Power Up Wealth podcast – Episode 117 – The Pink Steering Wheel: When a Roth Conversion Isn’t Your Ride
James Derrick 0:00
A Roth conversion can create a massive benefit for the right situation, but the details matter. I’m James Derrick, president of Smedley Financial. Today, I will be talking with Jordan Hadfield about orange sorbet and the Roth IRA.
Shane Thomas 0:17
Welcome to the SFS Power Up Wealth Podcast, where we provide impactful insight and expert opinions on timeless financial principles and timely investment topics, preparing you to make smarter decisions with your money.
James Derrick 0:33
Thank you for joining me today, Jordan.
Jordan Hadfield 0:35
Yes, James, thanks for having me.
James Derrick 0:37
Jordan has a CFP designation and is the Vice President of Wealth Management at Smedley Financial Services. Jordan you recently wrote about the Roth conversion. Why don’t you start out by sharing with us the story about the orange sorbet and the pink wheel?
Jordan Hadfield 0:52
Yeah, the pink wheel of Roth conversions. Everyone keeps asking me, “What does a pink wheel have to do with Roth conversions? The story goes like this: So I have a sweet tooth. Unfortunately, that sweet tooth has passed on to my children. And late one night, it was a Friday night, a little bit later. My kids wanted ice cream, and ice cream sounded pretty good to me. So I was like, “All right, this is a good idea. I’ll go pick up some ice cream.” So, I jumped in my wife’s car and I drove to our closest grocery store to get some ice cream. And I took a phone call. So I park. I walk into the store. I’m paying attention to my phone call. Grab my ice cream, check out. I’m walking back to the car. Well, I’m not really paying attention. I’m on the phone, so I climb into the car, and it’s dark, and that’s important. I climb into the car, and the first thing I notice is kind of a rearview mirror ornament and a sweater in the front seat that I didn’t recognize. And as I turn and kind of look forward, I saw this pink steering wheel cover, and James, you’d be shocked if you were if you knew how long it took me to realize that I’d gotten into the wrong car, and I was so embarrassed. I came flying out of that car so fast, looking around. I was paranoid that somebody saw me and was going to accuse me of trying to steal something. I was so embarrassed, but the truth is, it was the exact same car that my wife drives, and it was parked right next in the same adjacent spot, and so it was very easy to just, hey, this is my wife’s car, I jump in. But lock your doors, I guess, is the moral of the story when you go to the grocery store. But yeah, I got into the wrong car, thinking it was the right one. What does that have to do with Roth conversions? Well, I think that in our industry, we often tote the Roth IRA as being one of the most powerful wealth-building tools that exists, and that’s because it is. The Roth is really, really cool. I mean, you get tax-free growth. That is a win for investors across the board. Anytime we can get tax-free anything, we’re jumping up and down in excitement. Tax-free growth in a retirement account over 40 years, 50 years can be tremendous. So it is an incredible tool, and because it’s an incredible tool, people get excited about it, about the Roth IRA. And for those that don’t contribute directly to a Roth IRA because of income limits, or they’ve got a lot of assets in traditional, they want to take advantage of that, and so I think sometimes due to the hype for the Roth IRA in our industry, some investors forget about the details, and what happens is is they they see the vehicle, which is the Roth IRA, and it looks like the right vehicle, it sounds like the right vehicle, and they get into it and they don’t see the pink steering wheel cover. In other words, it’s the wrong vehicle for them for whatever reason. And there’s a number of reasons this may be true. The Roth conversion is not right for them, but they are so fixated on the pros they don’t notice they’re getting into a vehicle that isn’t going to get them where they want to go.
James Derrick 3:38
So because the Roth IRA contributions are taxed before they go into the account, and then not taxed later. The tax rate is one of the most pivotal inputs for the calculations. And if we knew that taxes were always going to go up, then the Roth IRA suddenly makes sense for most people. I mean, if you knew that taxes were going to be double next year, you would probably want to do a Roth IRA conversion. The reality is, is people have been talking about higher taxes for decades, and in our lifetimes, we’ve seen nothing but lower taxes.
