Bullshit on Stilts: Tackling the bullshitology of financial decisions.

Exposing Financial Fairytales 2: Myths About Tax-Free Roth Conversions

• Keli Alo & Mark Robinson • Season 1 • Episode 18

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Discover how to transform your retirement strategy with the power of Roth conversions! What if you could grow your retirement savings tax-free and enjoy financial freedom in your golden years? Join us on Bullshit on Stilts as we unravel the mechanics behind shifting your traditional IRA funds into a Roth IRA. We highlight the strategic use of Roth IRAs to minimize tax burdens and maximize tax-free growth and withdrawals. Our lively discussion, peppered with humor and expert insights, aims to empower you with the knowledge to make informed decisions for your financial future.

In this episode, we also tackle common misconceptions about Roth conversions and provide clarity on tax implications. We'll guide you through a scenario where a fixed indexed annuity can create a tax-neutral conversion process—turning traditional savings into tax-free wealth without the financial sting. We emphasize the importance of asking the right questions and challenging your financial advisor to ensure you get the best advice possible. Whether you're a seasoned investor or just contemplating your retirement plans, our insights will help you confidently navigate these complex financial waters. Tune in and arm yourself with the tools to secure a prosperous retirement!

Developing your financial bullshit sniffer one episode at a time.

Speaker 1:

Welcome to Bullshit on Stilts, a podcast hosted by two guys with vast financial backgrounds and great bullshit sniffers who call out the cliche crap, spackle and flap doodle spewed by so-called experts across the landscape of financial advice, identifying as doctors of bullshitology. You can count on your esteemed hosts okay, maybe knuckleheads to bring you a lively, if not deadly, mix of bullshitology. You can count on your esteemed hosts okay, maybe knuckleheads to bring you a lively, if not deadly, mix of serious analysis, hijinks and tomfoolery, all within a 99.1% bullshit-free safe space. Let's get after it. So let's set the table on the tax-free Roth conversion. So it's interesting, right? The whole name sounds pretty cool Tax-free. I love that, right, and so it kind of helps to suck you in, right? When it comes to subject lines, they're critical to get an individual to say, gee whiz, what's that all about? So, tax-free Roth conversion.

Speaker 1:

So first of all, let's figure out what is a Roth conversion in the first place. So first, a Roth conversion itself never mind the tax-free concept or scheme, but just a Roth conversion is when an individual has a traditional retirement account and has a Roth retirement account. In the Roth conversion the individual wants to move the money in the traditional retirement account. We presume it's pre-tax dollars that went in there, so the dollars never got taxed when they went in. It's kind of a benefit from the traditional retirement account. We want to take those monies out and we want to move them over to the Roth. We want to convert pre-tax retirement dollars into after-tax retirement dollars, hence Roth conversion.

Speaker 1:

An example would be let's say, you've been working for a long time, you've put money into in this example, just to be simple a traditional retirement account, a traditional IRA, and every year you put money in, you were able to take the beneficial tax deduction, meaning the dollars that went in there. Guess what? You didn't have to pay taxes on those dollars as a form of income tax deduction, also known as pre-tax dollars. Here's the catch. It's really cool because the traditional IRA grows tax-deferred, meaning every year I make money, every year I earn dividends, every year I earn interest. I don't have to pay taxes on that. But in retirement and we're presuming over the age of 59 and a half for this discussion when I take the money out of my traditional retirement account, guess what? I have to pay income taxes on the amount I take out of the account. Aw boo, Let me say that again, I have to pay taxes on the amount of money I withdraw out of my traditional retirement account. Essentially, the IRS views that as a paycheck and as a result, like we all know, with every paycheck we got to pay taxes. That's what the traditional IRA sets up for us. So pre-tax dollars goes in, I have tax deferred growth for a long time and then at a certain point, when I take money out of that account, I'm going to pay taxes on that. And, by the way, with a traditional retirement account, I have to begin taking a little bit of that money out every year, beginning at my age of 73. So I really am going to be forced someday, when I'm older at least, to start taking money out and creating income taxes in my world, and that's not necessarily a good thing or bad thing, but that's just the facts of the matter.

Speaker 1:

When it comes to a traditional retirement account the Roth retirement account and, again simplified, just the Roth IRA account well, guess what? It's sort of the complete opposite, in that when I put my money in, those dollars I put into the Roth contribute to the Roth are after-tax dollars. They've already been taxed. I got paid for my job. My employer took my taxes out of my paycheck and the money that's in my checking account after-tax dollars I get to put that money into my Roth IRA.

