Ep #58: Roth Conversion Options

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Have you noticed that the markets are down? Did you know there are some key opportunities to look into when this happens? Well, it just so happens that a phenomenal financial advisor, Christian Sakamoto, is joining the show today to chat with Micah about looking into doing Roth conversions.

Listen in as Christian shares key insight on tax diversification and how to set yourself up to be in the best situation no matter what the tax rates are. He also discusses how and when to do your Roth conversion effectively, as well as how to know what you want to be spending in retirement and how to be proactive about planning for future taxes.


What We Cover:

  • Differentiating between an emotional or financial reaction.
  • Determining the right time to do a Roth Conversion.
  • What tax diversification can do for you.
  • How to diversify taxes.
  • A common myth about taxes after retirement.
  • How to do a Roth conversion.
  • Contributions vs. conversions.
  • Using your tax bracket to help decide how much to put into your Roth.

Resources for this Episode:

Ideas Worth Sharing:

We are always looking for opportunities to deliver massive value to our clients. – Micah Shilanski Share on X

It comes down to tax diversification. It’s not just what’s going to be the best bucket for you—it’s about having both pretax and Roth money in our portfolio. – Christian Sakamoto Share on X

We can’t actually do a Roth conversion inside of a TSP. – Christian Sakamoto Share on X

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Full Episode Transcript
With Your Hosts
Micah Shilanski and Tammy Flanagan

You can spend. You can save. What is the right thing to do? Federal benefits, great savings plans too. You can save your own way, with help from Micah and Tammy. You can save your own way. Save your own way.

Micah Shilanski: Welcome back to the Plan Your Federal Retirement Podcast. I’m your co-host, Micah Shilanski, and with me not as usual, not the amazing Tammy Flanagan, but we have a phenomenal financial advisor that’s joined us today, Christian Sakamoto. Christian, how’s it going?

Christian Sakamoto:     It’s going well, Micah, how are you doing?

Micah Shilanski: I’m doing fantastic. Now, for our audience, you have actually been on the podcast before, which is great. For those that don’t know, Christian is an advisor in our office and in fact, you probably recognize his voice because he does a lot of their YouTube comments and YouTube videos, answering your questions about federal employee benefits. So, Christian, it’s great to have you on the pod.

Christian Sakamoto:     I’m super excited to be here again. I’ve done a podcast before, but really excited to do another, especially on this topic.

So, today, we’ll be talking about Roth conversions and especially right now, as we’re recording this in July, August of 2022, as we know the stock market’s down right now. And so, it’s created an opportunity to look at Roth conversions sort of in this time where the market’s down, might make a little bit of sense to do a Roth conversion. So, that’s what I wanted to make sure we were chatting about.

Micah Shilanski: Christian, I love it. Now, the neat part about this, is this is not theoretical information. In fact, Christian, this is what we’ve been doing with our clients the last several months, we’ve had a lot of conversations about this, we looked at a lot of things and we always are looking for opportunities to deliver what we call massive value to our clients.

What are areas of planning that we can push a little deeper? And what are areas of taxes that we need to know a little bit more? And what are activities that we can do? We can take a little bit more action on to deliver more value to clients.

And as we do those things with our clients, we want to step back at the pod and we want to make sure the federal community knows about this information because it works really well.

And in fact, we’re going to go through some of those steps and strategies today Christian has been doing tirelessly with going through a lot of client’s information about saying Roth conversions; do we convert, do we not convert? Do we fund, do we not fund?

And it all has to be centered about what is the best financial outcome we’re looking for with an unknown future.

Christian Sakamoto:     I love it. So, let’s unpack that today. And let’s look at what we’re looking at when we are doing it for our clients as well. So, Micah, what would be step one in determining, does it make sense to do a Roth conversion?

Micah Shilanski: I like that. Alright. So, right before we get to the steps though, I don’t know if this is a step one or a pre-step somewhere inside of here, but it’s going to be first about saying, “Hey, are we making an emotional or a financial reaction?” That’s one of the first things that we need to be looking at Christian, I know you know this.

