Webcast replay: Want tax-free growth plus versatility and flexibility? Think Roth IRA
February 23, 2017
Replay and transcript from a recent Vanguard webcast
In this replay of a recent webcast, Senior Investment Strategist Maria Bruno and Kahlilah Dowe, a senior financial advisor in Vanguard Personal Advisor Services®, look at Roth IRAs and how they can help you build a strong, flexible financial foundation.
Amy Chain: Hello, I'm Amy Chain, and welcome to this evening's live webcast about Roth IRAs and how they can help you build a strong and flexible financial foundation. Most investors know that a Roth IRA can be a sound retirement saving strategy, but Roth benefits can extend beyond just adding to your retirement nest egg. Today we'll hear from two experts who can explain why a Roth IRA can play an important role in your overall wealth management plan.
Joining us to discuss this important topic are Senior Investment Strategist Maria Bruno and Kahlilah Dowe, a senior financial advisor in Vanguard Personal Advisor Services®. Ladies, thank you both for being here.
Kahlilah Dowe: Thanks for having us.
Maria Bruno: Thanks. Good to be here.
Amy Chain: Now, as always, we'll spend most of tonight answering your questions. There's a couple of items I'd like to point out first. First, there's a widget at the bottom of your screen for technical help. It's the yellow widget on the left. And if you'd like to read some of Vanguard's thought leadership material that relates to tonight's topic or a few replays of past webcasts, you can click on the Resource List widget on the far right of the player. Does that sound good?
Maria Bruno: Yes.
Kahlilah Dowe: Sounds good.
Amy Chain: Okay, now we did something a little ahead of tonight's webcast. We actually asked our first poll question on Twitter earlier today. So why don't we go ahead and take a look at the results. We asked our viewers today whether or not they use Roth IRAs, and by a landslide, we had 74% weigh in and say, "Yes." Does this result surprise us? What do we think?
Kahlilah Dowe: Not really. So most of the investors that I work with have a Roth IRA. It's usually the lower balance of the portfolio, but, yes, that doesn't surprise me.
Amy Chain: Maria, were you surprised to hear?
Maria Bruno: No, I was actually happy to see the number that high.
Amy Chain: That's very good, good. All right, so we heard from our Twitter audience. Now we want to hear from you, our viewers this evening. So we're going to throw a question out to you. We'll let you weigh in, and then we'll discuss the results.
So the question for you, audience, is how are you most likely to use a Roth IRA? Your options are for retirement savings, as a wealth transfer vehicle, for tax diversification, or all of the above.
Now there's potentially some folks out there that don't have a Roth IRA, so we want to hear from you too. Why would you be considering using such a vehicle?
So while we wait for our audience to weigh in, Maria, I'm going to ask you to kick us off on a question that we got in many, many forms ahead of this evening's webcast. But this one, in particular, came from D.M. in Michigan who asks us to give some more specifics about finding a sweet spot for a conversion to a Roth IRA. So maybe first you can define what a conversion would be and then tell us what the sweet spot is.
Maria Bruno: Okay, yes, we're starting out of the gate with some good questions.
A conversion is, you take a distribution from a traditional IRA, that amount, the pretax balance is considered income, so it's added to your income for that year, and it's taxable accordingly. So, in essence, you are accelerating an income tax liability for some type of economic benefit; in the situation, it's to convert it to a Roth IRA. And then from there, the account grows tax-free and many other benefits that we'll talk about this evening.
So probably the big question that we get, and I'm sure Kahlilah gets this question a lot is, "Well, when should I convert to a Roth or should I convert to a Roth?" And when we think about the sweet spot, I often talk about this in the context of retirees. If you think about individuals that are still working, they can get tax diversification, and by that I mean having different account types, be it tax-deferred and Roth, by channeling their contribution. So that's one way to achieve tax diversification.
If you're retired, however, your options are limited. You would have to do a conversion in order to gain that tax diversification. So it's really just understanding does this make sense, and how would I accomplish this.
The sweet spot, generally speaking, is you want to since you're actually accelerating an income tax liability. The goal is to do that when you're in a low tax bracket or if the account is maybe relatively lower value because the gain might be lower, and so the goal there, or the tax might be lower, the goal there would be try to minimize that tax liability.
And for retirees, one thing to consider is, you know, between those ages maybe of 60, 65 through 70 could be the sweet spot. We call this oftentimes the Roth conversion zone, and it's a way to manage RMDs before age 70½. These are required distributions from traditional IRAs. So the thought would be is if you're in a lower tax bracket during those years, before you start taking Social Security, for instance, consider doing a series of Roth conversions to help build that tax diversification, ultimately lower your required minimum distributions accordingly.
So I'm sure we'll talk a lot about that this evening in terms of the trade-offs there, but when we talk about the sweet spot, that generally is one period.
Amy Chain: So the sweet spot at the highest level is when you think your tax bracket is going to be the lowest.
Maria Bruno: At the time of conversion. Your goal is to try to minimize the income tax liability that's due on that conversion.
Amy Chain: Good. Why don't we take a look at our poll results. Our audience has weighed in. It looks like we have a clear leader with retirement savings being the horse that's winning the race here.
But we also have a lot of people, about half, that say they use it for a little bit of everything, all of the above. Kahlilah, I'm looking at you because you talk to clients all day, every day.
Kahlilah Dowe: Yes.
Amy Chain: What do you see most of your clients using a Roth IRA for?
Kahlilah Dowe: You know, it's usually more retirement planning, but they're not always clear on exactly what they'll use it for. So we talk a lot about using it as a way to diversify income. So if you're at a point where you're taking required distributions, but let's say you need more income to cover living expenses, the Roth IRA could be a good way to get that additional income without increasing the tax bill. So that's one of the things.
Also for estate planning. So we often see clients that are planning to pass on the money in the Roth IRA to their children or to their heirs, and they'll use it for that as well.
