Transcript

SJ:

Hello everyone. And welcome back to the next episode of the Retirement Tax Services Podcast: Financial Professionals Edition. I’m your host, Steven Jarvis, CPA. And in this show, I teach financial advisors how to deliver massive value to their clients through retirement tax planning. This is another tax Q&A Friday edition, and last week Taylor Schulty and I had so much fun talking about Roth conversions that I thought I’d have him back. And we would answer another question that I get quite often, which is when should you not recommend a Roth conversion? So, Taylor, welcome back! 

TS:

Thanks Stephen. Thanks for having me. Yeah, we had a lot of fun and I’d read that email from the CPA that strongly disagreed with our tax planning proposal, but you know, he followed it up by saying, there’s this trend in your industry that Roth conversion seemed to be the answer for everything. So, I’m excited to talk about when not to do a Roth conversion, when is it appropriate to skip a Roth conversion in a given year? So, yeah, thanks for having me. I’m excited to dive in today.

How To Regulate Strategic Action and Inaction [01:26]

SJ:

Yeah, before we dive into Roth conversions in general. I really think taking time to evaluate when not to do something is a good. Just kind of step in your process to make sure you’re really taking the time to evaluate whatever strategy it is that you’re considering, because there aren’t universal truths when it comes to financial planning or tax planning, there are going to be exceptions. And so if you can’t clearly articulate when it’s a bad idea, you probably haven’t really thought through all the advantages of when it’s a good idea. So today we’re going to talk specifically about Roth conversions, but I think that’s a good thought process or a thought exercise for really any strategy.

TS:

Yeah, that’s a good point. You know, a lot of us financial planners, especially those that manage investments or clients, we find ourselves, you know, with this philosophy of saying, ‘don’t touch your portfolio, don’t make changes, just kind of set it and forget it.’ We don’t want to tamper too much with the portfolio, and the same can be said for planning, you know, tax planning as well. When do you not want to touch a portfolio? And when do you do want to touch a portfolio? When do you want to engage in tax planning? Or maybe when, when shouldn’t. I think that’s a really good point, not just about finance, but probably every area of our life as well.

SJ:

Or really, when you think about meeting with prospects and closing clients, it can be helpful to go in with this, all of this confidence of, ‘of course, every prospect should work with me, I’m the greatest person there is’. But especially if you look at focusing on a niche, or really just evaluating your skillset, whether that’s niche focus or just the services you offer, there are of course going to be people who you aren’t the right answer for it. So, we’ll steer this back Roth conversions, but I think that is a good thought exercise just in general in life to say, ‘okay, if I’m so confident, this is the right answer in all these situations. Have I really thought about when it’s not the right answer and how does that help me better articulate the advantages of it?’ All right. So, Roth conversions Taylor, I’ll let you start. What are things you look for to say, ‘okay, you know what, we’re not going to consider a Roth conversion because the CPA, essentially that email, I have to say he’s on something there that this does feel like a trend of one of those topics that just gets thrown out.’ In fact, for a lot of advisors, this almost is the very first thing that comes out. Anytime tax planning gets brought up as oh, Roth conversions. Yeah.

When Are Roth Conversions A Bad Idea? [03:36]

TS:

You know, I think that we’ll just start really simple here, right? The common situation where we probably don’t want to do a Roth conversion is when we know that a client will be in a much lower tax bracket in future years, in retirement. So maybe they’re in a really high tax bracket right now. They’re a high earning working professional, and we know for certain that in retirement, they’re going to be in a much lower tax bracket, maybe for a short period of time, maybe during their gap years in retirement. We’ve got, you know, 8 – 10 years to do some great tax planning. So in those situations, we might wait until they’re in a lower tax bracket to process Roth conversions. However, as you might know, I’m sure you do know, like there are some situations where it does make sense to still convert, up to a certain point.

TS:

Now we have to crunch numbers and everything’s unique to their situation, but we have to crunch the numbers and, and really make sure that it makes sense to skip a conversion. Sometimes it does make sense depending on their tax bracket, you know, maybe converting up to the 24% tax bracket. And then also, you know, something that, that we mentioned in last week’s episode, there’s this kind of common misconception that we skip Roth conversions, if a client anticipates being in the same tax bracket. ‘Well, my tax bracket is not going to change. Why would I accelerate paying taxes now? Why don’t I just wait, until the IRS comes knocking on my door?’ And so, one thing we just want to continue to highlight is reminding clients, that they have a growing tax liability. That even if their tax bracket stays the same, and taxes stay the same, that, you know, this $1 million dollars today is going to grow to $2 million and $3 million and $4 million. So, would you rather pay 22% now on a million dollars or let that grow to $2 million or $3 million and pay 22% on a higher number? So, two kind of little things there in the same answer, but yeah, just to recap: much lower tax bracket in future years, we’ll probably skip the Roth conversion. If they’re going to be in the same tax bracket, we might go ahead and do those Roth conversions, knowing that we have a growing tax liability on our hands.