But it’s okay, are we making a decision because we’re panicked, because the market’s up, the market’s down, the market’s sideways; oh my gosh, the fed said A, B, and C. Now, we think the world’s going to end.

Spoiler alert — we’ve all heard this before, we’ve seen it before. Sure, it’s something of a different flavor, but it’s all the same stuff we’ve been through before.

So, the first question, Christian, I like to get into, is this an emotional reaction to something? Or is this a financial and numeric reaction that we’re doing to something because I’m going to treat those two things differently.

Micah Shilanski: So, let’s assume that, hey, we’re all long-term focus, we know the market’s go up and down. We’ve talked on other pods about what’s the investment strategy with time and we say, okay, this isn’t an emotional reaction, this is a financial reaction. Things are volatile, whether they’re up or they down, they’re volatile, which is great.

Now, what do I do that the market is down with my TSP? Or the market’s down in my IRA account, what are my different options? And we got to look at this and take advantage.

Now, and Christian, you know this; when we’re teaching classes, especially in person, I like to draw out my tax buckets. We draw out our tax buckets and we go through all of this. And I give an example that says, “Does everyone remember back to 2008 when the market fell by 50%?” And everyone’s like, “Oh yeah, my TSP went … it was a 401K and went to a 201K.”

That was the joke, and the TSP got cut in half. And I was like, okay, you got a $400,000 TSP, 2008 happened and it moved down to $200,000. And then let’s say you did a Roth conversion and then all of a sudden, that money now, how many people’s TSP came back up? Everyone’s hand goes up, “Oh my TSP, I left it alone and it came back up and I made all my money back.”

Well, perfect. Imagine if you did that and all that money now was tax-free and now, we had 400, 500, 700,000, a hundred percent tax-free, do you think that’s better than leaving 4, 5, $600,000 inside of a taxable TSP account? What do we rather have? A pot of money that’s a hundred percent tax-free? Or a pot of money that’s a hundred percent taxable when we go to access that?

Christian Sakamoto:     Yeah. I mean, I think a lot of us would say “I’d like tax free, please.” I think that’s the option that I’d want to have, and I think a lot of people would think the same way.

It does come down to what we would consider tax diversification as well. And this is what we’re working with our clients on, thinking through, it’s not just what’s going to be the best bucket for you, what’s going to be the best investment for you. But can we also have both? Can we have pre-tax and Roth money in our portfolio?

Because then, that gives us more options in the future when we need to access that money. If taxes, for whatever reason go down, great. Then we can tax this from pre-tax money. If taxes go up, then great, maybe we take from Roth that given year.

So, it gives you more flexibility and more diversification actually when it comes to taxes. So, I really like that about the Roth bucket.

Micah Shilanski: You know, Christian, you hit the nail in the head that I think the piece that’s missing so often and I’ll pick on my engineers — I love you guys, don’t get me wrong. But my engineers sometimes will come out with these elaborate spreadsheets about why it makes sense or doesn’t make sense to do a Roth conversion.

And the only monkey wrench in there when they do these spreadsheets is we don’t know what the future’s going to be. Is Congress going to increase taxes or are they going to decrease taxes? Are they going to leave taxes the same? I have no idea.

The problem with this administration is the same problem as the previous administration. They’re not responding to my text messages. I got all these great ideas. Alright, little joke.

But on the serious note, we don’t know where taxes are going to be. And so, Christian, what you said I love, we have to diversify. And we hear that all the time when people are talking about investments, but we got to apply that to taxes.

So, Christian, how do we diversify when it comes to tax planning?

Christian Sakamoto:     Well, I think the easiest place to start is looking at the pre-tax money. Money that every one of you are putting away into your TSP. For the most part, it would be, what we call traditional TSP. That’s pre-tax money. So, that’s money that obviously, you haven’t paid taxes on. And when you take money out of that account, a hundred percent of that is going to be taxable.

Then on the opposite side of the spectrum would be the Roth option that is available in the TSP or a Roth option available in an IRA. You pay the taxes today at today’s tax rate, and then that account grows 100% tax-free.

So, it’s both accounts are playing off of each other where you don’t pay taxes on one account and eventually, you pay a hundred percent taxes versus the Roth. You pay the taxes today at today’s rates, then that account grows a hundred percent tax-free, which is great.