Amy Chain: Wonderful. Kahlilah, I'm going to stay with you here for a minute. A question from Todd in Charleston. He's asking what a backdoor Roth is and how one can do it. I know that's another topic we hear a lot.
Kahlilah Dowe: Yes.
Amy Chain: Questions from clients about.
Kahlilah Dowe: That's a big one. Very popular.
So, like Maria said, one of the benefits or the great benefits of having the Roth IRA is that you get tax-free growth. And when you take the money out of the account, that's also tax-free. The issue that many investors run into is that there are income limitations that prevent high-income investors from directly putting money into the Roth IRA. And so when you think of the backdoor conversion or backdoor contribution, it's really a way to allow investors to make a contribution to the Roth IRA through the traditional IRA. So that's the back door.
And the way it typically works is you make the IRA contribution, the traditional IRA contribution first. You typically wouldn't take the tax deduction though that may be allowed to you. And then you immediately move the money from the traditional IRA to the Roth IRA. So that's a way for high-income investors to get around that income restriction.
And the reason why it works so well or why it's so effective is because there's no income limitation on who can do conversions or who can move money from this traditional IRA to the Roth.
Amy Chain: We have a live question coming in from Greg, Kahlilah, who's asking, "Are there any restrictions on who can convert from a traditional to a Roth?"
Kahlilah Dowe: There are none. There are none. So, regardless of your income, that's right, regardless of your income, you can do a conversion from a traditional IRA to a Roth. That's why it's so effective.
Maria Bruno: Now, could I just add to that?
Amy Chain: Yes.
Maria Bruno: So not a limitation but a consideration. So for individuals who are doing the backdoor Roth or a contribute and convert strategies, Kahlilah explained you need to think about the aggregation rules. So, for instance, if you have other IRAs, other traditional IRAs that you're not converting, you need to think about that whole pool of IRAs together for the purpose of determining any taxable basis.
So as Kahlilah had mentioned, you might have the intention of doing a contribution to a traditional IRA. The deduction is not allowed, and then you would convert. So the hope there is that the account wouldn't grow any earnings, so you wouldn't trigger any income taxes. But if you have other IRAs, perhaps a 401(k) rollover, for instance, you need to think about that as well because the IRS doesn't allow you to cherry-pick which IRAs you're converting. So that bucket needs to come together, and you may be triggering some income taxes as a result of that.
Tax software does that for you. The form 8606 is where you can track your basis. But just be careful if you have other traditional IRAs you're not converting, because you just want to be thoughtful about that, but, otherwise, no income limitations, as you said.
Amy Chain: How about from a timing perspective? John is asking, Maria, if there's a right time to be considering this conversion. Close to retirement, not close to retirement? Are there special considerations for people approaching retirement?
Maria Bruno: Thinking about the backdoor Roth?
Amy Chain: About a conversion he's asking.
Maria Bruno: Oh, conversions in general.
Amy Chain: Conversions in general.
Maria Bruno: It can become a little client-specific, and you might see this, Kahlilah, because you have to think about the different factors. But I often say that I think everyone should consider it if they're in a situation where they are lacking tax diversification and are thinking about different goals for retirement or legacy planning, and then just in terms of implementing that, be as thoughtful as you can in terms of trying to mitigate that tax liability as you can.
When I think about individuals who are closer to retirement, there's I guess two things that I would think about. One is individuals who are nearing retirement are probably leaving the workforce today, this Boomer generation, are probably the RMD generation. And by that I mean they're leaving the workforce, probably with greater traditional IRA balances than Roth. We're seeing that. Traditional IRAs have been the legacy retirement vehicle. Roths weren't introduced until 1998, for instance, and they didn't really get into 401(k) plans until the mid-2000s, for instance.
So, they're facing these large tax-deferred balances, and they need to think about tax diversification. If you're working, you still have the opportunity to maximize your contributions, and you have the choice, for many, to go into a Roth or a traditional in a 401(k), for instance, because many employers offer that today. So you have contributions that you can funnel accordingly, and it doesn't have to be all or nothing. You can be thoughtful in terms of how you direct those proceeds.
With conversions, you can certainly do it at that period or, you know, you want to maybe take a look if you're near retirement and your tax bracket, as I mentioned earlier, that sweet spot if it's lower, maybe smaller conversions or a series of partial conversions could be one way around that.
But it's a long way to say yes. I think individuals in this category should really think about it, but think about other alternatives too in terms of contributions.
Amy Chain: Maria, you mentioned the five-year rule a moment ago. Can you just pause and define that for us, please.
Maria Bruno: The five-year rule, so, I guess when we think about holding periods for Roth IRAs, so when you think about access to the money, if you contribute to a Roth IRA, those contributions can be accessed without income tax or penalties. So there's a flexibility to those contribution dollars.
When you get into converted dollars, there's a five-year holding period. So you need to be thoughtful in terms of if you need access to those proceeds, for instance, there's a holding period before you can access those conversions without penalties. The dollars have already been taxed so they wouldn't be subject to income tax again but early withdrawal penalties.
Amy Chain: Good, Kahlilah, I think you were going to say something, and I cut you off.
Kahlilah Dowe: So I was just going back to the question that we had before about doing the conversions and the right time to do it. And for my clients who are coming up on retirement, one of the things that we focus on is making sure that you have the income that you need to live off of when you retire so that you're not forced to take money out of the IRA accounts if you're planning to do conversions. So that's one thing I would say to keep in mind.
I think it tends to be most beneficial when you have as little income as possible. So if you have cash that you can live off of for those first few years of retirement, I think that puts you in a better position to execute the strategy.
Amy Chain: What about for those, Kahlilah, who aren't certain about their tax bracket in the future. For example, Robert, from California, is asking us, word for word, "Is it better to stay in a traditional to maximize my accumulation if I have no way of predicting my tax situation?"
Kahlilah Dowe: Well, I don't know if anyone has a way to predict—
Amy Chain: Most of us.