Speaker 1:

Well, why would you do that? Why don't you take the tax benefit up front, like the traditional IRA has? Well, the answer is that over the life of the Roth IRA, and in my case, over the remaining time of my life, the dollars in there grow tax-free. The dividends I receive, I receive tax-free, interest I receive, I receive tax free. And oh, by the way, I never, ever, ever have to take money out. I'm not going to be required to withdraw a small percentage of the money when I'm 73. Not at all. I can keep that money in there and never touch it. I don't have to withdraw it. And lastly, when I do withdraw money out of my Roth IRA, guess what? I don't pay a dime in taxes. The IRS does not view it as a paycheck. So that's a pretty cool thing.

Speaker 1:

So a Roth conversion is simply seeking to move pre-tax dollars that I have in my traditional IRA, move it out of the traditional IRA. Guess what? I withdraw the money, so I'm going to create an income tax, but I can move those dollars from the traditional IRA. I have to pay a tax when I do that. And then the dollars that enter the Roth IRA. They are now after-tax dollars, meaning I never have to withdraw them ever in my life, and when I do withdraw them, they're tax-free. So long as I follow a couple simple Roth IRA rules. That's a really good deal and we're not going to get into that right now. So that's the setup.

Speaker 1:

So the target market for the tax-free Roth conversion are going to be folks that have a lot of money in traditional retirement accounts and they are going to be essentially convinced that the best thing for them to do is move some or all of that money from the traditional IRA into a Roth IRA. That's what a Roth conversion does. The selling points are you move it from taxable retirement monies. You move that over to tax-free money in retirement when you withdraw it into the Roth. That's the sale. And then to support the sell, what the financial service professional will do is create a story. Right. Storytelling sells a lot. They create the story around projections of future income tax rates. Promises that when you retire, income tax rates are going to be much higher. So paying lower income taxes a day is a smart idea. So in general, the Roth conversion conversation. So that conversation with a financial service professional is going to focus you on creating urgency around doing a Roth conversion, that it's better for you long term in terms of the amount of tax you pay and that they have a great solution for you in the process of doing your Roth conversions.

Speaker 1:

Okay, so we have a little bit of a basic foundation of what the Roth conversion is, what the point is, who might be a candidate to speak to about a Roth conversion? Now let's move over to the advertisements around tax-free Roth conversions. But wait a minute, kelly, you just said that when I do a Roth conversion, I create a taxable event when I withdraw money out of my traditional retirement, and the survey says that is the correct answer. True, the sales concept, the advertising concept, is tax-free. You don't have to pay taxes. You get around taxes. You get to be smarter than the average bear. Everybody else is paying taxes, but you don't have to right? That's what it sort of suggests. So how does a financial service professional get away with advertising tax-free Roth conversions?

Speaker 1:

Let's get into this. When you see tax-free Roth conversion, start thinking pretty quickly that it's an insurance agent that is behind the advertising. In fact, if you set up a 15-minute free consult, if you want to do a call, if you want more information about 90 plus percent likelihood maybe more than that, 100% likelihood it's going to be an insurance agent on the other end of that discussion. Nothing wrong yet Just know that you'll be talking to an insurance agent. Remember, insurance agents get paid money. They earn a living once and if you purchase a product In this case, the tax-free Roth conversion product that's behind the curtains is going to be most likely a fixed indexed annuity plus a bonus that the annuity pays you.

Speaker 1:

Now, that sounds delicious, right? This bonus? In this example that we're going to use today, we're going to assume a 20% bonus. Wow, that sounds fantastic. So let's set up an example here. Wow, that sounds fantastic. So let's set up an example here. I have $100,000 in traditional retirement account. I'm talking to a financial sales professional and in this case, an insurance agent about a tax-free Roth conversion, because it makes sense. I don't want to pay taxes when I'm older, so, yeah, this is something I kind of want to find out about.

Speaker 1:

All right, in the discussion for the tax-free Roth conversion, the conversation will eventually get to a recommendation around a fixed indexed annuity that pays you a bonus. Here's how that works. If we move or do a Roth conversion of all $100,000 of our traditional IRA, that $100,000 of our traditional IRA, that $100,000 is withdrawn from the IRA and we're going to assume a 20% tax rate on the money, meaning we owe the IRS this year now $20,000 in taxes. $100,000 withdrawn from my traditional IRA to do a Roth conversion triggers an income payment to my house of $100,000. That's the way the IRS sees it. And if I have a 20% tax rate in this case, at the end of the year when I do my tax return I'm going to have to make sure I come up with $20,000 to pay that tax bill. $20,000 to pay that tax bill when that money moves into the Roth IRA. That money is now after tax, remember, because I'm going to pay the tax bill for the withdrawal. Now I have $100,000 in this example now being withdrawn from my IRA, putting into the Roth IRA and now I got $100,000 there. We'll get back to why it's still $100,000 in a moment. So 20% bonus on $100,000 is $20,000. So I got a new fixed index annuity that I put $100,000 of after-tax dollars into it and the insurance company bonuses me $20,000 on top of the $100,000. Boy, that sounds sexy, that tastes good, I'm telling you. But there are some yeah buts in this whole storyline. So let's examine that. And before we examine that storyline, I want to digress for a second and just mention this.

