401k, IRA, Retirement, Roth, Roth IRA, Saving
October 18, 2020
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In this episode, Suze takes us back to “Suze School” for a lesson on Roth IRAs and the tax ramifications of each account. Pay attention and listen again, as this is important information to know.
Suze Orman’s Women and Money podcast is proudly sponsored by credit unions; a safe home for your money, rain or shine. October 18, 2020, welcome to the Women and Money podcast as well as the men smart enough to listen. Suze O. here and today we're going to go to Suze School, and the reason that we're going to go to Suze School today is that now that I'm really able to read the majority of the emails, the questions that you are sending in… By the way, if you would like to send in a question, simply go to the Women and Money Community app, and you can download that by going to Apple Apps or Google Play, search for Suze Orman, and guess what? It will come up right there and let me just give you a hint when writing a question. Honest to God, if I open a question and it goes on and on and on, I tend to just close it because I just can't. It's like, are you kidding me? There are thousands of these, I can't read all of that. So, if you really want your question to probably be answered, you have to make it very short, succinct, and just tell me what I need to know. I don't need to understand how you got into that situation, just tell me your question and what you want to know. In reading these emails, it dawns on me that there are so many of you that are still getting it just so, so, so wrong when it comes to converting money from a taxable retirement account into a Roth retirement account, you are getting it wrong. You're not really understanding for some reason, the tax consequences of doing so. So, today I really want to go to Suze School and really dig deep when it comes to Roth IRAs, converting money to a Roth IRA, or transferring money to a Roth IRA, a backdoor Roth IRAs and inherited Roth IRAs. And that has to do with something known as the Five Year Rule that I really need you all to understand. So, let's first begin with a Roth IRA. Obviously, you by now hopefully know that a Roth IRA is a retirement account. It's a type of retirement account that you fund with money you have already paid taxes on. So, you fund it with after-tax money. And then, if it sits in this account and you've invested it and it's been there for a number of years, and now you're into your retirement years, you're in your 60s or whatever, and you decide you want to take all of it out in one lump sum or some amount of it out, you can do so absolutely tax-free. Now, that is a big deal. A Roth IRA is a great investment vehicle, especially if you have years and years and years until you are going to need to access this money so that it has time to really accumulate and compound tax-free. Roth IRAs come in two versions. A contributory Roth IRA, which is one where you open it up and you contribute to it every single year, a specific amount of money. The maximum is set by law and usually changes every year. The other type of Roth IRA is a converted Roth IRA, where you have a taxable or a pre-tax retirement account, meaning you have a retirement account, but you've taken a deduction on the money that you've put in. So, it's with pre-tax money, and if you want to and you want to convert that money to a Roth IRA that's then known as a converted Roth IRA. You can have an individual Roth IRA at a discount brokerage firm or credit union, or wherever you decide to do it. You can also have an employer-sponsored Roth where you work. So, if you work and your employer happens to offer a 401k, a 403b, a TSP, or whatever. They usually will offer two kinds, a traditional one, which is pre-taxed, or a Roth. You absolutely can contribute to a Roth or a traditional employer-sponsored retirement plan and have a contributory Roth as well. And you can also have a converted Roth, an individual one, as well as your employer-sponsored plans. Your employer will also let you convert from a traditional 401k or 403b or TSP into the Roth plan that they happen to have. What you have got to understand are the tax ramifications. When you convert from a traditional retirement account, meaning pre-taxed, to a Roth retirement account, which is after-tax. That's the first thing we are going to talk about. Too many of you, because you understand how much I love a Roth IRA, and you understand why you would want one. You are literally converting large sums of money from a traditional 401k into a Roth 401k at your place at work. Maybe you have $200k in your traditional 401k and you're just transferring it, you're converting it to the Roth 401k where you work or you have a traditional 401k. And when I say 401k now, just know it also represents a 403b and a TSP, OK? So, you have a traditional 401k that you left with an ex-employer, and you just left it there, and now you are taking the money from that traditional 401k and you are transferring it to a Roth IRA at a discount brokerage firm, or wherever you've opened it up, all in one lump sum. Big, big mistake, especially if you have large sums of money in those traditional retirement accounts. Because when you convert money from a traditional retirement account under any circumstance into a Roth retirement account, you are going to pay ordinary income taxes on the amount of money that you converted. And that amount, if it's large, can put you in a very high tax bracket, and why would you want to do that? So, you are never, ever to convert large sums of money from a traditional retirement account into a Roth retirement account without first checking with your CPA or doing your taxes yourself online just to see what would happen, to see what would it do to your income tax bracket and how much money is it going to actually cost you? Because you need cash, you need cash outside of the retirement