Kahlilah Dowe: Right. So if you're in a low tax bracket right now, then you'd have to ask, like do you want to bet that maybe you'll be in an even lower tax bracket when you get to the point where you're taking required minimum distributions, or do you say, "Hey, I'm in, you know, 15% tax bracket today. That's fairly low. Let me take advantage of that." So that's one option.
But if you're really uncertain, one of the things I'd say to look at is just your future income. So if you're certain that your income is going to go up, I think you could say, reasonably, that you may have to pay more in taxes. If you're expecting it to go down, then you could make some inferences based on that. But if you decide that you'll just leave the money in the IRA account, I don't think there's anything wrong with that. You know, it's a great retirement savings vehicle that many people have used.
So I don't think there's anything wrong with leaving the money there, but just keep in mind that, of course, you'll pay the taxes on the contributions that you put into the account if you took the deduction. But, also, your future growth, you know, the IRS is entitled to a certain percentage of the growth that you get into in that account if you decide to stay there.
Maria Bruno: And there's a couple things, if I could add to that, because I think we get a lot of questions around retirees or those individuals that are close to retirement.
The one thing to keep in mind is retirees may not think that they're going to be in a high tax bracket because they're not working. But what you can't discount is required minimum distributions from these IRAs, and it's conceivable that RMDs could actually bump you into a higher marginal bracket. It could be an RMD shock at that point.
And at that point you have no choice but you have to take those mandated distributions. That additional income could also cause Social Security to be taxable or taxed at a higher percentage as well. So you can kind of see these factors coming together in an unpleasant tax hit for some retirees.
So the time to start planning for that is sooner, either before you enter retirement or in those earlier years to see what you're facing potentially in terms of distributions and how to manage that sooner rather than later.
Amy Chain: Maria, I'm glad you mentioned RMDs. Carolyn is asking us whether or not it's a good idea to consider investing an RMD in a Roth IRA. What do we think about that?
Maria Bruno: Technically, you can't do that. If you are still working, you can contribute to a Roth IRA, post-age 70½. The required distribution from the traditional IRA must be met. So you have to do that. If you're still working, and you have earned income, then you can contribute to a Roth as well. But you can't, technically, take that distribution and then just put it into a Roth IRA.
Amy Chain: Unless you have reportable income of at least that much. Is that—?
Maria Bruno: Right, but you still have to satisfy the RMD, and that still is a taxable event.
Amy Chain: Let's answer Bruce's question. Bruce, from Oregon, is asking us to explain a staged Roth conversion strategy. Maria, you want to kick us off on that?
Maria Bruno: Yes, I think that is a series of partial conversions. And I think, I don't know, Kahlilah, I'd be interested in your thoughts. But I think many individuals who are contemplating conversions may do it through partial conversions.
And so it's not all or nothing. If you make the decision to convert, you don't have to do that all in one year. And, in fact, doing so may actually, if it's a large balance, conceivably put you into a higher tax bracket.
So one way around that would be to stage them or stagger them and do a series of partial conversions over a few years, and what that does is it smooths the tax liability.
Kahlilah Dowe: Right. And that's typically what I see. It's rare that I see a lump sum, a huge lump sum converted at one time. It's usually done over time in an effort to keep you within a specific tax bracket. So you want to do that type of planning in advance, that way you know how much you need to convert. Typically, it's looked at, at the end of the year when you have a really good idea of what your income would be.
Amy Chain: That's a great point. Let's take a question that we got on Twitter today. Apprized from Twitter has asked us are all of my Roth IRA withdrawals tax-free or are there restrictions? Maria?
Maria Bruno: There are some restrictions. As we talked about, contributions, because the contributions are made with after-tax dollars, meaning that you don't get a deduction when you make the contribution.
So those dollars have already been taxed, so those contributions can be tapped income-tax-free and penalty-free. That's one of the neat features of a Roth when we think about it in terms of a multi-tasking account, for instance. And we'll probably talk more about that this evening as well.
When you get into converted dollars, for instance, we had talked about the five-year holding period, when you get into earnings, for instance, there's a five-year holding period, and you must be age 59½ to avoid triggering income taxes on the earnings. So there are some considerations there.
Also, accessing the contributions is a feature there. Keep in mind it is an account that's meant for retirement, and the benefit is the tax-free growth. So, certainly, the longer that you can let that account grow tax-free, you know, the better because of the compounded earnings.
Amy Chain: All right, I'm going to change things up a little bit, change topics here. Let's take a question that's coming in to us from Texas. Steele in Texas is saying that we're expecting tax reform and potentially lower tax rates, so is it wise to convert a Roth IRA during these uncertain economic times? Kahlilah, why don't you kick us off there. What do you think?
Kahlilah Dowe: So if you're expecting to be in a lower tax bracket, whether it's due to tax reform or your income just being lower at that time, then it's probably less beneficial to do the Roth conversion. But many investors will still do the Roth conversion right away because they want to get more of that growth in the Roth IRA. They want to do it earlier because the more you wait, theoretically, the more growth you're going to get and the more you'll have to convert at a later time.
So, I mean, it's hard to say. If you're in a low tax bracket right now, you'd almost think you could lock that in and just say— But, and then I think the other thing is it's not all or nothing. So if you think you're going to be in a lower tax bracket later, you could convert some now and then just save some for later.
Amy Chain: Tax diversification.
Kahlilah Dowe: Exactly.
Maria Bruno: Yes, and I think I would add to that too. So there's tax reform proposals that we're seeing and flattening the marginal rates and potentially lowering them. So if that's the case, if you're in a high tax bracket and the rates, potentially, are going down, that could be an attractive opportunity to do a Roth conversion, whereas in the past maybe you didn't want to because you were in a high bracket. So it could offer some opportunities for those individuals who thought that maybe they didn't want to because of the high tax bracket. So it can provide some opportunities there.
The one thing that I'm going to add too, and we didn't talk about it yet, but the thing to keep in mind too is if you have a traditional IRA and you make a, take a withdrawal and you make a conversion, the benefit of doing so and paying the conversion taxes from non-IRA dollars means that the entire balance then can move into the Roth. So, effectively, you're increasing the after-tax value of that Roth IRA because a dollar in a traditional IRA is not the same as a dollar in a Roth, because the dollar in the Roth is tax-free.