Jordan Hadfield 4:08
Exactly. So that is one key consideration. If we know that taxes are going up. If we’re in the 22% tax bracket, and we know that taxes are going up, the Roth conversion makes a ton of sense.
James Derrick 4:20
So before we jump into some of the details that could have impacted individuals, let’s talk about the this bigger tax rate. Do you think it will be going up?
Jordan Hadfield 4:29
No, I don’t. For the lower tax brackets, absolutely not. For 50 years, we’ve been talking about how taxes are going to go up, and for the lower tax brackets, they’ve only gone down. They haven’t gone up. They’ve only gone down.
James Derrick 4:39
But you know, the government does have a lot of debt.
Jordan Hadfield 4:41
Yes
James Derrick 4:42
They need to raise some money somehow.
Jordan Hadfield 4:44
Yeah, they do, and I think they will. But I don’t think the lower tax brackets is where they’re going to raise the money. That tax bracket is already being squeezed, number one. Number two, it’s really bad for re-election. If you raise the tax bracket on the on the lower income class, it’s really hard to get that vote again next cycle. And number three, there’s a number of ways that the government can tax us outside of income tax, and I think they’ll use some of those ways to generate more income as opposed to raising the income tax. And those ways are often not noticed. I mean, they’re felt, but it’s difficult to place the blame on your president for raising those taxes. Yeah, they often go under the radar.
James Derrick 5:24
One of these that goes under the radar that we don’t think about as a tax is inflation. Inflation, in its own way, is like a tax, and it’s a way for the the government has been able to print money, which causes inflation, but it also helps fund the government.
Jordan Hadfield 5:36
Another way is tariffs. I mean, that’s something we’ve seen, and with current legislation, the tariffs have gone away, but you know there was a lot of people that were cheering on tariffs, not realizing that that was largely a tax on the American people, and that absolutely contributed to inflation. That was a tax that the federal government was collecting that was indirect from it. It was separate from income tax, and people just didn’t understand it because it’s a complex issue.
James Derrick 6:11
Yeah I think a lot of people are going to have a hard time accepting it even now. Although the numbers do support it, I mean the idea is basically though that if let’s say Ford is manufacturing an SUV and they want to sell it, they are going to pass on the higher costs to their customers.
Jordan Hadfield 6:16
Correct.
James Derrick 6:17
If they can.
Jordan Hadfield 6:18
Yeah, absolutely.
James Derrick 6:19
Yeah I mean that’s business.
Jordan Hadfield 6:20
100%
James Derrick 6:21
Okay, so let’s get back to the Roth IRA then. We don’t know what taxes are going to be like in the future.
Jordan Hadfield 6:42
That’s true.
James Derrick 6:42
So then, what other benchmarks or red flags are we looking for to know whether a Roth IRA is a good idea or bad idea?
Jordan Hadfield 6:33
Again, we don’t know what future tax rates are going to be. But if you’ve got a reasonable expectation that tax rates are going to be lower in the future for you. This isn’t because the federal government’s going to change the tax brackets. This is because you’re going to retire and your income is going to significantly drop. Then a Roth conversion is not for you. Let me give you one example. I had a client who was he was a doctor. He was making a lot of money. He was in a very high tax bracket. Plus, he had a traditional IRA that had a lot of assets in it, which meant a Roth conversion would trigger the prorata rule, which is something else that needs to be considered. Well, they were sold on this idea of a Roth conversion, and they came into me and said, “We want to do a Roth conversion.” And I said, “You are in the highest tax bracket, and it is extremely likely that when you retire, you are going to be in not just a lower bracket, but a much lower bracket. Like you are the perfect candidate not to do a Roth conversion.” But this client had been sold on the idea that Roth conversions were just so great he had to do it, and he didn’t like my answer of, “Hey, this is not right for you. And it doesn’t make sense.” There isn’t a world where it made sense for him to do a Roth conversion. But he was so fixated on this vehicle that he didn’t see the pink steering wheel cover. It was not his vehicle. It was not the right vehicle for him. He was fixated on the wrong things. And you know, if you find yourself in a high tax bracket with a reasonable expectation to be in a lower tax bracket in retirement, it is not a time to do a Roth conversion.
