Ep # 41: Tax Free Is The Way For Me! Roth IRA Strategies For All.
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Benjamin Haas 00:02
Hi everyone and welcome to A/B Conversations, where we will help you CFP your way out of it. A podcast where you get into the minds of a couple Certified Financial Planners on how we think and feel about everyday financial planning questions and what should really matter most to you. A healthier financial life starts...now!
Adam Werner 00:26
Hey Ben. How are ya?
Benjamin Haas 00:30
Feeling great. How are you, Adam?
Adam Werner 00:33
Just fine.
Benjamin Haas 00:35
Great.
Adam Werner 00:39
We're going to talk today about another recent headline. This one may have flown under the radar for a lot of people. It certainly caught our attention but it's about Roth IRAs and there was a story recently, man by the name of Peter Thiel.
Benjamin Haas 00:57
Yes.
Adam Werner 00:58
Hence, you're feeling okay, Theiling great.
Benjamin Haas 01:01
I am.
Adam Werner 01:04
He apparently has over $5 billion in a Roth IRA and you and I said, How is that even possible? Because there are limits to what you can get in a Roth IRA so we'll go through a little bit of that. Then what does that actually mean for clients. How do we see it used most frequently but I guess let me give the rest of the backstory on the Peter Thiel event.
Benjamin Haas 01:34
Yeah, please.
Adam Werner 01:36
So apparently, he is a co-founder of PayPal which became a very large, profitable company but this is back in 1997, I think is when he was able to contribute a whole $1,700 to the Roth IRA or maybe it was 1999? Whatever it was, it was many, many years ago but the loophole that was exploited here, and it may or may not pass muster with the IRS in the end, is that he was able to buy shares of a private company, his own company, PayPal, before it went public. Then over the years, that grew to $20 million, $30 million very quickly when PayPal went public and then he just kept flipping that into more private ventures, which eventually turned that into $5 billion, which is now within a Roth IRA that when he hits age 59 and a half, he can access without paying tax on a single penny of his $4.98 billion of gains.
Benjamin Haas 02:39
So moral of the story for all of us is, we'll never be able to do this.
Adam Werner 02:45
Never say never.
Benjamin Haas 02:46
Yeah, okay but a very special thank you to Peter Thiel, who now has presented us with the opportunity to talk about how wonderful the Roth IRA is and ways that you can hopefully contribute, convert, make tax free income available for yourself, even if you don't own a private company.
Adam Werner 03:08
Alright, fine.
Benjamin Haas 03:10
So, let's just start at the beginning and we often liken in this podcast to kind of like, let's talk about a misconception that might be out there. There definitely are limits to people that want to put money into a Roth IRA. So a couple key things. One, you have to have earnings to contribute to an IRA. Two, you have to have adjusted gross income, married couple, like less than
Adam Werner 03:37
$196.
Benjamin Haas 03:38
I was going to say $200,000.
Adam Werner 03:40
Close counts.
Benjamin Haas 03:42
Single individual less than, like $125-ish?
Adam Werner 03:45
Sure. Yep.
Benjamin Haas 03:46
So if you earn more than that, you can't contribute and you can only contribute up to IRS limits which $6,000 for somebody under the age of 50, $7,000, for somebody over. If you don't meet all those qualifications, you can't really contribute to a Roth IRA.
Adam Werner 04:06
Yeah, how many years would it take me to get the $5 billion if I put $6,000 a year into it?
Benjamin Haas 04:12
You'd have to live a really long time.
Adam Werner 04:15
Infinity.
Benjamin Haas 04:17
And have really good investments but that's one of the misconceptions that if I can't contribute them, I can't get money into a Roth IRA. False! Let's start at the beginning. We're seeing it more and more frequently that companies for profit companies within a 401(k) platform are offering the ability for the employee, our clients or prospects, people out there earning money. They're allowing them to put money into that 401(k) after tax, which is in that Roth IRA feel. What does that mean, you don't get a tax deduction for putting your money into that but that money then is hopefully able to grow over your lifetime or until you need to withdraw it tax free so that's a really important one.