Amy Chain: Tell us that again. I want you to sort of re-say that.
Maria Bruno: Re-say that more slowly?
Amy Chain: Because I think people's ears probably just perked up.
Maria Bruno: So if you have a traditional IRA and you do a conversion, it triggers an income tax liability. If you can pay the income tax with dollars outside of the IRA, in a sense you're keeping that conversion whole, all those dollars then can funnel into the Roth, effectively increasing the after-tax value. So that's something to keep in mind. It's another layer of this whole tax, not to complicate it, but it's just another important feature to consider in that you're actually increasing the after-tax value of that Roth because the full balance can migrate over to that account and grow tax-free.
Amy Chain: We asked at the outset of this webcast several questions about how people were using Roth IRAs. Eric, from North Carolina, is asking about the use of a Roth IRA as an emergency fund. Is this possible? Is this something that people do? Kahlilah, do you talk to clients who suggest this?
Kahlilah Dowe: I have spoken with clients who suggested that, and I kind of softly discourage them from doing that. It's possible though because, as Maria had mentioned, your contributions can be taken out tax- and penalty-free. And so many investors feel inclined to use that money, since they have access to it, and they don't have to worry about the tax liability.
So it's possible. I would question whether or not that's the best use of that type of account. Again, the main feature being that, you know, you're going to get this growth over time in this account, and you don't have to worry about the tax liability.
Also, because there are restrictions on how much you can put in each year, it's hard to come by, you know, accumulating in a Roth IRA. So I wouldn't want investors to use it as an emergency fund because when you want to replenish it, how do you go about replenishing it if you've taken the money out?
Especially if you have other sources available to you as an emergency fund, for instance, a taxable account. So it's possible to do it, but I think the account is best used for more long-term growth purposes.
Amy Chain: It sounds like what I'm hearing is that it isn't necessarily the best emergency fund plan, but certainly in an emergency, the funds are available to you.
Kahlilah Dowe: Right.
Amy Chain: Maria, you look like you have something to add.
Maria Bruno: I'm going to go a little off-label here, but I completely agree with you, Kahlilah, that the account is for retirement. But, the fact of the matter is there are some features there. I like to have this conversation with young investors. If you think about someone who is starting their working career and they may be cash-strapped, between saving for a retirement within their 401(k), for instance, living expenses, and then building that emergency fund, a Roth might be an option for those types of individuals to start that retirement savings clock but have the flexibility to tap that money if they need to, because to save all of this for retirement and then overlay another cash account can be a little tough to juggle all at once. So I think maybe trying to find that balance of having liquid reserves and then potentially also funding a Roth and having access to that money if you need it can be attractive.
What's interesting is when we look, and my team has done some work around looking at investor trends with our IRA shareholders. And what we see is a larger adoption with Roth IRAs with young investors. I don't think that's a surprise there.
We're a little interested in seeing what does Roth withdrawal activity look like. Are individuals actually using this liquidity feature, and the numbers are really, really, really low. So it's encouraging to me in that these types of investors are using it for the right reason, but the flexibility is there if they need it.
Amy Chain: There's peace of mind, although potentially not the need to use it.
Maria Bruno: Well, it's a unique feature, and it's something to consider, although I completely agree with Kahlilah that it's a retirement vehicle and it should be earmarked as such.
Amy Chain: Okay, Maria, I need you to answer for Mary, who's watching this evening, please explain what the concept of pro rata when doing a Roth conversion means.
Maria Bruno: Okay, we talked about that a little bit earlier when we were talking about it in the context of the backdoor Roth, in that if you have other IRA balances, traditional IRA balances that you're not converting, the IRS, essentially, doesn't allow you to cherry-pick which IRAs you're going to convert. Mechanically you can. But for the purposes of calculating what the taxable basis might be, you must aggregate all of those IRAs together and then do a pro rata calculation of what that taxable basis is.
So, essentially, that's what that means. It doesn't factor in 401(k) balances. It's just IRA balances.
Kahlilah Dowe: And that's something I think is important because many investors are planning to do Roth conversions, especially once they're coming up on retirement, faced with the option of rolling over their 401(k) or leaving it with the employer. And so that's one of the things that I bring up. If you're planning to do a Roth conversion with traditional IRA dollars and you have nondeductible contributions, you want to make sure you're not diluting that by rolling over the 401(k) first to a traditional IRA because then you'd have to factor that in as well.
Amy Chain: That's an excellent point.
Maria Bruno: And one way around that even further would be is if you have a rollover IRA that you haven't commingled with contributory dollars and you're still working with an employer that would allow you to actually roll that 401(k) into the new 401(k); that's one way, potentially, around the aggregation rules.
So, I think the bottom line would be, and if you would agree with this, is that if you are thinking about doing the conversions, and you have large traditional balances, consider what the pro rata situation would look like and see what options you might have.
Amy Chain: Make sure you're looking at the whole picture, not just the one particular sleeve. Is that right, what we're saying? Okay, Mike is asking, so I'm going to ask a two-part question here. Mike is asking if there are certain types of investments that are better to hold in a Roth versus a traditional IRA. And Anna, or Anne, from California, is asking if a Roth IRA should hold the more aggressive investment options because it grows tax-free. Let's talk a little bit about that. Maria, why don't you kick us off.
Maria Bruno: Sure. When you have different account types, you want to be thoughtful in terms of how, what type of assets do you put in different types of accounts. Really, the goal should be to try and shelter those assets that have the higher return potential from the heaviest taxation. And that would be income taxation.
So think about bonds, for instance. Taxable bond funds will pay monthly dividends, and those are taxed at ordinary income tax rates. If you can shelter that into a tax-advantaged account, you're getting the full value of that dividend and it's growing either tax-deferred or tax-free, depending upon what account it's in. So that's attractive.
