal of earnings, including earnings on converted amounts, a Roth account must meet a five-year holding period beginning January 1 of the year your first Roth account was opened, and the withdrawal must take place after age 59½ or meet an IRS exception. If you have had a Roth IRA for some time, this may not be an issue, but it could come into play if you open your first Roth IRA for the conversion.

Assets converted to a Roth IRA can be withdrawn free of ordinary income tax at any time, because you paid taxes at the time of the conversion. However, a 10% penalty may apply if you withdraw the assets before the end of a different five-year period, which begins January 1 of the year of each conversion, unless you are age 59½ or another exception applies.

More Favorable RMD Rules

Unlike a traditional IRA, Roth IRAs are not subject to required minimum distribution (RMD) rules during the lifetime of the original owner. Spouse beneficiaries who treat a Roth IRA as their own are also not subject to RMDs during their lifetimes.  Other beneficiaries inheriting a Roth IRA are subject to the RMD rules. In any case, Roth distributions would be tax-free. The longer your investments can pursue growth, the more advantageous it may be for you and your beneficiaries to have tax-free income.

If you are interested in completing a Roth conversion, please contact us to complete a cost-benefit analysis to help you understand the implications of completing a conversion.

Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

By:  Michael Allbee, CFP®, Senior Portfolio Manager

Volatility or down markets only become a problem if you’re forced to liquidate at the wrong time. If you have enough cash to get you through, you’re going to come out fine on the other side most of the time. We generally recommend setting aside funds to cover 3-6 months’ (6-12 months’ if retired) worth of non-discretionary living expenses (i.e., housing, taxes, debt service, groceries referred to as needs) as an emergency reserve. This recommendation helps our clients handle short-term problems that are beyond their control (i.e., unemployment, car problems, medical bills, etc.). Without an emergency fund most people resort to using high-interest rate credit cards to pay their expenses. This conflicts with your long-term goal of saving for retirement and/or portfolio withdrawals at an inopportune time.

We also recommend matching the time horizon for when you may need the money with the chosen savings product. For example, we recommend keeping some of your emergency reserve in a FDIC-insured savings account at your bank, an online bank, or credit union that offer daily liquidity. What you earn on your emergency reserve is irrelevant and the main goal of this investment is liquidity. However, one positive of the current increase in yields, is that many of these FDIC-insured savings accounts now offer yields up to 0.90% today. Recently, we have been working with clients to purchase 3-month to 2-year Treasury bills yielding between 1.7% – 3.2% for a portion of their emergency reserves or for other short- and medium-term savings goals, such as a down payment for a house or car purchase. These yields are higher than current Certificate of Deposit (CD) rates and are principal protected if held to maturity.

If you have excess reserves that you won’t need for at least 12-months (and preferably 5 years), we have been recommending Series I savings bonds (I Bonds). I Bonds are currently yielding 9.62% and can be bought directly from the Treasury Direct website. Unfortunately, each person is limited to purchasing $10,000 worth of I Bonds a year, and the yields will fluctuate based on inflation. Furthermore, if you cash in your I Bonds within five years of purchasing them, you lose the previous 3 months of interest.

Another consideration is a Roth IRA. The Roth is unique, in that any contributions you make to a Roth can be withdrawn without penalty or taxes. The caveat is that any earnings in the account need to remain for five years, and you must be 59.5 years old or older (unless an exception applies) for it to be considered a qualified distribution to avoid taxes and a 10% penalty. In turn, you are technically saving for retirement and building a nest egg for any short-term unexpected expenses. This option should be looked at as an additional cushion to your emergency reserve and not as a replacement, since the funds in your Roth account should be invested in the markets which will fluctuate in value.

We highly encourage you to Talk With Us if you want to strategize about your emergency reserves or need help building your emergency fund.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.