My Roth Conversion: Why I Ignored the Calculators

Transcript:
(00:00) all right we’re going to talk about my own Roth conversion that’s right I had $248,000 left of traditional 401K funds that I wanted to convert to Roth and I’ve been delaying it I’m a Roth guy but I’ve been delaying it because I didn’t want to pay the taxes but I finally got over it and I converted now when I did the conversion I summed on some very interesting points here the typical Roth calculators all the calculators on the web that tell you when you should convert or not that are supposed to take into account all these factors have the
(00:28) wrong defaults the settings and assumptions in these calculators are wrong and I’m going to go into what you need to know to convert now I did my own calculations using the calculator here which I’m going to share I converted $248,000 now when I put it into the calculator here this is bankrate.com this calculator is the same as what you’ll see at Fidelity or Schwab when I put in my numbers it told me I should not convert it said converting traditional IRA or traditional $ 41k to Roth dollars will cost me $53,000 you
(00:58) can see it right here in the graph now most people would stop and say I’m not going to convert not going to do it the calculator said don’t do it it will actually cost me money now I’m going to show you why that’s wrong okay now we have to get into details of this now the number one thing we know when you convert you’re going to pay tax on the Roth conversion now the calculator is assuming that the current tax rate is 25% again these are the default settings if you just walked into the calculator you can modify it here which is what I
(01:23) did to get to the right answer that told me I should convert we’re going to get to why that was the case but the default settings here assume you’re in a 25% % tax bracket so if I add 248,000 of income into my tax bracket that’s going to cost me $ 62,1 now by the way if you’re in the 25% tax bracket on a $248,000 conversion you’re going to be jumping up to a 37% tax bracket that’s one flaw with this calculator it’s actually off on the tax it’s actually going to cost me more but stay tuned cuz I’m going to show you why
(01:52) it still made sense for me to convert now when you’re deciding whether to convert or not you’ve got to know okay I’ve got to pay the IRS $62,000 I’ve got to send that into the government but if I stayed as a traditional I could have invested that $62,000 we’re not assuming that $62,000 goes away there’s a cost of that $62,000 so when I convert I’m having to take $62,000 off the table if I go Roth but if I stay traditional I get to keep that 62,000 and invest it and that investment is going to grow over time and you can
(02:22) see on the calculator here it’s telling me that at a 7% rate of return that 62,000 in a taxable account where I will pay tax as it’s growing is going to come out to $197,000 it’s going to come out to $197,000 now this is in 20 years cuz that’s again what the calculator assumed it assumed I was 45 and I was going to retire at 65 that’s actually pretty closer I’m actually 44 so that one’s not too far off and this is probably the biggest piece a lot of people don’t think about when they’re converting to Roth and a lot of Roth fans don’t take
(02:52) into account that money that we have to pay the IRS and sometimes you in your state depending on your state you’ve got a state tax that money could otherwise be invested invested and grow for you Building Wealth outside of your retirement account we can’t discount that so the calculator is taking this into account now why did the calculator tell me I should not convert and that it will cost me $53,000 to convert it’s very simple and it’s right here tax rates this calculator has an assumption that my tax rate now is 25% and my tax
(03:21) rate in retirement is going to be 15% why does that matter because I’m paying tax on the conversion now at a higher tax bracket which costs me more and it’s assuming my tax rate is going to be lower when I reach retirement plan age now that might be the case for you and that might be the case for many but for most of our clients who are Building Wealth they intend to have more income in retirement than they have right now they’re Building Wealth they’re building assets and I’ve seen it over and over and over again clients get in their 60s
(03:51) and 70s and they have more income than they had in their 40s and 50s because they’ve built businesses they’ve built assets that create income and value over time and they’ve built large retirement accounts that are traditional which by the way when you distribute is taxable income pushing you up into a higher tax bracket so that’s the number one problem is the assumption is you are going to be at a lower tax rate in retirement now let’s just say I’m going to stay in the exact same tax bracket I’m not going up
(04:16) I’m not going down let’s just say I’m going to stay at the exact same tax rate this is what I did to calculate my Roth conversion all right so let’s plug in my numbers on the calculator this is the bankrate.com calculator this formula this model is used on all the other sites Voya Fidel TDM a trade they’re all using the same calculator and the same method but take my $248,400 I know I’m a Roth guy that I finally converted to Roth now you’re going to look here there’s three areas that affect the decision on whether to