On the equity side as well, I mean if you're thinking about actively managed funds, for instance, that might have higher potential for capital gains distributions or higher turnover, resulting in these types of distributions, then it's generally best to shelter those types of assets in Roth-type accounts or tax-deferred accounts because you're sheltering that current income taxation.
For nonretirement accounts, broad market index funds can be prudent because they're very tax-efficient or municipal bond funds that are not taxed at the federal and potentially state level as well.
Amy Chain: Well, go ahead, Kahlilah.
Kahlilah Dowe: I was just going to say one of the things that I see quite often is that investors look at their portfolio in buckets where they'll say, "Okay, the taxable account is what I'll use when I retire in, let's say, five years or so. The IRA I won't need for another ten years," and so they'll put more of their growth-oriented investments in the IRA account and more of the bonds in the taxable account for that reason. And what they often don't see and what we explain is that you're essentially increasing the required minimum distributions. And so when they're looking to implement a Roth conversion strategy, it's just that much more that you have to convert if you have those more growth-oriented investments within that account. So I think that really drives home what Maria said about having more of the fixed income investments. And what I hear most often is, "No, I have to grow the IRA because I'll be required to take the money out, and so I want to make sure that I'm getting enough growth to keep up with that."
But one of the things that we look at is not just how much you're growing the portfolio but how much of that you're actually keeping, right? And so that, like I said, is an argument for, if you can, getting more of your growth in accounts that won't require you to take the money out and have the tax hit.
Amy Chain: That's great. I'm going to keep with this topic. Debbie is asking a similar question, wondering if this guidance changes if you're intending to bequeath these assets to your heirs. If you're not planning on spending them yourself, does the guidance change?
Kahlilah Dowe: As far as the, how you invest within the accounts?
Maria Bruno: How you would allocate within the accounts.
Kahlilah Dowe: Yes, so for the Roth IRAs, I would say definitely. If you're trying to maximize what you pass on to heirs and you're using the Roth IRA to do that, then, generally, speaking, you'd want to have your more aggressive investments in that account.
Maria Bruno: When you think about a situation like that, your goal is different. It has a long-term horizon, typically, as well too. So that would typically warrant a more aggressive asset allocation as well.
Amy Chain: I know we've covered a lot quickly here, so I'll remind our viewers that we have a Resource widget that you can view on the bottom of your screen that will link you to more information on some of the things that we just covered.
But in the meantime, let's take another question. When we started this off, Maria talked to us about the sweet spot for a conversion. Kahlilah, I'll ask you, is there ever a bad time to think about converting from a traditional to a Roth?
Kahlilah Dowe: A bad time?
Amy Chain: Or is it ever a bad idea?
Kahlilah Dowe: So there are times when I would say it's definitely not as beneficial. So the first thing is if you're in the highest tax bracket, let's say now, and you know for sure that you'll have a lot less income, generally it's better to wait.
The other thing that I'd look at is when you think about passing wealth onto heirs, you want to look at your heirs that are going to inherit the money. And if you can, try to understand their tax situation because sometimes I find that investors are kind of pre-paying the taxes for heirs, but they're pre-paying at a much higher rate than their heirs would pay if they just inherited the money flat out. So if you're reasonably certain that your heirs are going to inherit the money, that's something to consider, whether or not it makes sense to do the conversion.
Also, if you're charitably inclined. So now that the IRS has made the provision permanent about being able to give your required minimum distributions to charities and not have it count as income, if you're planning to gift a good portion of the required minimum distributions, then doing a Roth conversion wouldn't be suitable for you.
Amy Chain: Thank you. Let's take a question from Jeffrey in Virginia who says retirees with large traditional IRA balances and have not yet begun to take minimum distributions, what should be considered in deciding about whether or not to do a partial Roth conversion?
Kahlilah, you want to start us there too.
Kahlilah Dowe: Sure. So I'll say how much time you have. So, generally, there's that sweet spot where you have some time to convert before your required distributions kick in. So I would say consider how much time you have. And then also, if you'll actually need the required distributions to cover your living expenses. And that's something that I found gets overlooked quite a bit because if you— Let's say your required minimum distribution is $50,000, but you know you'll need, let's say, $60,000 to cover your expenses, well, not only will you need the required distribution, but you'll have to get the additional $10,000 from somewhere else.
And so what we want to try and avoid, if we can, is, one, taking more from the IRA than what you actually need and then also tapping the Roth IRA prematurely so that you don't have enough time for it to grow. So that's one thing I would say to consider.
Some of the other things, how it would impact things like Medicare or your Social Security and any additional taxes that you may have to pay on that.
Let me think, any other things that you'd consider for the large IRA balances. Of course, just your taxes. So whether or not those IRA balances will put you in a higher tax bracket once you retire, higher than the tax bracket that you're currently in, because that's something that I think that comparison is important because you may find that you have the benefit of doing the Roth conversion but that you're simply pre-paying the taxes because you're paying it at the same rate that you would pay if you had just waited and taken the required minimum distribution.
Amy Chain: Maria, anything to add?
Maria Bruno: Yes, I think I would add the Social Security claiming strategies is an interesting one that factors into this as well too. Because as individuals are approaching, and, again, that’s a one-time event in terms of when you decide when you're going to take Social Security. So for our listeners that have already begun taking Social Security benefits, then this doesn't apply to them. But for individuals as they're thinking through this, there's a significant value in deferring Social Security until age 70, for instance, which is the latest time that you can in terms of maximizing both lifetime as well as spousal benefits.
But for many retirees, they need income. So in that situation, if they have large balances, it may make sense to either, I would say, conversions could be a possibility, but most likely could be drawing down those tax-deferred assets as a way to meet their living expenses.
So to think about it not just in the context of the tax situation now versus later, but the interplay is, clearly, I had mentioned with Social Security, the potential taxation of Social Security, and then the Medicare benefits is a big one. And this doesn't really necessarily manifest itself until two years after the conversion, and maybe we'll talk about that a little bit.