SJ:

Those are both great! And you hit something else in there, you know, ‘making sure the client knows what their options are’. And another reason to not do a Roth conversion is if your client doesn’t want to. And that might seem like an overly simple statement, but you really should be explaining these things in a way that they understand what their options are, this should not be all right, ‘Mr. & Mrs. Client, this is what we recommend for everyone. So you have to do it. We’re going to go ahead and do it. Here we go!’ This should be an educational process, a guided discovery of here’s what your potential options are. Here’s why we think there would be some benefits here. And you might have situations where the client goes, ‘you know what? I understand the numbers you’re telling me, but I would still rather wait as long as I can before I write that check.’

TS:

Yeah. It’s such an important point. In fact, we were getting questions during tax planning season. Questions from clients saying like, ‘do I have to do this?’ And even in actual our sales process, because we’ll start to talk about Roth conversions during our sales process and some prospects that were saying, ‘well, if I don’t want to do Roth conversions, does that mean I can’t be a client of your firm?’ And so, we do like to lead off by saying, ‘look, there’s always the textbook answer and there’s your answer. And our job is to show you what’s possible and help you make an informed decision. And we’re okay with your answer, as long as it doesn’t put your retirement in jeopardy.’ Right? So if skipping Roth conversions is going to, while they increase their tax bracket and not allow them to retire, then that’s going to be something that’s hard for us to support. But we really, these days emphasize that look, this may or may not be for you. We’re going to educate you. We’re going to explain it. We’re going to help you arrive at your answer and we’ll make a decision together.

Sharpening The Finer Details [06:53]

SJ:

Yeah, I like that. Another reason to potentially not do a Roth conversion is that usually when breath conversions get talked about, we’re talking about filling up different tax brackets, but we also have to make sure that we’re thinking about other things tied to adjusted gross income, other than just a marginal tax rate. And so this is where it just really reinforces how important it is to make this specific to the client you’re talking to. And that you’re evaluating their situation. This is a great one for maybe even doing a draft tax return or maybe working with their CPA to, so that you’re in a recent episode, I, some guests of mine referred to these as shadow taxes. These things that aren’t just your federal income tax rate, but will come up because your AGI is changing, whether this is different deductions or credits that phase out, or you no longer have the ability to take or things like how much of social security is taxable or Medicare premium adjustment, things like that. There are other elements that are tied to your adjusted gross income, which will inevitably go up as you do Roth conversions.

TS:

Steven, I’m curious your advice for advisors. If they want to do a mock tax return, based on the tax planning opportunities they’ve uncovered, where do you suggest that they do that? Do you suggest that they go to the CPA, and ask the CPA to do it? Or is there some software they can adopt? 

SJ:

It definitely gets really hard to do on the back of a napkin, or even in an Excel document, no matter how much you might love Excel. Probably the most accurate way to do it is going to be in a tax preparation software. Which for a lot of advisors, it’s probably not going to make sense to, to have that in-house, trying to work with a CPA – and to our conversation we were having last week of working with CPAs – this might be a great way to help build those relationships. Of giving you something to reach out to the CPA on not asking them to completely do the tax return outside of their tax season, but to say, hey, we’d love to even maybe potentially offer to pay for an hour of their time to have someone on their team, you know, run a draft tax return for you. There are starting to be more options; Taylor, I think you use Holistic Plan, if I remember correctly.

TS:

Correct, yeah that’s right.

SJ:

Yeah. So, so there’s starting to be more options out there that FinTech around financial advising is certainly becoming more and more interesting, but it’s definitely when you get into some of those, okay, what else is going to be impacted by AGI? That’s certainly not a back of the napkin kind of a thing.

