Is Your 401k Plan Missing This Secret? (Roth Conversions Explained)

You've probably heard the same thing over and over when it comes to retirement. Just put money in your 401k and you'll be fine. But here's the thing. When it comes to Roth conversions, typical advice like always convert to a Roth no matter what can actually cost you more in the long run. Our firm has helped clients save millions by handling Roth conversions correctly. So, we've seen firsthand what works and what doesn't.

Today I'm sitting down with Phil Clark, our CEO, who's got a lot to say about Roth conversions.

In finance, there is no one-size-fits-all. They think that if I put my money in Roth that I'm going to be much better off, but it is not the panacea, and people need to be aware of that.

We're covering the good, the bad, and the misunderstood. And together, we're going to unpack how you can know if this move makes sense for you.

So, I get the pleasure today, Phil, of putting you on the spot. And this is going to become the new norm. So, I'm going to come up with the questions. You're going to come up with the answers because you've been at this for a long time. There's a wealth of knowledge that you've collected over three decades of experience. And so, this is a delivery that is much different. You ready for that?

I'm gonna give it my best shot.

All right. I'm liking it. So, why do you get so frustrated when people give one-size-fits-all advice about Roth conversions?

Well, because in finance, there is no one-size-fits-all. There's plenty of things that sound like they can fit everyone, and there's plenty of things that everybody wants. That doesn't mean it fits everybody. So, it isn't that I don't like Roth conversion for everybody. I wish it would fit everybody, but the fact is it doesn't.

Yeah.

And so depending on age, depending on time to retirement, depending on income levels, depending on tax rate, there's so many variables, Spell, but everybody, every year, we meet people that say, "Oh, well, I've been told I ought to do this Roth conversion or that I need to be doing everything Roth." And the fact of the matter is when you run the numbers, if they're done properly, that's the that really in my opinion is where people get off course. They think they have the right numbers, but their math is flawed in a lot of cases or they're getting advice from someone who really doesn't understand all of the nuances.

Yeah.

And so if you don't get that right, well, I can build a set of numbers and make a Roth look like it's the right thing to do.

Yeah.

And so yet it's frustrating because I see people making mistakes that are avoidable.

Yeah.

And when you can avoid a mistake, in my opinion, that translates to dollars in your pocket if you avoid blowing them by doing things that really didn't make sense for you. So yeah, it gets me riled a little bit.

Well, I had to ask because we were in the office last week. In fact, sitting at the you were sitting at the table with someone who I think maybe was misinformed or misled or misguided, however you want to say it, by another individual and they sat at our table and I think you walked them through why in this case a Roth conversion made sense for them, right? So I thought and I could feel the frustration because by and large I think this person was sold a bill of goods and we knew that that probably wasn't the best thing for them.

It's easy to love the bill of goods.

Yeah.

When someone says to you everything is tax-free. Who doesn't like that?

Yeah.

We live in a society where a wonderful society. Don't get me wrong, I think America is it's why we have a American flag right behind us. There's no other country in the world that gives you the ability to do what we can do here, right? And so I'm not complaining that much, but I am saying that the tax code is not meant to make life easy for you. In fact, if you don't know it, know it well and how to use it, then you're going to make mistakes and people misuse it all the time. So, I think yeah, give people something that sounds like it's a panacea. Yeah, they're going to jump all over it. But if you don't look beyond the surface, that panacea, you're going to figure out real quick wasn't a panacea at all.

It's true. That's a good point. Why do you think Roth conversions carry such a stigma when it comes to taxes? Why is that?

Well, I don't know that they always have a stigma, but I do believe that Roth has been coined as the saving grace to all things. But because it's been misused, it gets stigmatized a little bit.

Mhm.

I think that's because, Spell, people are just not getting what they need and everyone believes, okay, my tax rate must be going up. When I reach retirement, I'm going to be in this much higher tax rate.

Yeah.

When the facts tell us that when a person retires, the average rate is 20% or lower. Now, I'm not saying that's for everybody or that it's going to be the case for everyone, right? Some people will be blessed with much larger incomes and their tax rate won't be 20%. Right? But there's also a tremendous number of tools out there that we can use to whittle away at the tax bite.

Learning how to use the brackets, for example, one thing that nobody knows how to do. Well, most people don't understand how our tax system works. People think that they reach a certain income and all of a sudden all of their dollars are taxed at that level, which is just not. That's not the case. If you lived in Canada, yeah, you'd be closer to that, right? But even Canada has a sort of a graded system, right? But up there once you get over about $218,000, I think it is, Spell, you're hitting 50% for the rest of your income. So, you ought to look at our tax bracket or graded system and realize, this ain't all bad relative to the Canadian system.