Now if you are taking Medicare benefits, so the Part B premiums are based upon different income thresholds, but there's a little bit of a lag. So, for instance, if you do a conversion in 2016, the tax return that's filed in 2017 is what determines the 2018 Medicare premium. So if you do a conversion and it brings your income higher, it's not just the tax situation, but it could potentially impact your Medicare premium two years later for that year. So to be thoughtful with these financial planning strategies collectively, not just the income tax.
Amy Chain: Kahlilah, for you, John from Ocean City, New Jersey—place near and dear to my heart—is asking about funding Roth IRAs for grandkids. Is that something that investors can do?
Kahlilah Dowe: Yes. So I see it quite often where investors will open Roth IRAs for their grandchildren as a way to gift to them. And one of the good things about it is that just having the Roth IRA itself in the grandchild's name doesn't count against them for financial aid purposes when they go to college.
One of the things I'd say to consider is they have to have the earned income to support that. The child has to have the earned income to support that. You also want to make sure that the parent isn't making Roth IRA contributions on behalf of the child as well.
Amy Chain: In consideration of the maximum contribution amount?
Kahlilah Dowe: Right, because of the maximum amount that they can contribute. If they're under 50, then it's $5,500 for this year. And then also considering the fact that they can basically have control over the assets once they turn the age of majority because I think most grandparents, when they think of putting money in a Roth IRA for their grandkids, a lot of times they're trying to give them a leg up in terms of retirement savings. But, so just keep in mind that they could pretty much use the Roth IRA for whatever they choose to. Of course, be mindful of taxes and penalties if they're not of age.
Amy Chain: Very good. Let's move to some of the flexibility considerations of a Roth IRA. Maria, you touched on some of this earlier, so I'm going to ask you to kick us off here. Joe is asking specifically about the flexibility of a Roth IRA as it applies to using the proceeds to fund a child's education expenses. So this is a nice transition from where Kahlilah just left us off.
Maria Bruno: Yes, there's a couple of things. First, I would start off by thinking about if you're making the decision of how to save for a child's education, think about a 529 maybe first. So a 529, essentially, is a Roth for college, and there's more benefits there in terms of higher contribution limits, unlimited participation. Many states offer a state deduction or credit on contributions. So those are specifically earmarked towards college funding and there's benefits there, so don't discount the 529 as a primary college savings vehicle.
Amy Chain: I'm going to take you on an aside there. Can grandparents contribute to their grandchild's 529?
Maria Bruno: Yes.
Amy Chain: Good.
Maria Bruno: And as Kahlilah had mentioned, you don't have to worry about— Because there's unlimited participation and the contribution limits are so high, you don't have to worry in terms of, well, did the parent also contribute or whatnot, so you can have different 529s. So there's an attractiveness there.
The question often is, is, "Okay, well I have a Roth, a parental Roth, can I use those assets to fund my child's education?" And, essentially, a lot of what we talked about earlier this evening applies there in terms of being able to access the contributions income-tax-free and penalty-free.
There's also a benefit to if you are making withdrawals specifically towards postsecondary education expenses, then those funds could be accessed penalty-free, for instance. So there are some benefits there that may qualify as a qualified withdrawal. So there's some flexibility there and, yes, it can work. I mean I think it's the decision of, okay, I have these types of accounts, which do I pull from?
The other thing I would think about too is the impact on financial aid. So parental Roth assets, for instance, may not negatively impact financial aid; however, any withdrawals from a Roth are considered income in the financial aid calculation, even though the dollars themselves may not be subject to income tax.
So a few things to think about if you are actually taking withdrawals from your Roth to fund your child's college education.
Amy Chain: Angela from Boston is asking us about flexibility as it relates to first-time home purchases. Can you go into detail about that for us?
Maria Bruno: Yes. So there are some qualified withdrawal benefits, as we had just talked about. So there's a lifetime— Again, you can access the contributions. I'm probably going to say that a million times this evening. But to the extent that you tap into earnings, for instance, there is a benefit. You could do, for your first home purchase, up to $10,000, there's a lifetime benefit there. So you can tap those monies, income- and penalty-free.
Amy Chain: Very good. We're going to—
Maria Bruno: And I would suggest if anyone is really wanting to learn more about this, there's information on vanguard.com, but certainly the IRS website. If you just look up withdrawals for distributions from IRAs, either Roth or traditional, they do a nice job of outlining what constitutes a qualified withdrawal, and if there's any limits on how much can be withdrawn. So, you know, a little bit of reading prior to actually taking the distribution. And there's information on our website as well.
Amy Chain: We've gotten a few clarifying questions about a comment we made earlier related to if you donate your RMD to charity, does it have to be reported as income for tax bracket purposes? Can we clarify what we meant when we said that?
Kahlilah Dowe: Right, so I'd mentioned that if you gift your RMD, and it has to be the required minimum distribution, if you gift that to a charity, I think the limit is $100,000, though, then you don't have to declare that as taxable income. And so that's why I was explaining if you're planning to do Roth conversions, but you also want to gift to charities, then you don't need to do both.
Amy Chain: Very good.
Maria Bruno: Because essentially the charity gets the full benefit. They don't have to pay income taxes on that piece. So if you are incurring a tax liability to make a contribution, you're actually economically worse off. So the qualified charitable distribution, it's above the line, so it's not even factored into the income; whereas if you would make a contribution to a charity, the income is the income and then you offset that with the deduction. And that could impact below the line items. So as Kahlilah had mentioned, if you're charitably inclined, taking advantage of that feature is oftentimes the better route.
Kahlilah Dowe: Right, because you're essentially pre-paying the taxes for the charity, but they don't pay taxes, so.
Amy Chain: Let's take a question from Mamie. Mamie is a young person watching this evening. Mamie, thank you for being engaged in your investing. She's 25 years old and saving for retirement. And she says people have told her that she should first max out her employer-matched contributions and then max out her Roth IRA if she can. Is that the right order of priority or should the Roth IRA come before the 401(k)? So, yes, great job saving. Tell your friends, save, save, save.