TS:

Yeah. That’s tough. And you know, something that you could offer to pay for as well. You know, if we’re talking about a tax planning opportunity that could save the client, hundreds of thousands of dollars paying a CPA for an hour of their time, or a couple of hours of their time to help, you know, do a mock tax return so that you can validate the idea. Not, not the worst idea. Yeah. Well, 

SJ:

And here’s the dirty little secret about tax preparation software. It’s actually not that expensive. And so, especially for an advisor who maybe has been doing tax planning for a little while and feels pretty comfortable with it, it might be worth it to have access to an online tax preparation tool to be able to kind of run some of these situations to see… to give you that additional level of confidence as you go back to the client of, okay, here’s the different points where we might start tripping some of these thresholds.

Who Not How? Widening Our Networks [09:46]

TS:

We’re going down a rabbit hole here, but a thought that popped into my head. You know, Stephen, sometimes this stuff is not a good use of our time, right? As a financial planner to go and adopt a tax prep software and try to figure it out and try to learn it, you know, especially if it’s not what we do day in and day out. I’m willing to bet there are some great independent contractors on Upwork, right? That you can just outsource by the hour to help you do mock tax returns. So, you know, think about, who, not how in some of these situations as well.

The Importance of Cash Management And Effective Communication [10:42]

SJ:

Definitely any CPAs listening, cover your ears for a second. A lot of tax preparation is data entry, there’s a lot of legwork behind it that it doesn’t need to be a professional with years and years of experience. And really trying to keep this podcast focused on just providing great content, this is actually something that RTS, Retirement Tax Services will start partnering with advisors to do later this year as well, because we just see a huge need in the industry for advisors having access to that. And then, so we’re working really hard to keep building out our team and resources to offer that service as well.

TS:

Absolutely looking forward to that. Well, another reason I jotted down when not to do a Roth conversion again, might seem really, really simple is – when a client is simply doesn’t have the cash to pay the tax bill, right? When you do a Roth conversion, it triggers a tax bill and it might seem really simple, but sometimes again, we get so excited about the opportunity that we’re introducing to the client and the client’s getting excited. We kind of forget that there does need to be cash to pay for this tax bill that’s coming up. So this emphasizes why cash management is so important. A lot of times financial planners just kind of forget about cash, right? We’re just managing the investments, but this is why cash management is so important and why it’s important to really plan ahead for Roth conversions and not wait until the last minute. Nobody likes to be caught off guard with a tax bill. And also by plan ahead, I don’t mean just like earlier in the year, sometimes we’re planning five years in advance, right? We’re doing these projections and saying, ‘okay, you know, Mr. & Mrs. Client five years, we’re going to have an opportunity for Roth conversions. Let’s start to think about our cash situation and managing that cash. So, when that time comes, we’re prepared and we can pay those tax bills.’

SJ:

Yeah, definitely. Cause you’re going to maximize the benefit from a Roth conversion, if you’re actually putting the full amount of the conversion into the Roth account and paying the tax from somewhere else. And if you’re doing a Roth conversion before 59 and-a-half, you’re potentially subjecting yourself to that additional 10% penalty on whatever you withheld for taxes. If you’re withholding from the conversion. Taylor, the only other one I had on my list that we haven’t talked about yet is there are two different five-year rules related to Roth accounts and one specific to Roth conversions. It doesn’t seem to come up a ton depending on to your point – how far in advance you’re planning for these – but it’s something that you at least need to be aware of. That you’re not putting your client in an unfortunate situation where you’ve recommended a strategy that’s not going to play out the way you’ve told them it will.

TS:

Yeah, I had that one written down as well. You know, if a client’s going to do a Roth conversion and then want to take all the money out within five years, again, like you said, there’s a couple different five-year rules there to think about. So, this is a long-term bucket that we don’t really want to touch. So just be aware of these five-year rules.

SJ:

And that really should be part of, as you’re educating the client on whether this is the right opportunity for them, making sure they understand that you shouldn’t be making assumptions about what your client’s going to do. And so, as you’re planning to do these, just throwing that out there, instead of assuming; ‘oh, I can see their assets, I can see their cashflow. They’re going to be fine for the next five years. They’ll never touch this.’ put it to them, let them know, because what if they’re planning something that you just don’t know about yet? And you say, ‘Hey, you’re not going to touch this for five years.’ And they say, ‘oh, wait a second, what about this thing we thought about doing?’ So, make sure you’re giving them the options and making sure that they can make an informed decision.