Adam Werner 05:05
Yeah, and then the key component there is that contributing to a 401(k) is not subject to those income limits. So the $196,000 for married couple, $124,000 for a single individual, you can earn above those limits and still be eligible to contribute to your Roth 401(k) just because of the shell that it's under. The 401(k) doesn't have those limits which is a nice way for people who can't contribute to the Roth IRA to still get money into that preferred tax free, preferred bucket. Even though they may earn more than those limits.
Benjamin Haas 05:45
And that whole cap on how much you can put in is subject to the 401(k) rules. $19,500 or, again, if there's caps or provisions for somebody over 50, $25-$26,000 so it certainly is available. And if you don't know if it's available, certainly check out your summary plan description but we do get that question a lot. Should I put money into it? Shouldn't I? I realize there are certain situations where we probably maybe go against this general comment but I think just the sheer fact that you could choose to pay taxes on $1, hope it grows to $10 and then have $9 completely tax free, feels better to me than deducting the $1 letting it grow to $10, and then having to pay income taxes on all of it.
Adam Werner 06:34
Yeah, the whole, I think the previous wisdom was the traditional IRA, the Roth IRA, I don't even think came into existence until 1997. So it's still a fairly new development when it comes to like retirement planning. Now, the traditional IRA and the pre-tax 401(k), all of those investment vehicles, the old wisdom was well I'll avoid the taxes now while I'm earning right and theoretically at a higher tax bracket and then when I retire, I don't have all of these earnings, I'll be at a lower tax bracket. So I could essentially deduct the contribution at a higher rate and then when I go to take it out, I'm going to get a lower rate so this is going to work out for me. What we've seen is that's not necessarily always the case. Once you start to stack income in retirement, it's very easy to get back to where you were while you were earning and then by the way, if you have money in a pre-tax retirement account, you are forced to start to take distributions at age 72, whether you want them or need them. The IRS says, hey, you've avoided taxes on these pre-tax dollars up to this point, now it's time to pay the piper.
Benjamin Haas 07:49
So that leads me to the second thing on why I was kind of like, happy to have this be the headline that would allow us to talk about it because I think another misconception was, well, the Roth IRA really isn't for people that have more wealth or significant wealth or doing retirement planning or, you know, not able to save anymore and that's just not true. I mean, we work with a lot of people that I would say have significant earning, significant wealth, that there are other strategies that now lead us to go, well, if this is what we're projecting and this is not what you want to see happen. Now, this Roth IRA may be able to serve a purpose so I'm teeing that up. Do you want me to kind of talk about Roth conversions? Or should I throw that to you?
Adam Werner 08:31
Yeah, so I'll take it from here. Thanks for throwing that baton right at my face. As we talked about, the Roth IRA contributing to a Roth IRA has income limits, but converting, so taking traditional or pretax IRA or 401(k) dollars and moving them, converting them into a Roth IRA does not come with those income limitations. So to your point, those that have earnings over and above those limits, may have other significant wealth are still eligible to move money into the Roth IRA. The caveat being the time that you do that, whenever you're converting from an IRA to a Roth IRA, you have to pay the taxes at that point, in that tax year. But we can certainly make the argument based on their situation, it's still may behoove them to do that for that tax-free growth moving forward.