James Derrick 8:00
What about tax deductions or tax credits? Do these come into play as well?
Jordan Hadfield 8:05
Yeah, that’s right. There’s lots of little things that need to be considered besides just your taxable income and your current tax bracket. For example, there’s another situation. I had a client who was in the 12% tax bracket. He was retired and low income. Just looking at the surface, a Roth conversion sounds like it makes a lot of sense for him. He’s in the 12% tax bracket. That’s a very low bracket. You know, you want to fill up that 12% bracket because it’s so low. Let’s do Roth conversions. But in his situation, not all of his social security was being taxed. In other words, for every dollar that he converted up to a point, it would bring in $1 of Social Security to be taxed. So he converts $1 and he’s going to pay roughly 24 cents in federal income tax. That’s not 12% that’s closer to 24. Every dollar that’s converted, another dollar of Social Security comes in. That’s $2 added to his taxable income. Another thing for him is capital gains rates. He was in the 0% capital gains rates, so he could place trades, long-term capital gains, and pay zero taxes. We add a Roth conversion, well now he’s paying 15% on those capital gains, long-term capital gains trades. This is not considered when we’re just looking about oh my income’s low. I’m in the 12% tax bracket. Another thing that needs to be considered, of course, is Medicaid and IRMAA tax. There’s lots of little things that need to be considered. The Roth IRA is absolutely fantastic. I love the Roth IRA. Roth conversions in the right situation are fantastic. But again, I think our industry hypes them so much that every investor out there is thinking, I got to do a Roth conversion, and they jump into it, even though again there’s that pink steering wheel cover. It’s not for them. It’s not their car. Not the right vehicle.
James Derrick 9:53
You really have to crunch the numbers then. But what would you recommend for anybody who is questioning whether they should be doing a Roth IRA? And tell us, does that apply to the Roth 401k contributions as well?
Jordan Hadfield 10:05
Any time we contribute to traditional or Roth, we need to take into account both current and future tax brackets. Now we’ve already stated future tax brackets are unknown, but they still need to be considered. If we’re in a high tax bracket now and expect to be in a low tax bracket later, we want to be contributing to traditional, not to Roth. It wouldn’t make any sense to do Roth conversions if you’re looking for tax deductions now, because a Roth conversion does the opposite. It creates a tax liability now. Generally speaking, if you’re in a high tax bracket, you want to be claiming those tax deductions now by contributing to traditional. If you’re in a lower tax bracket, or expect your tax bracket to stay about the same, you know, we should be looking into into Roth 401k contributions at that point. Ultimately, though, there is no general advice. I can turn on the radio and hear about how great Roth conversions are. We have to do individual planning to know if a Roth conversion and a Roth IRA or a Roth 401k is what’s right for the individual. And so, my advice is: before you do a Roth conversion, speak to a professional. Speak to us. We will analyze your situation and all of the different implications that contributing to Roth or a Roth conversion will have for you, and we’ll make sure it is the right vehicle for you. And if it’s not the right vehicle for you, please believe us. Roth conversions aren’t for everybody.
James Derrick 11:23
Jordan, thank you for coming in today.
Jordan Hadfield 11:25
Yeah, thank you so much.
Shane Thomas 11:31
Thank you for joining the Power Up Wealth podcast. Smedley Financial is located at 102 S 200 E Ste 100 in Salt Lake City, UT 84111. Call us today at 800-748-4788. You can also find us on the web at Smedleyfinancial.com, Facebook, Instagram, Twitter, and LinkedIn. The views expressed are Smedley Financials and should not be construed directly or indirectly as an offer to buy or sell any securities or services mentioned herein. Investing is subject to risks, including loss of principal invested. Past performance is not a guarantee of future results. No strategy can assure a profit nor protect against loss. Please note that individual situations can vary. Therefore, the information should only be relied upon when coordinated with individual professional advice. Securities offered through Osaic Wealth, Inc., member FINRA/SIPC. Investment advisory services offered through Smedley Financial Services, Inc.® Osaic Wealth is separately owned, and other entities and/or marketing names, products, or services referenced here are independent of Osaic Wealth.