(04:45) convert to a Roth Now the first thing we think of when converting to Roth of course is I’ve got to pay tax now and when we know we have to pay tax now on the conversion that’s going to take money off the table that money could otherwise be invested here and that’s of course the big difference of going from traditional to Roth you’re going to have pay now cuz you’ve got a volunteer money to the IRS and some of you to your state government but you get the benefit of this account growing and coming out totally tax-free at retirement now
(05:13) there’s three factors that are critical in this calculation when I put in the defaults into the calculator it told me it will cost you $53,000 to do a Roth conversion in other words you lose Matt do not do a Roth conversion you will lose you will have less money in your pocket but as we go through the numbers here in the analysis I’m going to show you why that’s BS why it’s actually wrong and why you shouldn’t be following these calculators or at least the default settings in them so let’s hit the three areas we got to address first
(05:41) the tax rate now and the tax rate in retirement second what is the investment tax rate that 62,000 of tax that it’s assuming I need to pay right now what’s the tax rate on that is it’s being invested CU that’s not in a retirement account anymore that’s non-retirement account dollars that I would have had to pay to the IRS but if I didn’t convert to to Roth that money could have still grown we got to take that into account and then the last piece is the rate of return on our investing the money in the retirement account as well as the money
(06:08) that has to get paid to the IRS if I do the Roth conversion that I could have otherwise invested for another 20 years okay so let’s start with the first Factor here now the calculator assumes something that I don’t believe is correct they’re assuming that I’m in a current tax rate of 25% and that at retirement I’ll be in a 15% tax bracket now a lot of people make that assumption a lot of financial advisers say that hey when you hit reti you won’t be working or you won’t have your business so you’ll have less income and because of
(06:34) that you’ll be in a lower tax rate so don’t worry about all the distributions coming out of your traditional retirement account a Roth’s not that valuable because you’re pulling the money out later in retirement when you don’t have high income I’m sorry but that’s not been the case for a lot of my clients 20 years of doing this talking to clients really Building Wealth they’re accumulating assets that produce income they’re taking out large retirement account distributions and if it’s traditional it’s taxable they’re
(06:58) staying in a high tax bracket now there’s the other group of folks that say Hey tax rates are actually be higher in retirement not because your income’s down because the government keeps raising tax rates and if you believe that’s the case that’s even more reason to convert right now but we don’t have to go to that extreme let’s just assume the tax rates are going to be the exact same now as they’re going to be in retirement now for me I just assume the highest federal tax rate of 37% right now and in retirement and at 37% when I
(07:26) do this now it says you win by converting to to Roth now we still got two other factors to hit but now this swings from me losing 50k to making $63,000 like they’ll be $63,000 more in my pocket now because I converted because I changed that one factor in the calculator the tax rates now and in retirement all right so now I’m up 63k but I kept looking at this calculator to think of my specific situation and should I actually convert guys this was my money on the line my own wealth sending to the government or getting to
(07:57) keep it and invest it so I was very intentional about this in doing it specific to my situation and that’s what everybody needs to do when they’re doing a Roth conversion I’m not saying a Roth conversions for everyone it’s got to be specific to your situation so make sure you’re considering the right inputs here now the second thing I changed on the calculator because the defaults weren’t right was the investment tax rate now the investment tax rate set by default is 15% I don’t believe that’s the case the long-term federal capital gains rate
(08:24) is 20% I don’t know who made this calculator but investment income is at least tax at 20% this could be end income this could be interest income this could be rental income this could be capital gain when you sell an asset it’s at least 20% in my experience if you have any income of substance you’re going to be at least at a 20% tax rate and that matters because this decreases the value of the money that I’m sending to the government for the Roth conversion therefore it swings me another 20K in favor of doing a Roth
(08:53) conversion now the third factor and calculation that was wrong in the defa on the calculator is the investment rate of return now this assumed a 7% investment rate of return and you can do that if I kept that it still told me I should con convert to Roth but I’ve been getting a 14% rate of return in my retirement account a lot of self-directed investors we work with and accounts that we have are getting this type of rate of return so I assume that for myself in calculating this now this was the most drastic change in whether I
(09:23) should convert to Roth or not now when I change the rate of return to 14% in the calculator this is now a half a million dollar benefit to convert to Roth I will have a half a million dollars more money in my pocket because I converted to Roth according to the calculator on the assumptions in my situation in my circumstances I should convert to Roth it’s a no-brainer that’s why I submitted the conversion form last week to just go freaking get it done and pay the tax already now there was one last thing in here and this is maybe a bonus reason