So, that’s when it comes to retirement accounts. Of course, there’s other investment accounts that are available outside of retirement accounts. And that’s where we’re tracking our basis.

If I bought Coca-Cola stock at a hundred dollars a share and it grew to $200 a share, great. Well, if I go and sell at $200 a share, well, I’m not going to be paying taxes on the a hundred dollars a share just on the growth.

So, that’s unique in an account outside of a retirement account, but to answer your question, there’s different types of accounts available and it would be either pre-tax, Roth, or accounts outside of retirement accounts.

Micah Shilanski: That’s right. Now, one of the misconceptions, Christian, I hear a lot is with people when they’re starting to get into retirement planning, they are thinking, because this is what they’ve been told for a long time.

Now, granted more and more people out of this mindset, which I love, but I still hear it; “When I retire my taxes will be less.” That means Micah, I don’t need any this fancy tax planning today because once I retire, my paycheck goes away, therefore, my expenses will be less.

So, let’s dispel that myth really quickly, and then let’s get into some logic that we’re going to use when we’re helping clients determine, does it make sense or not make sense to a Roth conversion.

So, the first concept, and whenever we’re talking with retirees, we always want to know how much do they want to spend and how much are they spending today? How much are you spending today and how much you want to spend in retirement?

Here’s the trick answer to that question; it’s the same. However much you’re spending today is what you want to spend into retirement.

Now, here’s the other question; how much a month are you making?

The trick answer to that one is it’s also how much you’re spending. Yes, there’s always a little bit of difference, but the reality is what we have coming in is what we’re spending. Christian, would you say that’s fair with the clients you work with as well?

Christian Sakamoto:     Absolutely, across the board. And it makes planning a little bit easier because instead of having to come up with a spreadsheet with 72 different items in it, it’s really easy to just say, “Alright, great, Mr. & Mrs. Client, you’re making $5,000 a month, let’s try to replace that income going into retirement.”

Micah Shilanski: Exactly. So, we can see what that is. Now, if you’re making 5,000, 10,000, 11,000 a month, whatever that number is and you’re spending that today and I got to replace that in retirement, and you’re going to have a pension which is taxable — that’s your first; federal employee retirement system, pension is taxable. Your social security which is taxable, your TSP which is taxable.

And I got to make up that $10,000 a month, well, guess what? Why are your taxes going to be lower when all of your income in retirement is taxable income? So, yes, it could be lower, but especially as a federal employee. So, it makes you unique to other places out there. You have to be proactive to make that a reality. You have such a great pension and such a great benefit set, it’s setting you up for a potential tax issue so you have to be proactive.

So, we’ve kind of gone through that. We’ve decided it’s not an emotional decision, it’s a financial decision. We talked about tax diversification, we talked about futures that are out there, taxes might be higher, it’s good to have a little bit of mix. We talked about the myth that’s out there. And let’s say, we look at all those things, those all make sense.

So, Christian, what’s the next step? Once all those boxes make sense, we want to do a Roth conversion, how do we do it?

Christian Sakamoto:     Great. So, looking at it, we would first look at if we’re working with our clients, what of our clients have IRA accounts open currently. Because as we know, we can’t actually do a Roth conversion inside of the TSP.

Now, that’s not to say that just because someone doesn’t have an IRA just yet that they can’t create one and then transfer some of their TSP to an IRA. But that was the first step is just looking at who of our clients would have an IRA already. If you do not have an IRA, then there’s some rules there on, can you transfer some of your TSP to your IRA?

So, in order to do that, you would need to be at least 59 and a half years young to transfer your IRA. Assuming you’re still working, transfer your TSP to an IRA. Now, if you’ve separated from service, great, you can transfer it sooner than that. But assuming if you’re still working, 59 and a half would be that magical number.

Micah Shilanski: You know, Christian, one of the things I was thinking about too, we should have defined a couple of terms for our audience to begin with. And so, sorry about not doing that sooner guys, but let’s go ahead and do that right now.

We think about Roth contributions or TSP contributions and really, that’s money coming out of our pocket, which we’re contributing into accounts and there’s limits in how much we can put in.