It's not if you know how to use it.

That's right. Now, that's right. I think if people learn that, then I believe Roth can be used in a really, really good way. Can be really strategic. But I think in general people are getting duped because there is someone on the other end of that transaction who wants to get them transition to a Roth. It's good for them, but it might not be good for the taxpayer for the person making that transition.

I just I love Roth. Don't get me wrong. I use Roth in my 401k. But it is not the panacea and people need to be aware of that. People that are trying to do these transitions, they think that if I put my money in Roth that I'm gonna be much better off and so let me pay the tax now and I'm going to be much better off down the road. On the surface that sounds right.

Sure.

But if I give you an after tax contribution and we do a before tax contribution, if we run that math and we go out 5, 10, 15 years, we're going to end up with the same amount of distributable income, right? We're going to get the same number. That's what people are missing. They think for some reason it's going to make a lot more sense to do the Roth now. And it could, but if you just look at all things being equal, no other parts being included here in terms of taxable income or tax deductible things, just dollars in tax t before tax and dollars in after tax, meaning Roth, take that out five or 10 years, the net results can be the same.

Here's what I this will definitely fire you up because I know you. When people hear taxes and government, they often think the worst. What worries you the most about how those interact?

Yeah, you're right. That's a good question. So, taxes, government, yes, generally speaking, people hear the word tax and they immediately say government equals bad. They might say something different, but we're not going to speak that way on the show.

We won't say it on the show.

But yes, expletives can fly. People don't like it. I don't like tax.

I don't either.

And naturally, I look to the government because that's who levies the taxes, right? But, Spell, if you look around the world, our tax system is really fair. What's more is our tax system allows, if you know it, if you understand how to use it.

Mhm.

I see people that are making 5, 6, 700k a year. I see people making a million a year. And if they understand how to buy assets, what assets make sense, how to finance those assets, if it happens to be hard assets, if they understand how to use the tax system, it's not as penalizing as people might believe. It's not great. Don't get me wrong. No one wants to pay 37% of their income to Uncle Sam. But, Spell, you've got to earn 7800K to even get to 37%.

Yeah.

So, you're not paying 37% right out of the gate. And I hear people say that. It frustrates me because that's not the case.

Yeah.

The first 20,000, you're not paying 37% or the first 100,000 or 200 or 300. You're not paying 37%.

Right.

But people somehow they take their top bracket if they touch it with 2,000 bucks. Oh, I'm in the 37% bracket. No, you're not. No, you're not. But then they think that way and so they get angry with the government. I'm not saying the government's right. They're wasteful. I hate that the government is so wasteful. I hate that we have 37 trillion dollars of debt in this country. That's why we have to deal with taxes in the first place.

Yeah.

But taxes in government, people just shouldn't look at it that way. What people should do is get educated and learn how to use the tax system so that they don't have to be angry. Focus on what's going to really matter. Your anger isn't going to change anything. Not a thing. And it's certainly not going to change the law. Just learn the system.

That's right.

And learn how to exploit what the system allows you to do.

Phil, I have another question for you. And I think people often get this wrong and so maybe you can shed some light on it.

I'll try.

The super high net worth and a lot of the folks in the political scene or you hear about this all the time. The rich don't pay their fair share in tax. Do you believe that? Do you think that the rich don't pay their fair share in taxes?

No, I don't really believe that.

I don't either.

Do I believe that they understand the tax code better? Yes.

Or they pay someone to understand it for them.

You're exactly right. So, I think they have enough people around them.

Yeah.

That really know how to navigate the tax code and these people help them mitigate and in some cases eliminate tax. But these arguments that you hear, Spell, about people paying less income tax the richer they are. I would this is probably a full show. We talk about this for a long time. If you look at some of the richest people in the world and you think about first the number of people that they employ, they are paying taxes on all of that.

Mhm.

What they spend is far more than most of us ever conceive.

Really?

Yeah. These people have lifestyles that pay so much in sales tax and use tax, property tax. Spell, we're talking about people with properties that are some of these folks. Jeff Bezos, he has homes that are worth $150 million for a home. It's unbelievable. Think about what his property tax looks like.

Oh, yeah.

So, I'm not saying that that makes it okay that they don't pay a lot of income tax, but they are paying a lot. And if you look at the statistics, what they pay is an incredible amount compared to what the lower ranking society pays. So, I'm not saying it's right or wrong. There will never be a perfect system, but no, I don't think that they get a free ride. They pay a lot of tax. I'm glad we have those people.

Yep.