Kahlilah Dowe: Right, we're smiling.
Amy Chain: And then how do we think about the priority of where to save first?
Kahlilah Dowe: Yes, that's a good question. We never want to leave money on the table. So I like the idea of getting the full employer match first. And then when you think about where you put additional dollars, that I think comes down to more of your current tax bracket. And some investors who are clearly in a very high tax bracket will benefit from putting more into the traditional 401(k), and some investors who are kind of, let's say, on the cusp, maybe not in a very high tax bracket, certainly those who are in a lower tax bracket, will use more of the Roth IRA. But we don't want to leave the employer contribution on the table, so I think she's on the right path with that.
Amy Chain: And some 401(k)s offer a Roth option as well, correct? So maybe Mamie should check with her employer to see if there's a Roth option within her 401(k) to diversify that future tax impact.
Maria Bruno: For Mamie in her profile, I actually really like the approach that she's taking in terms of she's contributing to the 401(k), capturing the match, but then saving in the Roth IRA because it gives the flexibility, for some of the reasons that we had talked about earlier, and then extra savings should go back into the 401(k). So I really like that approach.
Amy Chain: I'm going to take us back to where we started. We're getting some questions to recover that sweet spot discussion. Let's go back to where we started and, Maria, retell us about the specifics of when would be the right time to consider a conversion to a Roth IRA.
Maria Bruno: Okay, well generally speaking, if you're thinking about a Roth conversion, you want to try and minimize that income tax liability to the best that you can. And we talked about this this evening in terms of planning for required minimum distributions before age 70½. So for retirees, before they start taking Social Security, for instance, or facing RMDs, those are the years to be really thoughtful in terms of doing potentially partial conversions.
If they're in a lower tax bracket, and many will be relatively speaking, so basically it's taking advantage of those relatively lower marginal tax brackets. Sometimes it's called filling the buckets. So you have different thresholds of marginal income tax rates, and you're fully utilizing those rates, so those dollars will be taxed at the lowest possible rate.
It takes some work, and it needs to be very thoughtful in terms of some of the things that we discussed this evening and that, oftentimes, is a really good opportunity to work with a financial planner or an advisor to be thoughtful in terms of when to convert and how much to convert.
And then it's part of annual tax planning. If you're charitably inclined, for instance, your Roth conversion could increase your taxable income. However, it could allow you to do more in terms of charitable contributions because charitable contributions, for instance, are capped at 50% of income. So if your income is higher, you might be able to offset some of that with a higher charitable contribution.
There's other tax considerations in terms of AMT for individuals that are subject to alternative minimum tax.
Amy Chain: How about Medicare? William's asking if there are Medicare considerations to be made?
Maria Bruno: Yes, we covered that earlier in terms of the Medicare Part B premiums, so to be thoughtful in terms of what that income looks like in the year of conversion. And, again, it won't manifest itself until probably two years later because, again, if you do a conversion— We'll use the same example as we did earlier in that if you do a conversion in 2016, the tax return that's filed in 2017 is used for the basis of the 2018 Medicare premium and there's different income thresholds. Again, the medicare.gov website has information on what those specific thresholds are, and you can kind of gauge where you are. You know, using last year's tax return is a prudent start and then adjusting from there.
The other thing we haven't talked about is recharacterizations. So we've talked a lot about conversions, but there's an interesting feature here with conversions in that there's a recharacterization window, meaning that if you do a conversion, let's say you did a conversion in 2016 and you're preparing your 2017, you're sitting down to do your taxes, and you realize that, whoops, I converted too much or made a mistake or want to unwind some of that, you can actually recharacterize all or part of that conversion back into the traditional IRA.
And there's things to think about if there were earnings in the account or losses, but, nevertheless, there's a flexibility there. And you have that really until October 15 the following year of conversion. So there's a window there. I often call it a mulligan from the IRS, which we don't get very many of. It can be a little bit of an administrative headache, but there's a flexibility to unwind some of that that can allow individuals to be thoughtful even after the conversion.
Kahlilah Dowe: And just going back to, Maria, what you mentioned about the sweet spot, that really takes some planning to do conversions and to really identify the period that works best for you, one, because you'd want to have cash to pay the taxes on the conversions, so you have to plan for that, and then, also, cash to live off of during those years when you're doing the conversions. And I'm saying cash, but it doesn't have to be cash, but it should be income that you can get without a heavy tax bill because that will eat into the amount that you're able to convert.
Amy Chain: What about if— Go ahead.
Maria Bruno: You know, and I think too, and these are probably strategies for higher-net-worth individuals as well. And, again, I mentioned that we've been doing some research around investor trends. And what we see is there's a cohort of individuals, and this is a very fortunate position to be in, that may not need their required minimum distributions because what we're seeing is about 20% of individuals, Vanguard shareholders that are taking RMDs, are reinvesting the proceeds in taxable account, nonretirement accounts. That leads us to think that individuals may not need their distributions, and that's where some of these strategies can come into play to time these years where the marginal bracket may be lower so that it could help manage RMDs going forward. But as Kahlilah mentioned, there's an interplay here, and it's something where you might want to work with a financial planner or an advisor.
Amy Chain: Kahlilah, I would love for you to tackle Ellen's question. Ellen is suggesting that at 70 years old, "Even with longevity genes," she says, "conversion seems not worth it due to the added tax complexity with the little financial gain." What's your take on that?
Kahlilah Dowe: It can be rather complex. I'm glad that she brought that up because generally you want to consult a tax advisor. See, there are great tools out there to help investors understand not only what Roth conversions are, but when it may be beneficial and how much they should convert. But to Ellen's point, it can be rather complex, and so I think there's no substitute for consulting a tax advisor with this.