But what we’re talking about is not that limit because in a Roth contribution, we’re limited in two things. One, how much money we can put in; its limited every single year. And the second thing, it’s limited by income. “If you make too much money,” you’re not able to contribute to a Roth IRA.

Great news, we’re not talking about contributions, we’re talking about conversions. What that is, is we’re taking money that’s already in some type of retirement account, a TSP, a traditional IRA, a 401k, something of that nature, it’s already pre-tax that has the eligibility to move to convert into a Roth IRA.

Great news, no income limits. I was just talking to a client today, Christian, and they haven’t been doing this. They’re now 72, 73, but they haven’t been doing this. They said, “Micah, when we retired, we made too much money to make a Roth contribution, so I can’t be doing any of this fancy planning.”

And that’s an easy mistake to make, because we assume that a contribution is the same as a conversion when actually those are two different things.

Christian Sakamoto:     Good clarifying point there. I’ve had that same experience in meetings before as well where somebody doesn’t know the difference. So, make sure we’re talking about the same thing. A contribution is different than a conversion.

Micah Shilanski: So, you got to have a retirement account. Inside of TSP, just like Christian said, TSP prohibits you from doing an in-plan conversion. That’s just the way the rules are set up. So, that means we got to have money inside of an IRA, or we got to be able to put money inside of an IRA.

Now, if you don’t have that ability, let’s say you’re 52 and still working, all of your money’s in the TSP account, well, then, don’t despair because you could make Roth TSP contributions. Not the same as a conversion, but now, you could start contributing to the Roth TSP if that makes sense.

You could make Roth IRA contributions, potentially. If your income is too much for that, look into it, we don’t got time to explain it here, but you can look into a backdoor Roth IRA conversion. There’s information on our website, planyourfederalretirement.com. You can see that information.

And Christian, let’s not forget about that HSA, that Health Savings Account which I’m a huge fan of because you don’t only get double tax savings, you actually get triple tax savings because you get to put in after tax-free money, you get a tax deduction for your HSA contribution.

It grows tax-deferred and you get to take it out tax-free if it’s for a qualified medical expense, which believe it or not, we’re probably going to have it some time in our life.

So, there’s some great tools that you have. So, if you are not eligible for a conversion today, don’t despair. There’s three other great options for you right there.

Christian Sakamoto:     Love it.

Micah Shilanski: So, let’s move on to kind of that next step along the plane there. So, one we determined great, we have an IRA, we’re eligible to a conversion and now, we got to figure out, well, how much do I convert?

But before we kind of figure that out, Christian, what do we need to know? What’s that piece of data that we really need to know before we can do our planning?

Christian Sakamoto:     This is where we help our clients to come up with this but what we really want to see is a tax projection put together. And what does that mean? Well, the first step is just adding up what are your sources of income going to be for this year? If you’re working, then it’s going to be your wages. If you’re married, we got to factor in what our spouse may or may not be earning as well.

Do we have any rental properties and rental income we need to factor in? Any investment income, dividend income, interest income — all of those sources of income that are available to us that we have, we need to add up to figure what is our gross income projected to be for that year?

Once you have your gross income, then we get to take the standard deduction or for those that itemize their deductions, the itemized deduction amount, from that gross number to determine what we think our taxable income will be for the year.

And so, to give an example, let’s say a married couple, both spouses are working, they’re both earning $5,000 gross per month. So, that’s $10,000 a month. They’re making $120,000 of income and that’s their gross income for the year.

So, from that $120,000 of gross income, we would take the standard deduction for them for the 2022 year that’s $25,900. And I’m going to round and say their taxable income for the year is somewhere around $94,000 for the year.

So, great, now, we know $94,000, we need to figure out what tax bracket, what is that top tax bracket that they’re in?

Well, if we look at the table and what their tax bracket would be for that year, they would be in the 22% bracket because that bracket extends from $83,550 of income up to 178,000, 150 of income. So, they’re right there, kind of in the beginning of that 22% bracket. What does that mean? What does that information tell us?