Because those are the innovators. Those are the people that put other people to work without them doing what they do and creating all these great companies. Take Elon Musk. People say he doesn't pay enough tax. I have no idea what he pays, but I bet it is a mountain of tax that he pays.

Oh, yeah.

In number of ways. Well, what would we be? Where would this country be today? How many people would be without work if we didn't have Tesla? Whether you like you or not.

Yeah. Yeah. It's a good question.

Or Jeff Bezos, whether you like him or not, I don't care what your feelings are about the man.

Politics aside.

Politics aside, look at what they've done, right? And so that level of employment, that's huge.

Yeah.

And then take it all the way down to your smaller, still very wealthy people, but smaller employers.

Oh, yeah.

Maybe they only employ a few hundred people.

Mhm.

But I know people right here in our hometown, Spell, that employs several hundred. These people are pay a fortune in taxes. Now, do they remove a lot of their income to pay lower tax amounts? Absolutely. But they're paying it in droves or in huge amounts on other parts of their life.

Yeah.

So, no, I don't really I don't buy that.

Yeah. Okay. All right. Fair enough.

Maybe there's a few outliers, but no, I don't buy it in general.

I'm going to bring us back into the topic of Roth conversions. You've been around for a long time, so I want you to share some of your Roth conversion success stories. Pick one.

Okay. One comes to mind. I go all the way back to 2010. Mhm. And in 2010, we had this really unusual period where you could convert a Roth to a Roth and you could pay the tax over a period. Okay? You didn't have to pay it in one year. Got it. So you could pay it over multiple years, which was really awesome. And Spell, we had this one-time deal, one year. If the Roth conversion didn't make sense, you could recharacterize the Roth. In other words, you could undo it.

So, there was leniency. One year. One year. We had one year to do it. That's pretty uncommon. So, you could take the chance, roll the dice. Yep. And then if all of a sudden the market fell, for example, you'd say, "Gosh, I would have been better off to wait a minute." Yeah. So you could just recharacterize. You could just take it back and say, "Do over." Right. What a great opportunity that was.

And we did some way back then in 2010. That was 15 years ago. And we did some of those. Now, today, number one, the things that we looked for in that situation was what I call a client's valley, which means when their income stops, all of a sudden, I've got a little bit of an opportunity to figure out if Roth's going to make sense. While they're earning two, three, 400,000 a year, you don't want to do RAW, right? Right. Because, or conversions, because you could, that along with other sources of income, you could be in a really high bracket, in that top bracket for example. Yeah, you really don't want to convert at that point.

But there were situations back then where we took one family in particular, they were in that valley, no income, both were retired. And so I had this perfect opportunity and it was around 2010 where I knew we could, if this thing didn't work out or the markets failed, we could undo it. That's always nice to have the undo button. It was perfect. Yeah. That's awesome. And we could spread the cost. Yep. And not having to pay it in one lump sum in one year made it really attractive.

But we did that in 15 years later. Spell, that was a, it might have been a few hundred thousand. And it wasn't a big account, but today that account, I'll say this, in 15 years, we invested it pretty aggressively for this client. It was designed from the beginning to be an education funding mechanism for a lot of grandkids. That's right. I know exactly who you're talking. You know the client? Yes, I do.

Well, today, Spell, that Roth is so large, there's going to be a lot left after we fund five grandkids. We're going to put them all through school. If they want to go get their masters, so be it. And there's going to be a lot of money left. Now, the beauty of that is, one of the reasons for that is we don't have to pay any tax when that money comes out. So, it does make it much more beneficial, and when they leave it to their kids, they don't have an estate tax problem. Fortunately, we've done great planning for that. So now that money goes outside of a traditional IRA, zero tax to their children and ultimately the grandchildren. That to me is a win with a Roth. Yeah. But the circumstances need to be right for Roth to be right.

Well, you gave some qualifying factors. So you were looking for an opportune time where income was low or non-existent. Babe, you mentioned they're both retired and I know exactly who you're talking about. So, they're retired, no income, tax bracket is at the floor. Yep. Lowest it's gonna be. Lowest it's going to be. And now we don't have this luxury today, unfortunately. But in the event that the market melted down, which you have, nobody has an idea of when that will happen, but you had the undo button. That's right.

There's still a way to do it today without having the undo button present. I think looking for the low years of income. Still want to look for that valley. Yeah. And particularly when people have banked some dollars. Yeah. For so that maybe a pension hasn't turned on yet. They don't have earned income. No Social Security.

I was going to ask, what about Social Security? So better if it's not there, because Social Security can create some issues, right? Not so much that it causes everything else to be taxed, but it causes the Social Security to be taxed, and that's part of the equation, and you're making a conversion and up to 85% of your Social Security could be taxed as ordinary income. Yeah. So, you really don't want to invite that into the picture if you don't have to. Right.