accounts to pay the taxes. It's not like you can convert it, and now you owe taxes and you can get that money from your Roth IRA, you need the money to be able to pay taxes outside of a retirement account. So that is the first thing that I want to tell you. A lot of you also right now have lost your jobs and you feel like you're in a lower income tax bracket, so now is the perfect time for you to possibly convert $30k, $40k, or $50k from your ex-employer’s traditional retirement account into a Roth IRA. We are really close to the end of the year. As we are recording this, this is October 18, 2020, so, depending on in the future, when you listen to this, it might be different if we're at the beginning of the year, all right? But we are really close to the end of the year, so if you have a sum of money that you do want to convert from a traditional retirement account into a Roth IRA, why not divide it up and convert half this year and half next year? And that way, if it makes sense tax-wise, now you check this with your CPA, then you're not getting a $30k hit if that happens to be what you have in your retirement account, all in one tax year. Maybe then you would be getting only a $15k income tax hit this year and $15k next year, and you're dividing it up. Now, you need to check this out because maybe you have been out of work since February and you haven't had any income except unemployment, which, by the way, is taxable. So, it may make sense for you to convert it all at once because possibly next year you might have a job where you're making a whole lot of money so maybe you don't want to add to it next year. That is why it is very important before you do anything, you just don't listen to the fact that I like a Roth IRA and you convert, bam, done. You think about this and again, you consult with a CPA whenever you are going to initiate a taxable event for you. Now, are we clear on all that? I really need you to be clear, as there are people out there that have converted $300k at once to a Roth because that's just what they thought they should do. That is not what you should do. And you always want to make sure because I'm also getting emails with this question: Suze, I'm three years away from retirement. Does it make sense for me to convert my money in the traditional 401k into a Roth 401k? If you're three years away from retirement, five years away from retirement, anything less than eight years away from retirement, and you're in a tax bracket where you're paying taxes, not where you're unemployed, but you're really you're still making money. It makes absolutely no sense for you to convert from a traditional retirement account into a Roth retirement account because there isn't enough time for you to make up the taxes that you're going to have to pay. Now, there are many people out there that will convert because they know very well they're not going to touch the money that's in their Roth IRA or Roth 401k, they don't want to touch it, they don't need it. But when people are writing me and saying they're going to retire in three years and they're going to need to take out $35k a year from their retirement account to live on, it's like, don't you dare convert. So, let's just make a list. When is it a good idea for you to convert? Well, I just said one of the things is that you don't need this money for at least eight years, preferably longer, I have to tell you. You're not going to need to touch this money for at least eight or more years. I also said it earlier that you actually have the income tax money that's going to be owed on your conversion, you have that money and so, therefore, that's great. It's also a good idea to convert if you know that you're not going to be using this money at all, you don't need it, and you want to leave it to your children who are probably going to be in a higher income tax bracket than you're going to be so that upon your death they get to inherit it and take it out and not have to pay income taxes on it at all. So, that would be a great reason for you also to convert. Another great reason is that you don't expect to need this money at all but you never know, and you want to leave it in there, possibly to pay for a long-term care stay or whatever it may be. And you don't want to have to take it out at 72 which is now the new required minimum distribution age for traditional IRAs. And you want to leave it in there so, therefore, you convert it and you don't have to take it out at 72, that's one of the wonderful parts of a Roth IRA. And another reason that you might really want to convert is that you may be somebody like me who believes that we're carrying such deficits and record debt. We have never, the United States of America, has never been in debt to the tune that we are right now, and you believe that in the future, income tax brackets across the board are going to be higher. So, even if you are making less money at the time of retirement, you may be in a higher income tax bracket. So that's another reason that you would want to convert. Another reason that you would want to convert is you just simply want to know that what you have in your retirement account is what you are going to get to keep. You don't want to have to see that you have $400k that you have saved in a retirement account, and now you go to take it out and every time you take it out you’re tax at 50% or whatever it is, so really, you only have $200k after taxes. You want to pay the taxes now and not have to think about it ever again. Those are all really great reasons for you to convert. So, a bad reason to convert would be if any of those things that I just said didn't apply to you. So, I really need you to take this seriously and think about it before you do it. OK? Now, when it comes to a contributory Roth IRA, this is the cream of all the Roth IRAs because a contributory Roth is different than a converted Roth, everybody. A contributory Roth, any money that you