Well, if they have 94,000 of taxable income for the year, they’ve got almost, what is that? 70, $80,000 more of room in the 22% tax bracket where they’re going to stay in that 22% bracket until they jump to the 24% bracket.

So, that’s what we’re looking at first, is what is the tax projection showing? What will their taxable income be for the year once we added up this gross income, took the standard deduction, or itemized deduction, kind of where will they be in taxes for the year?

Micah Shilanski: Christian, I love it. So, what you’re talking about is saying great, how much room do they have in their current tax bracket? Without bumping to the next point, how much room can we stick inside of our current tax bracket?

Now, where people will go wrong is they will look at what’s called their effective tax rate. Turbo Tax likes to throw that number out. Pretty useless in my opinion, interesting fact toy, that’s on your tax return. It should be on your Turbo Tax spread out.

But from a planning purpose, it really doesn’t matter, why? Because in our marginal tax bracket system that Christian was describing, any new income you have coming in for this Roth conversion would be new income, that means it’s going to be taxable at the highest rate that you’re in. That’s why your marginal bracket is so important.

So, we’re going to look at that marginal bracket and we’re going to say, “Great, you’re in a 22% bracket, how much of a conversion can we do that keeps you inside of that 22% bracket?”

Now, for our clients that are over 65, some really important things to think about IRMAA. You have an income limit that you can make before your Medicare premium goes up. And those don’t correspond to tax brackets. Why? Because that would be convenient if they did, but they don’t, they’re different. So, you got to know those rules.

You also got to watch out for phase-outs are really, really important. Am I making a Roth IRA contribution? And now, I’m going to be phased out of does this affect my deductibility of my medical expenses that’s there? Am I phased out of a child tax credit? Am I phased out of education tax credit that I’m getting? All of these other things can apply.

And so, it’s really important to work with someone that understands taxes or make sure you have a good understanding of taxes.

So, if you don’t work with someone, Christian, what I would suggest, is open up that tax software when you did your tax return last year, and just go add in a Roth conversion for 30 grand, 40 grand, 50 grand, and see what it does.

Have the tax software calculate this for you because that’s why we use software as professionals, because we don’t want to be liable for forgetting the phase-out of some Roth IRA contribution.

So, we’re going to put client’s information into software to kick it out, then we’re going to apply our logic into, “Hey, does this pass our straight face test?”

Christian Sakamoto:     Exactly. Exactly, I love it.

Micah Shilanski: Okay. Now, the important part about this is we’ve talked about, is it emotional/financial? We’ve went through if you have an IRA, what our options are. We’ve talked about a tax projection, which is super important. We should be doing these anyways, in my humble opinion, so you know what your taxes are.

Then you decide on a dollar amount to do. Let’s say you do 30,000, 40,000, it’s not a recommendation; but you decide to do that.

Christian, what is the top thing that you need to be thinking about once you decide to do a 30, $40,000 conversion? What comes with that?

Christian Sakamoto:     Well, how are we going to pay the taxes?

Micah Shilanski: Nailed it.

Christian Sakamoto:     Is top of mind.

Micah Shilanski: Nailed it. Yes.

Christian Sakamoto:     So, the good news is there’s a few options. And so, that’s what I’d like to share. So, if you’re younger than 59 and a half, then we lose out on one of the options. And that option would be to actually convert, let’s say, in your example, $40,000. Maybe we take a portion of that $40,000 and send a payment to the IRS when we do the conversion and say, we send that 20%, $8,000 to the IRS. Then in our Roth account, we’d have actually $32,000.

So, that’s available to people who are over 59 and a half because of the IRS rules regarding when you can take money out of your IRA account. If you’re younger than 59 and a half, and for those that don’t want to take more out of their conversion than they have to, you can also just pay the taxes using an outside account.

We can use maybe another investment account that’s not in a retirement account. Maybe have some extra money in your savings account that you could write a check for. So, that’s the other option as well.

And which option makes the most sense for you is really going to be determined by what outside accounts that you have in your situation and that sort of thing.

Micah Shilanski: So, knowing this and understanding how much of a tax bill am I going to have, where am I going to get the money to pay for this? And what’s the plan is really, really important.