Benjamin Haas 09:30
We've seen this in a number of situations where people have just been really good savers and all that money went tax deferred into a 401(k) or into an IRA. And now it's like, maybe I don't need all of that early in my retirement years. Where I'm able to, I have a pension, I have social security, maybe I have a significant savings just at the bank that I'm able to kind of pull money from. They don't have to take distributions until 72. That may be the perfect period of time to go, gee, compounding returns, so just going to make that tax bomb feel even worse 10, 8, 6, however many years it is from now, maybe I should start converting those dollars. So that way I'm paying the taxes now and again, allowing myself to have a different bucket of money that's going to be tax free that I can pull from later in life. If we just run simple math, dollar for dollar, same assumptions on both sides, we've seen situations where you really can see significant tax savings by doing it that way and I know that maybe takes us agreeing to the assumption that maybe tax rates are not going to go down further from here but are more likely to go up which I think is a fair assumption. But really, we've seen people that have significant wealth, really looking to convert some of that into a Roth IRA and I think it makes a lot of sense.
Adam Werner 10:52
I think often the next iteration of that is, if the idea is right, they have enough, we think they have enough savings, we think they have enough fixed income, that they don't need to rely on that full pre-tax IRA to meet their needs for the rest of their lives. Then it makes sense to start to convert that to a Roth IRA, pay the taxes today and if, again, the idea being they may not ever need to use this for themselves, the Roth IRA is a great vehicle to pass on to the next generation.
Benjamin Haas 11:28
Absolutely. Yeah. So good lead in. I think this Roth IRA and our love affair with it grew even stronger at the end of 2019 when the Secure Act, not the Cares Act, get myself confused at this point. These government programs and other acronyms. The Secure Act said that, by the way, when you have beneficiaries that are inheriting your IRA, they used to be able to stretch that out over their lifetime and think about taxability. The reason you have to start taking money out at 72 from these qualified accounts is that if you've never paid taxes, the IRS is going, guess what time to pay the piper. You pass away with that balance; your beneficiary still needs to pay those income taxes and now the rule is they can't just spread that out over their lifetime, it has to be exhausted within 10 years. So oof, now your kids may be inheriting money at their prime earning years. Have to make these distributions on top of what they're earning and all of a sudden, they're paying more in taxes than you may have been and you can see where I'm going with this. There absolutely becomes reason to have a conversation on is it better for you to convert these dollars in you pay the taxes and allow that growth to be tax free so that your kids don't have to pay those taxes and there's certainly going to be enough situations where people will go, yeah, that's great, let's figure that out.
Adam Werner 13:00
Yeah, and we've certainly seen both spectrums of that last piece of the conversation. We've seen enough and heard enough people say, hey, you know what, when I'm gone, if I didn't use it, you know, if you got to pay some taxes, tough break, like you're going to inherit this money, pay the taxes. The IRS is going to be a beneficiary. I don't care. I think more often than not and the conversation we had recently is, if they almost view the inheritance as a gift. I'm going to give this to either my kids, grandkids, whatever it may be and like giving a birthday gift, you're not giving them a gift minus, and then they have to pay you back some taxes after they open the card and see a $20 bill, you don't ask for $3 back. So I think that's becoming more and more kind of the mindset that we're seeing is, maybe if I truly want to look at this as leaving a legacy for my next of kin, then it may make sense for me to just take on some of this tax burden now and know that when I pass, what I have left, whatever's in a Roth IRA, is going to actually pass to them dollar for dollar that they can use tax free. So I guess the point being, it's still subject to that 10-year withdrawal period, even if it's a Roth IRA, but again, those distributions as long as it's within a Roth IRA are still tax free. So they may have to take out bigger chunks over a 10-year period instead of their lifetime but it's still you're not feeling the bite of the you know, the IRS taking some tax dollars.
Benjamin Haas 14:45
Yeah, I think that also one of the other reasons that we think about that not just gifting for the next generation and then I actually want to come back to charitable gifts but the reality is later in life when something may occur where you need to tap into money. If you're having to tap into a traditional IRA and that's all taxable, then you're really not controlling your tax bracket in a way that you might if you had a little bit in a Roth or you had a little bit in savings, where you could say, well, gee, I'm already at a threshold of where I want to be with income taxes, now's the time for me to go to that Roth IRA and not increase that. So I really just think it adds to a lot of flexibility later in life too where people that already have higher taxable income, if it's based on their savings, their required minimum distributions, their pensions, whatever it is, you almost want to have that spot you can go to for big expenditures, that's not going to increase your tax liability.