At age 70, it can be difficult because you're already at a point where you have to take the required distributions, and those have to be taken first, before you can do any conversions. So it's rare. It's somewhat rare that I see where it's very beneficial to take, I mean to do Roth conversions once you get to the point where you're taking required distributions. But it does happen. There are times where it could work, and I mainly see that with legacy planning where investors are really planning for their heirs and really trying to pass on as much wealth as they can, as much tax-free wealth as they can. And so in that case, it could work, even if you're well into your 70s.
Amy Chain: And so, Maria, would you say that in addition to, unless you're using it for wealth planning, are Roth IRAs typically more appropriate for younger investors?
Maria Bruno: No. I would agree with Kahlilah in that it can be appropriate for any life stage. I think when you get more into advanced retirement and for higher-net-worth individuals they can be a very effective estate planning tool. Because, essentially, what you're doing is you are pre-paying the income tax for your beneficiaries. So you're taking an asset that has an embedded tax liability, paying that tax today so that your beneficiaries get those assets and don’t have to pay income tax on their distributions.
Roths do not have lifetime mandatory distributions, so an account owner doesn’t have to take a distribution from a Roth. The beneficiaries will, but they're income-tax-free. So that's where, when you get into advanced retirement, you might have large balances and you're looking at it from a wealth transfer standpoint, Roths beyond retirement can be very effective.
Amy Chain: How about, this sort of sounds like it's an asset allocation question that's coming in from Jack in California. Jack says, "Where should a 28-year-old invest their Roth IRA?" So I think this is more of a "what sorts of investments should be in my Roth IRA?" Kahlilah, you want to tackle this one for us?
Kahlilah Dowe: Sure. So, generally, we're looking at your most aggressive investments. And part of it does depend on what the overall portfolio looks like. But, generally speaking, if you're 28, you're contributing to a Roth IRA, maybe you're not in a very high tax bracket yet. You really want to try and maximize not only your contributions there but also the growth that you'll get in that account. So I would just say, generally, we're talking about stock investment. Stock mutual funds is what we would say.
Maria Bruno: And for someone in that age with a long investing horizon, most likely you're looking at a heavy stock allocation to begin with.
Amy Chain: We've talked a lot about when the right time to convert might be and how to think about your future tax bracket, current tax bracket. John is asking whether or not a conversion in a year when he's not going to have to pay any taxes makes sense. What do we think about that, Maria?
Maria Bruno: That's probably a unique situation, and, certainly, if you're in a situation where you encounter that, then, certainly, explore these types of opportunities. It's probably more likely for someone to be in an atypical low bracket and how to take advantage of that low bracket by accelerating income. And a Roth conversion or a distribution from an IRA can be quite valuable from that type of standpoint.
You also need to think about, and this is all part of the annual tax planning, in terms of how to— Maybe you're in an average tax bracket or high tax bracket, about what type of strategies might you be able to do to help lower that a bit. We talked about charitable giving, managing the AMT envelope, like those types of things.
So, yes, certainly, if you find yourself in a low tax bracket situation, take advantage of it to the best that you can as an individual. And that may be different types of things. It could be Roth conversions. It could be maybe if you have a concentrated stock portfolio and you want to diversify the portfolio where there's a good opportunity to do that, and potentially pay lower taxes as a result. So not just Roth conversions, but take advantage of that in full financial planning.
Amy Chain: Our viewers this evening are commenting on how they really appreciated us pausing to talk about Medicare premiums. Is there anything related to that topic that we haven't covered that might warrant a few more minutes spent on it or maybe we can even just recap again for the audience how to consider Medicare as it relates to a Roth conversion. Maria, I'll look at you first.
Maria Bruno: Yes, I think that's the big one. And I think many of us when we think about conversions, we talk a lot about the income tax picture. And that's part of it, and that's a big driver of it. And, again, I'll reiterate a couple of things. One will be is it's the income tax now versus the future, but it's the future of when you're taking the withdrawals. That's what matters, whether it's you or your beneficiary. And that's the tax rate that comes into play there.
But when you're in this period of time where potentially you're retired but you're not taking distributions, look at the overall picture in terms of what type of account types you have, how they're being taxed, how much do you spend from these accounts, and where are you taking them from? And be strategic as possible, and think about the income tax liability, but also think about the Medicare premiums. I think that's the big one in terms of the Medicare Part B premium and the income thresholds, understanding that and understanding that any type of additional income may impact that one way or the other.
Kahlilah Dowe: Yes, and we talked a little bit about recharacterizations, but that's actually the main reason why I see recharacterizations because they didn't take into consideration the impact on Medicare premiums or Social Security and also because they didn't realize it until their tax consultant looked at their taxes, and then told them, "Okay, these are going to be the implications." So I say that to stress, you know, that you definitely want to consult a tax advisor. They would be the ones to bring up some of these topics that you may not consider.
Amy Chain: Well, that sounds like a great place to wind down our conversation. Any final thoughts before we close for the evening, Kahlilah?
Kahlilah Dowe: I would just stress that— I don't want it to sound like traditional IRAs are bad, like do whatever you can to get out of them. I think they could be great retirement vehicles. And if you feel like Roth conversions are not for you, and they're not for everyone, one of the ways to help manage the required minimum distributions is by getting more of your income-oriented investments in your IRA accounts as opposed to the growth-oriented investments. It's somewhat counterintuitive for many investors, but I think it can be a good strategy.
Amy Chain: Maria?
Maria Bruno: I will just reiterate, too, we've talked a lot about retirees versus young investors. I think for young investors, Roths are a relatively easy decision because they've got a long investing horizon for retirement, and they're probably at a low tax bracket now versus what they would be later. So the value of the tax deduction on a traditional IRA or a traditional 401(k), for instance, isn't as valuable as the benefit of the tax-free growth. So that's probably the easier decision to make. As you start to get closer to retirement, start thinking about these other things, including Social Security and the combination of the income tax picture and then personali— Use this as a framework and then personalize it and take a look at it on an annual basis with your advisor.
Amy Chain: Okay, well, Maria, thank you; Kahlilah, thank you.
Kahlilah Dowe: Thank you.
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For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
Past performance is not a guarantee of future results.
Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).
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