Now, just because you may not have the cash sitting sound to do a 30, 40, 50, a hundred thousand dollars Roth conversion, doesn’t mean you shouldn’t look at one. We’ve done micro conversions with clients, some clients that say, “Hey, I can fund 4,000 in a Roth every single year, but I really want to put the full $6,000 in.” Great, well, maybe a $2,000 micro conversion because they can afford the taxes on that $2,000.

But now, we’re doing a little bit at a time where we have the money to pay for it. We’ve also done macro conversions and I’ll confess this is something that I did this year personally as well. I said, “You know what? I don’t think tax rates are going down, the markets are down. I’m going to take advantage of this, and I’m going to convert a decent amount of money into a Roth IRA.”

So, that’s how committed I am to this strategy. We did it ourselves. But with that, comes with knowing you have a tax bill that you have to pay. So, you really got to balance these things in your mind.

Christian, the other thing that I wanted to bring up is on this conversion that you’re talking about. So, we decide on a conversion amount, whatever it is, but we’re mid-year, so do we do all the conversion at once? Is that the best strategy?

Do you dollar cost average where you’re doing this every converting a little bit every single month? That seems a little extreme. Is there a Goldilocks somewhere in between? What do you think?

Christian Sakamoto:     That was a case-by-case basis particularly for our clients. I would say probably 80 to 90% of our clients, we made the recommendation that we would do 100% of what we were planning on converting right now in one go.

There were a few clients that I can think of where it made sense that we hedged our bets. Maybe they were worried the market would go down even more, or maybe we just weren’t sure on the tax projection where they would end up, and it made more sense to wait until the end of the year where we had more history behind us to determine how much taxable income that they would have to then do that conversion.

So, we kind of split the difference, did some, now waiting at the end of the year, we’ll do a little bit more with more clarity on how much to do.

Micah Shilanski: And that’s a huge thing right there, is having clarity in what these dollar amounts are because the problem that we’re going to run into with this is overshooting the mark a little bit, especially as we start really trying to focus in on a certain bracket and keep in mind, there’s no undo button. Once you do a Roth conversion, you are stuck with it. So, you really got to be cognizant about what that effect is.

So, guess what? If you’re not sure exactly how much to do, but you have a range, perfect, take the lower part of the range, take half of the range. Do something that’s going to move you that direction because we got to take action. It’s not enough just to have a plan or a concept. We got to take action to move forward.

So, on that note, this podcast is all about action items.

So, one of the things and Christian I’ll go first and I’d love you to have an action item for us. But number one, I’m going to say, does it make sense for you to do a Roth conversion? Every person should look at this.

Now, if you’re saying I don’t have an IRA, doesn’t apply to me; it still does because the question is, should you look at funding a Roth TSP? Should you look at funding an HSA? Should you look at funding a Roth IRA, all of those have a tax effect.

So, you need to say, it does it make sense for me to do a Roth conversion and or contribution for this year.

Christian Sakamoto:     Yep. Second action item; do a tax projection. Go in, look at what your sources of income are going to be this year and try to add up what is that total number going to be? What is that gross number going to be?

And if you use TurboTax or another software, great, go into that software like Micah mentioned, plug in a conversion of a number that you’re thinking of doing, and see how that tax software reacts.

If you’re working with a CPA, I’m sure they’d be able to assist with doing something similar, sort of a projection for you. But that would be the second item is to do a tax projection for you kind of see where you’re at taxable income-wise for the year.

Micah Shilanski: I love it. Now, if you’re working with a financial advisor and they’re doing a stellar job for you, that’s fantastic. Now, how would I deem a stellar job? I’d ask a couple of questions. One, have they reviewed your tax return? And what suggestions did they make when they reviewed it?

And the other one, have they talked to you about a Roth conversion this year? If the answer to either one of those is no, you need to have a conversation with your financial planner, because maybe they’re not really doing full planning.

Maybe they can’t because of where they work, maybe that’s just not their area of focus, but you need to know this because taxes are going to be one of the largest expenses that you have in retirement. So, that means the more you can reduce that, the more of your money you get to keep. Until next time, happy planning.

Christian Sakamoto:     Happy planning.


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