originally put in, you can access at any time without taxes or penalties or regardless of how long the money has been in there. I've given this example before, but I will give it again. You are 35 years of age, you are 45 years of age, you're 22 years of age. I don't care how old you are, all right, but you're younger than 59 and a half, which is the age that you could take money out of a retirement account in most cases without taxes or penalties. All right, so here you are, and you're 35 years of age, you put in $6k which is the max for 2020, $6k this year, $6k next year, $6k the year after, it's now worth $18k and it's grown to $20k and you need money. You can take out anything up to that $18k without taxes or penalties, regardless of how long the account has been open. The $2k, or the earnings on that money, has got to stay in there for at least five years. So, the account has to be open for at least five years and until you are 59 and a half years of age, so the sooner you can begin a Roth IRA, the faster you will meet that five-year time limit for money as you get older, to be able to withdraw without paying taxes on that money. But for your original contributions, not your earnings but your original money that you contributed, you can access it any time you want without taxes or penalties. Now, that is a big deal. Think about how that would have helped you during this last crisis this year when you lost your job, unemployment wasn't coming, and you had all this money that you put into a Roth IRA for all these years, you could have taken it out. My goodness, it would have been fabulous for you, you wouldn't have had to think about it. All right, so, therefore, because these retirement accounts are absolutely so incredible, really, not everybody qualifies for one. So, you have to have, in order to put the full maximum contribution in, which this year is $6k if you are under 50, $7k if you are 50 or older. You have to have a modified adjusted gross income of $124k a year or less if you are single or if you are married filing jointly, $196k of modified adjusted gross income. Now, there is a scale there, and the scale says that you can still contribute to a Roth IRA if you make over $124k, or $196k if you're married filing jointly of modified adjusted gross income, just the amount of money that you can put into a Roth IRA scales down until where you absolutely no longer qualify at all once you are making $139k of modified adjusted gross income if you are single, and $206k of modified adjusted gross income if you are married filing jointly. And there are many of you out there that make more than that and you want to do a backdoor Roth IRA. And the reason that they call it a backdoor Roth IRA is that because you can't go into the front door, so to speak, because you make too much money, there is a way for you to get into a Roth, and that is going through the back door, just that simple. And this is what you need to understand about how a backdoor Roth IRA works. Let's say you make over that amount of money, you're making $500k a year. I love that for you. And you open up a traditional IRA but you make it nondeductible. There's a little place you just check it off, and it's nondeductible, so you are funding it with after-tax dollars. And then once you have funded it with after-tax dollars, and let's just say you didn't invest it, it's just sitting there, not earning money, it's just sitting there. And a few months later, I would let three or four months, five months go by, and then you converted the nondeductible traditional IRA to a Roth. All of a sudden, you now have a Roth IRA, a converted Roth IRA, not a contributory one, but a converted Roth IRA, and I will tell you the difference again in a second here. If you just do it that way, no taxes, everything's great, wonderful. All right, now, if the money that you put into a nondeductible IRA is growing and earning money while it's in there, and you then do a conversion, you will owe ordinary income tax on whatever amount it grew above the amount that you put in. What you have to be careful of, however, is that if all you have are 401ks, 403bs, employer retirement accounts, you have no other traditional retirement account. You don't have a SEP IRA, a Simple IRA, a traditional IRA, you have nothing like that and you simply fund a nondeductible IRA and you convert it. No problem. The problem comes in, however, when you have an IRA rollover, you have a SEP IRA, you have money in traditional retirement accounts, pre-tax, and then you fund a nondeductible IRA and you convert it. Now you are going to have to pay what's called a pro-rata tax on that money. Let me give you an example, and I understand very well that this podcast is probably making your head spin. But this one podcast here, if you actually understand everything, is going to save you thousands and thousands and thousands of dollars. So, you really better pay attention to this because this is so important, and very few people really understand this and know how it really works. So, let's just say, for example, you had $84k in a 401k plan with an ex-employer that you rolled over to an IRA rollover, and you now are going to fund a traditional, nondeductible IRA with $6k that you plan to convert. And you think, OK, I'm just going to convert it, and I'm not going to have to pay any income tax on it. Wrong. This is how it works. You have got to take the amount of money that you have in the total of all your pre-taxed retirement accounts. So, if he had a SEP IRA, a traditional IRA, a Simple IRA, an IRA rollover, all funded with pre-tax money, you have to add up all those accounts. In this circumstance, it's only one account, and it's $84k and you have to add that to the $6k that you are going to convert from your nondeductible IRA. That equals $90k. You then have to divide $6k, what you're going to convert by, in this case, $90k, and that will give you 6.6%. What that 