TS:

Yeah, that’s a really good point. It’s not just always about reducing their tax bill, which is really important, but what’s the goal? What’s the reason for doing this? the personal reason for it, because you’re right. They might anticipate using that Roth money to go buy something, right? To go buy a new car or whatever it might be. Now that this money is, you know, essentially tax free and tax has been paid, they know that they can touch it whenever they want, so that’s important. The last thing that I had on my list is – and I’d love to hear your thoughts on it – if a client plans to leave their traditional IRA money to charity, maybe they don’t have heirs and just want to give all their money to charity. And they have a bunch of money in a traditional IRA. Maybe they’re doing QCD is while they’re alive, right. To send that money to charity. And then whatever’s left at the end of the day will just go to charity as well. So if you have a super charitably inclined client doing Roth conversions and forcing that client to pay taxes now, while they’re alive, when they’re just going to give it all to charity anyways, not only maybe doing your client a disservice, but that charity a disservice as well.

SJ:

Yeah, you know, at some point in your planning process with your clients, you should be having a conversation of here’s what happens when you ultimately pass away? It’s never a fun conversation, but a fact of life for all of us. And so, yes, you’re exactly right that if, depending on what that kind of end-of-life scenario looks like for the client and what their goals are, it might make sense to just leave it in that tax deferred account. If their intention is to, you know, really benefit the community on their way out or, or whatever organization it is that they’re passionate about.

Action Items [15:26]

SJ:

Well, Taylor, I think this is a really great list of helping you understand that. Okay. If we think this is a great idea, most of the time, do we really understand when we wouldn’t make a recommendation on a particular strategy. So, I really appreciate you taking the time to do this with me. We want to wrap up really quick with action items so that we know what we can take this knowledge and now go and do with it. So, I’ll start with not specific to Roth conversions, but I would strongly recommend that you pick some strategy, whatever it is in your financial planning process that you find yourself consistently recommending to the majority or all of your clients. And to go through this thought exercise of can I clearly articulate when this would not be a good idea? and maybe write that down and see if there’s some part of your process you need to adjust to make sure you’re really allowing your clients to make informed decisions.

TS:

The action item I want to highlight is cash management. Again, I think just cash often just gets forgotten about by financial advisors. So, make sure that you have a cash management plan for every single client. It’s not always as simple as like, oh, just go put your money in a high yield savings account, but in a lot of situations, especially in retirement, like we need to lean on that cash. So put together a plan, a financial plan, you know, for that cash, especially when Roth conversions are in the picture. Don’t ignore cash.

SJ:

Yeah, I really liked that. The last action item I’m going to recommend just because we didn’t actually get to it on the last episode we did together, but make sure you’re getting your tax returns for all of your clients every single year. And that might seem like a little bit of a jump from what we’ve been talking about today. But anytime we’re talking about tax planning strategies, a really essential part of the implementation is the reporting piece to the IRS, because if it doesn’t get reported, it didn’t happen. And really the only way for you to make sure that the strategies you’re implementing with your clients get reported correctly, is if you check that tax return. So, make sure you’re getting those returns, make sure you have a process for how those get received and how they get reviewed. To make sure that strategies you implemented during the year are getting reported correctly.

TS:

Yeah, that was a game changer for us to finally collect tax returns from clients and make it a requirement. The amount that we’re now able to do for clients, having those tax returns is just way more than we ever used to be able to do in the past*. You know, we have, we have eyes on every single piece of their financial life at this point. So, highly recommend building a process to get those tax returns. And the last thing I’ll leave everybody with a I’ve said it twice already in the last couple of weeks is just give your clients permission to come to their own decision in these situations. So long as their financial plan is not being put in jeopardy. I know as financial planners, we get really excited about this stuff. We see the opportunity. Sometimes, it even sounds like we’re in sales mode, right? And like selling them a Roth conversion. Like they feel like they have to do it, but treat this as an education process, show them what’s possible, show them the impact and then let them make an informed decision after they have all the information in their hands. Try to hold yourself back a little bit. And don’t go into sales mode all the time. Cause sometimes, you know, clients and even prospects, like I had shared can sometimes get a little bit nervous. Like, ‘oh, I don’t know if I should work with this guy that says like, I have to commit to Roth conversions for the next 10 years.’ That’s a little scary. So yeah, just, you know, take an educational approach here and give your clients permission to, to choose their answer, when it may not align with the textbook answer.

SJ:

Yeah. I love that. Thanks for sharing that. Taylor, thanks so much for being here. I really appreciate all your insight on this! And until next time, really appreciate everyone listening. Good luck out there and remember – tip your server, not the IRS!