But, so that valley, very important. If they don't have the income, great. Let's think about it. And then how might we construct the Roth conversion? It could be a very useful tool today, but it needs to be orchestrated in such a way that you're thinking about a lot of possibilities. And if it doesn't make sense, then say to the client, it doesn't make sense.

Okay, hold on to that thought. That leads me to my next question, and that is, tell me about either something that you've been associated with or that you know of specific to a Roth conversion where it failed or it wasn't the best idea for the client and they went ahead and did it. Well, I'll give you a perfect example right now. I just finished testing one for a client.

We'll get right back to today's show, but first I'd like to ask you a quick favor. If you're enjoying this episode, hit that like button and make sure that you're subscribed to our channel so you don't miss what's coming next. And hey, if something in today's episode has you wondering about your own financial plan, why not get a second opinion? Visit omnirestarfinancial.com to schedule a consultation with one of our team members. It's quick, it's easy, and it could make a huge difference in your financial future. Now, let's get back to the show.

Spouse is still making a quarter of a million a year and then on top of that there's other income. When you start to look at all of that income, there's five 600k of income, right? Add a Roth conversion to that, right? And you are paying 37% of a lot of your income plus whatever your state is, right? So you could easily be over 40%. That takes a long time to make up for losing 40% on a conversion.

I think let's go into that quickly. Sure. And for the listener who maybe isn't able to follow you there, you said it takes a long time with Roth conversions. It sounds like what you're saying, and I know this to be true, there is a break even for the conversion making sense versus not. Right. That's right. Okay. So after, and what you test for is, after 10 years does this make sense or after 15 years does this make sense? Does it put me in a better financial situation at that time? That's right. That's right. And in this case it was going to take 20 years. Okay.

Because the bite is so, and here's the other thing that a lot of people miss when you're making the conversion. You got to get the cash to pay the tax. Right. Right. You don't want to convert and then convert even more to pay the tax, right? You don't want to have to make a distribution from a qualified account to pay the tax. That's going to make the catch up even worse or even longer. Yeah. So, you need the cash on hand to pay that tax bill, or Spell, and this is the part that a lot of people miss. This where you look for these opportunities. Mhm.

What if you have a situation where a loss has occurred and we can use that to offset the conversion, and people don't think about that. So if you can just look into the future a little bit and figure out what's your tax situation going to look like year after next or five years or whenever it is. If you can see that based on your business model or the sale of a business or losses that might occur. If you know those things, then you can really begin to model it the right way for a Roth conversion.

So, while it might not be good today, if you said, we're going to close a business next year, we know we're carrying a lot of losses here. We're going to have some losses. We're going to use that help offset. That might help. Sounds like you're planning. Yeah, you got to plan. Or what if you're charitably inclined? True. And so now we want to start using some charitable contributions to help offset some of that conversion. If people can start to plan like that, then all of a sudden Roth can make sense.

Now, yeah, conversion is great. What I'd rather see people do, again, conversion can work. Yeah. What I'd rather see people do is work on this stuff long before they get to the point of needing to convert. When you're at your lowest tax rate, your earnings are at their lowest. That's when you need to be pumping money into Roth. Get it into the Roth environment, not when you're making a 35 or enough money to have to pay 30 or 40% tax. Do it when you're paying 20. Yep.

Or in some cases, if you've got kids and you're smart with your money and you understand how to write down a lot of those expenses so that your tax rate might only be 10 or 15%, why wouldn't you be maximizing Roth contribution then? Great question, right? Lowest rate, because down the road, as your earning years go up and you build greater wealth, when you reach retirement, you're probably not going to be in the 15% tax rate. Yep. So, if you can get the money in at that low rate, so be it. If you're 65 and your tax rate is 25, right? Or even 20, the arbitrage is still there. You still made money on that deal and you're better off.

I think to add to that, if I might, whenever you're contributing to a Roth, and I know that language has changed in the 401k environment a little bit. So there is Roth capability in the 401k space now, right? But before that there wasn't an opportunity to get a lot of money in the Roth environment. True. This year the contribution limit for a Roth is $7,000 unless you're over 50 and then you only, you get an extra thousand. Get an extra grand, 8,000. So, if you make a certain amount and you got a back door just try to get it in there. So, you got a lot of hoops to jump through just try to get it. Now, it's doable. It's doable, but it's still not a lot of money, right? It helps, but it's not a lot.