(09:51) for some of you that was interesting to me the calculator assumed I was 45 and I want to retire at 65 that was actually pretty close for me I do want to retire when I’m 65 but I’m only 44 now if I change that one year now the decision to convert goes up again another $85,000 that one additional year of taxfree growth in the Roth account gave me an $85,000 benefit so another lesson here at the end the younger you are the more valuable the conversion is or I should say the more time you take before you start pulling money out of
(10:24) retirement cuz now it went from a 20-year window to a 21-year window of investing that one additional year swung at 85k in my favor on doing a Roth conversion because again more tax-free dollars are building up and growing in the account and compounding benefiting me later in retirement so on that last point if you have a long-term view to say I’m going to be investing for 20 30 years longer I’m not going to pull the money out till I’m 70 or 75 you significantly benefit by doing the Roth conversion If instead I changed that and
(10:57) said nope I don’t want to retire at 44 I only want a 10-year Horizon zero reason to convert look at the calculator here it says eh zero reason to convert that’s why a lot of times when I have clients in their 60s that are like Matt should I convert eh only if you have like a really windfall big deal and you’re like I conver convert a 100 Grand and turn it into a million in two years would I convert to Roth but otherwise the typical 7% 14% type of return it doesn’t make sense so the decision on whether to convert is specific for your situation
(11:27) do not rely on the default settings in the Roth conversion calculators they will Jack you up and it’s going to slant you towards not converting so make sure you’re inputting the right tax rates the right investment tax rates and the right investment rate of return and also keep in mind make sure you have the right time frame of how long you will continue with this account and investing it so make sure you have the right current age and retirement age in there to determine whether you should convert or not all
(11:52) right now based on my example let’s hit some takeaways for everyone else on whether you should convert or not and let’s take into account these same factors I talked about the first one I want to start with and actually work backwards here is what is your investment time Horizon if you’re going to convert now how much time do you have until you want to pull the money out if you’re in your 20s or 30s it’s a no-brainer convert to Roth Now the benefit of the tax-free growth over time 30 40 years is insane but also for some
(12:19) of you that are like 50 and you’re like mat I don’t know that doesn’t seem fair the 20 and 30 year olds I’m just hearing about this I never knew about Roth or understood the power of it guys if you don’t pull the money out to your 70 you’ve still got 20 years to convert now if you’re like but I want to start drawing the money out when I’m 59 and a half eh maybe you shouldn’t convert I don’t think it’s beneficial for you to convert I don’t know the compounding and the value of that Roth money growing is worth it in just a 9 and 1 half 10e
(12:42) Horizon so first focus on the length of time you have to continue to invest those Roth dollars until you want to pull it out in retirement and I like to think for many of my clients the Roth bucket of money is the last bucket you draw on so if you have other funds and other resources draw on those before you get to the Roth bucket of funds so your social security income your other savings maybe other traditional retirement accounts leave the Roth until your late 70s let that grow that’s your tax-free bucket of wealth so let that be
(13:12) the last one you draw okay the second factor that is important in everyone’s situation is different is will you be in a lower tax bracket at retirement than you are now so let’s again assume you’re in your 50s you’re in the highest tax bracket right now you’re in your highest times of earning income you’re making great money you’re at the max tax federal tax rate and you don’t have a business or other investment income to rely on in retirement you might have some assets maybe some equity in your home some savings and a significant
(13:39) retirement account but that’s it and so you will likely have a lower rate of income when you hit retirement because that large income from your W2 or whatever it may be is going to be going away so you’ll simply have your retirement account Social Security me some other savings or Investments to rely on so if you truly believe that and look at your numbers and be realistic that you’re taxable income is going to be significantly Less in retirement than it is now it is another Factor against whether you should convert now again if
(14:07) you have a longtime investment Horizon of 30 years the WTH might still make sense but if you only have a 5 10 maybe even 20 year time Horizon it might be on the fence of whether to convert or not all right now the calculator I was using here is bankrate.com a lot of the other sites have this similar calculator but make sure you’re putting in the right inputs to give you the right direction in your specific situation where you should convert to Roth as for me I’ve converted I have no more traditional dollars anymore I’m just going to Roth
(14:35) and roll from here on out please subscribe to the channel I’ve got more tips on how to build wealth grow your retirement account save on taxes protect your assets we’ll see you next time