Adam Werner 15:39
Yeah, fair. So I know you said you wanted to come back to the charitable giving side of things. So maybe I'll just start here first and then I'll leave that to you. We were talking about the pre-RMD age, pre-age 72, conversions where there's that window between maybe retirement and when you're forced to start to take money out but what happens when you're 72 or beyond and you're still forced to take those RMDs from a pre-tax retirement account. The IRS says, yes, you may want to convert some of this to a Roth IRA but you must take your full RMD, pay the taxes on it and then if you would like to convert, you can do that over and above what you're going to pay. What you're forced to take out and pay taxes on first. So it's to be very clear, if you want to convert any dollars from an IRA after age 72, it has to be over and above that RMD amount.
Benjamin Haas 16:41
Except if it was 2020 when your RMD was suspended because of Cares Act. Just because we know we probably have listeners out there that we told they could do that last year. Very special case.
Adam Werner 16:51
It's the exception that proves the rule.
Benjamin Haas 16:53
Yes, so this is just one more place and I'm glad you remember because I already had left my head that we can talk about charitable giving with this. It's another place where we are fortunate to work with some people that are very charitable, this is the best of both worlds. If you want to get money into that Roth IRA and to your good point, it would only mean taking more taxable income out of your IRA because you're over that age 72. Sometimes it's really neat to pair that with a charitable gift where you're getting charitable deduction on one side, that offsets the taxability on the other side, especially if part of your estate plan was to involve charities. I think there's just another way that we can talk to people that have wealth and are good givers. They're not worried about running out of money in life to utilize this tool, not only for themselves but for potentially the next generation and scratch the itch on the charitable giving.
Adam Werner 17:54
Ultimately we like any part of planning, right? It's a big puzzle, we start to pair these pieces together. As long as we have a good enough picture of their total financial situation, we can start to piece together. Do they have charitable inclinations? Do they want to give gifts? And maybe part of that is they are good gift givers but it's still we've talked about this on previous podcasts, right? The standard deduction now being so high $24-$25,000, you have to have itemized deductions over and above that $25,000 amount to be able to then deduct them. So being able to lump some of this together, whether you're giving all in one year combined with Roth conversions. Again, it to us it's a big puzzle where we can start to try to piece these things together, that piecemeal may not work but in one cohesive strategy. It's pretty exciting the things that you can actually accomplish.
Benjamin Haas 18:53
Yeah, I think maybe I can wrap this all up in saying, hopefully, we've now illustrated that no matter what phase of life, this really can be a tool for you. All the way to the people that are just getting started in their financial life, save into that Roth IRA because it's compounding tax-free returns for however long you're going to work all the way down to this estate planning mechanism and of course, in between. So it really is a great tool. It can be used, I think, in many different situations, regardless of your phase of life or financial profile and the fact that Peter Thiel got it into the headlines again, gave us this opportunity to say, well, you're not going to be able to do what he did. Make sure it's something you're considering for your own situation.
Adam Werner 19:41
Yep. Yep, I agree.
Benjamin Haas 19:44
And if you have questions.
Adam Werner 19:46
Feel free to reach out.
Benjamin Haas 19:49
You brought it all the way back around. Well done.
Adam Werner 19:53
Beat you to it.
Benjamin Haas 19:55
Thank you for the feedback and the commentary again, today.
Adam Werner 20:00
Absolutely, it's my pleasure.
Benjamin Haas 20:03
We'll bring you back next time. Hey everyone, Adam and I really appreciate you tuning in. Please note that the opinions we've listed in the show are for general information only, and are not intended to provide specific recommendations for any individual. To determine which strategies or investments may be most appropriate for you, consult with your attorney, your accountant and financial advisor, or tax advisor prior to making any decisions or investing. Thanks for listening!
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