But your point was get it in as early as you can. Start early, from the time where your tax bracket isn't through the roof. That's right. That gives that money time to compound and grow for 30 or 40 years.

If you think about it like this, Spell, there's a lot of parents out there and they'll say, "Well, gosh, if I have kids and all those things, I might not be able to afford it." Well, you're probably putting in your 401k contribution anyway, right? Whether you have kids or not. But guess when a parent's best years for low tax rates happens to be. It's when those kids are young. It's when they're dependent and you have standard deductions. You've got those kids. Your income probably is not at its highest, but you're still saving in your 401k and your tax rate is probably at its lowest. Yeah.

And so that's when you want to take advantage of Roth. After tax looks wonderful. When you forecast 10, 20, 30 years from that point, you say, "Wow, I might have 23 $3 million in this 401k plan Roth when I'm 60 years old." Yeah. And so if you can just fast forward 30 years and you think like that, well, if you've got three million and you say, "I'm going to take 6% a year to live on, you're pulling almost 200k a year tax-free."

And guess what else that does, Bill? If Social Security's around when they get there, big if. When they get that Social Security, guess what? They don't have to worry about 85% of it being taxed as ordinary income because their Roth distributions are tax-free. So you just saved on your Roth distribution, no tax. And you just kept your Social Security from being taxed. Pretty good. It's a no-brainer. Pretty good. But people aren't thinking that way. No, they're not.

Last question for you, Phil, for someone listening who's wondering, is this even right for me? A Roth conversion, that is. How can they figure out if it makes sense for them? Well, it's hard to say. Okay. It's hard to answer that because everybody's footprint in the financial world's different, right? We all have a different print. I think the only way one is to get a professional to help you figure it out. I think you're right. It's not simple.

Spell, if there was a one-size-fits-all, if that solution existed, then I could tell you here's how you do it, right? But it's not a basic puzzle that anyone can put together because we're talking about earned income that goes into this mix.

We're talking about rate of return. We're talking about tax rate. We're talking about time to retirement. Yeah. So there's, and that's just a few. Oh yeah. So all of those things. Do you have other income sources? There a pension. All these things matter. How much is in your current environment that you want to convert? And then what's your current income?

And are you into that? Are you into the tax rate that would clearly, undeniably say it makes more sense to pre-tax your money into a 401k and profit sharing kind of environment? I don't know until we can see everything. But once you see everything and the right professional can help that person understand conversion is an absolute right. Yes. Where it's an absolute no. There's usually not a lot of gray. No.

And if you get into the gray, you probably ought to avoid paying all that tax. If you're really in gray and you think this may be better, but it may not be better, you probably are better off not to do it. I think you're right. If you have questions like that, but there are ways to figure it out, Spell, you work on this stuff all the time.

It's knowing the right questions to ask. It's giving the right information to the professional and then letting them do their job. And you know what? If you're not sure, if you're not sure, then reach out to someone like us. Oh, yeah. Right. They can reach out to us, get a second opinion. They may not do business with us, but if you've received something from someone and you just want to get our eyes on it to say, "Yes, that makes sense." Or, "No, it doesn't." You don't have to do business with us. No. But you need to get the right opinion so that you don't make a mistake.

These mistakes are not undoable. You just took the words from my mouth. I was going to say these are, they're irrevocable. There is no, what, Uno, the reverse card. We don't have that. You had that in 2010, but that is not on the table anymore. One time deal and Uncle Sam said uh-uh, not doing that anymore. Yeah. Once people realized that this was, it's literally an industry, Spell. Yeah. People are selling this stuff left and right.

And one of the other things that frustrates me is a lot of times people that are trying to get everyone to make Roth conversions, they're doing it because they want to sell a product. Yeah. Or they want to get them into something that benefits them. It's not generally just because it makes great sense.

And the other part that frustrates me is the people, those people that are doing it, the so-called advisors, I think they're undereducated because I see their mistakes all the time. And when I can spot their mistakes on the surface, who knows what's under the surface? But when you see that, you realize there's a lot of bad information out there. And I don't think it's because they're egregiously doing it. Yeah. I just think there's a lot to understand. And not every advisor is going to put the time and energy into learning it such that they can always give the right advice. And not everybody has 30 plus years of experience to call on. It's true.

So, I think it's hard to say that it's who, where it's going to be a fit, but there are ways to know that. Okay. Yeah. Do pretty good under pressure, under the gun, without knowing what I'm going to throw at you. Well, you know me, Spell, I like the high pressure. This is cool. This our first one. Yeah, I like it. And I'm sure you'll turn up the heat as we go. I will definitely turn up the heat in subsequent episodes. And until then, we'll see you next time on We're Talking Money.