6.6% represents is that is the only amount of money that you're not going to have to pay taxes on. So, if you happen to take 6.6% of $6k, that would be $396 that's non-taxable. You would owe income tax on $5604 of the $6k that you are about to convert. So, you better be aware of that. A backdoor Roth is not necessarily something that you want to do if you have money in traditional IRAs, an IRA rollover, or something like that. How can you get around it? Well, if you're working for an employer right now that has a 401k plan, you could convert the IRA rollover back to the employer's plan if you wanted to because 401ks or any employer-sponsored plan do not figure into the pro-rata calculation. Another option would be, now listen very closely here, is if you happen to have self-employment income, so you could set up a solo 401k and then roll your pre-tax IRAs into your solo 401k. Now, you have to make sure that the company that you are setting up this solo 401k with and you have to have self-employment income to do this, everybody, you have to make sure that they allow what's called roll-ins. Fidelity used to do it, I'm not sure they do it anymore, but if they do, then you do the transfer all of your pre-taxed retirement accounts are now in your solo 401k at a discount brokerage firm. Now I get that that's complicated, but those are things that you really need to understand. Just make sure you have to have, even if it's a small amount of money, right, you have to have a small amount of self-employment income. So, before I end this podcast, I just want to talk to you about one more thing that will make your head spin but you need to know, and it's called the Five Year Rule, and you really need to look it up and study it and see how does it apply to you when it comes to a Roth IRA, a traditional IRA, and an inherited IRA? But let's just say, let's go back to a Roth IRA for a second, a contributory Roth IRA. Here you are, you are 57 years of age, and you just started your Roth IRA for the very first time, and you're going to retire at 59 and a half. But, you think it is absolutely worth it to have it for 2.5 years, so you fund it with $7k this year, $7k the next year, and you now have $14k in there and you hit it big in the market, and you now have $25k in there. And you turn 59 and a half, and now you want to take all of your money out. You can take your original contributions, as I told you before, any time you want, but do you remember me saying to you, it is your earnings that have got to stay in there until you are 59 a half and five years? If you are 59 and a half but your Roth IRA has not been open for five years, you are going to pay taxes and a penalty on any of the earnings that you take out. So, if you put in $14k, it's now worth $25k and you took it all out, you're going to pay taxes and a penalty on that $11k. So, it is really important that you understand the Five Year Rule. I also just have to say, you better understand it when it comes to an inherited Roth IRA as well, because if your parents, for instance, your mother opened up a Roth IRA three years ago and she's been contributing to it for three years, it now has $21k in it, it's grown to $40k or some amount of money just let's say because you never know what she invested in. And you now inherited this Roth IRA, you can take out her original contributions no taxes or penalties because it was funded with after-tax money, but the earnings on that money cannot be taken out without taxes and penalties until that account has been open for five years. Converted Roth IRAs work very differently than contributory Roth IRAs, where if you convert to a Roth IRA, that then will start it's holding period. You convert again the next year, which starts a new holding period. You convert again the year after that, it starts a new holding period. So, every time you convert, the five-year clock starts ticking on the amount of money that you converted that year. So, you really need to really do a deep dive into Roth IRAs, inherited IRAs, that Five Year Rule, the backdoor Roth IRAs, but there's a lot of information, good information, out there. This is a topic that I really need you to understand, so come back, listen to it over and over and over again, write questions about it, and if you have a lot of questions about it, then I can possibly continue this with another Suze School. So, until next week, all right, are you glad this Suze School is over? You stay safe. Hi, I'm Sarah, and I'm Robert, and we're from Suze Orman's Women and Money podcast team here to tell you that Alloya's member credit unions are so proud to have brought you this episode. You know, Robert, credit unions live by a people helping people philosophy. Absolutely, Sarah. And that means when you bank with a credit union, you can trust that they have your best interest at heart. The fact is, regardless of circumstance, a credit union will have your back and keep your money safe, that's the credit union promise. Go to www.MyCreditUnion.gov to find a credit union that fits your needs. That's MyCreditUnion.gov. In providing answers neither Suze Orman Media nor Suze Orman is acting as a Certified Financial Planner, advisor, a Certified Financial Analyst, an economist, CPA, accountant, or lawyer. Neither Suze Orman Media nor Suze Orman makes any recommendations as to any specific securities or investments. All content is for informational and general purposes only and does not constitute financial, accounting or legal advice. You should consult your own tax, legal and financial advisors regarding your particular situation. Neither Suze Orman Media nor Suze Orman accepts any responsibility for any loss, which may arise from accessing or reliance on the information in this podcast and to the fullest extent permitted by law, we exclude all liability for loss or damages, direct or indirect, arising from use of the information.
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