Speaker 1:

When it comes to a Roth conversion never mind tax-free or any other type when it comes to a Roth conversion nevermind tax-free or any other type a Roth conversion there are two ways that an individual pays that income tax bill. One way is to take money outside of the retirement accounts, like in your checking account or a trust account or an investment brokerage account, anything that's outside of retirement. That money can be used to pay the tax bill and on average, that's the recommended course of action. So the recommended course of action when I do my $100,000 Roth conversion here is to convert $100,000, withdraw $100,000 out of the traditional IRA and move that $100,000, all $100,000 of it, to the Roth IRA, all the while knowing that I'm going to end up writing a check, in this example, out of my checking account for the $20,000 tax bill. So I pay it, but I don't take it out of my Roth conversion monies, I take it from somewhere else. That way, all $100,000 gets to be slapped into a tax-free investment account called a Roth IRA and grow tax-free for the remainder of my days on the face of the earth. And, by the way, the beneficiaries that I assign to my Roth IRA get to take the money out when I pass away tax-free as well. Pretty slick. The other way to pay for the taxes is to take it out of the $100,000, put it in the bank getting ready to pay tax on it later in the year, and then move $80,000 over to the Roth IRA and in this case, a 20% bonus on 80 grand is 16,000, not 20,000. Big difference, okay.

Speaker 1:

So back to our storyline Once again. We got 100 grand in traditional IRA. We want to do a Roth conversion. We're going to withdraw 100 grand out of the traditional IRA, creating a taxable event of $20,000 in this year because our tax rate is 20%. We're going to pay that with outside money so that all $100,000 is deposited into the Roth IRA. Now after-tax dollars. That's the Roth conversion in a nutshell.

Speaker 1:

Let's go back to the tax-free Roth conversion and how that all works. First of all, tax-free is a little bit of a misnomer and a misdirection, because in the tax-free Roth conversion you still pay the income tax of 20 grand the year that you withdraw or the year you do your Roth conversion. You still pay that tax, but in the tax-free Roth conversion that payment is sort of offset or is intended to be offset by the bonus the index annuity pays you. So, remember, we put $100,000 in 20% bonus. My contract statement shows $120,000, not 100 grand. That's pretty slick. And, by the way, dollar for dollar, if we pay 20% in tax and we get a 20% bonus on 100 grand, dollar for dollar, it negates the tax payment. So it's a neutral situation, not tax-free, but at least tax neutral when it comes to the payment.

Speaker 1:

So, kelly, hey, is that bonus all my money? And why don't I just put the money in and then a few months later take all the money out tax-free? Hell, yeah, that's what I'm talking about. Well, there's a whole bunch of reasons why you don't. And, from the product standpoint, because you don't really own the $20,000 they bonused you. Yet what the hell? Sure, it's on paper, sure, the number looks bigger, but it's not all yours. See, in most bonus index annuity products paying 16, 18, 20 plus percent bonus, you're going to be locked into that investment product on average for 10 years, a decade. What do I mean by locked?

Speaker 1:

These annuities will let you access your money every year, but only a little bit. See, you only get to take 10% of the value of that indexed annuity out any one year without you having to pay a penalty to the insurance company. If you take $15,000 out on a $100,000 contract, well, that's 15%. So 10%, 10 grand you got and you didn't have to pay a penalty. But the additional five grand above the 10 mark you're gonna pay a penalty, meaning you will surrender some of your money to the insurance company because you took out more than 10%. What the hell? So you get this tax payment neutral product. I paid 20%, you bonus me 20%. Okay, I'm made whole again.

Speaker 1:

But you don't have true access to all your money like you did in your traditional IRA. Your access is limited to normally only 10% of the value of that indexed annuity any one year and for 10 years. Anytime you take out more than 10% of the value of the indexed annuity, you're going to be paying penalties to the insurance company. Isn't that fun? They don't want you to know that. By the way, remember that $20,000 bonus and I said it's not yours. Guess what. It'll take you 10 years to actually own outright that $20,000 bonus. With its growth you suck. Let me say that again 10 years before you actually own 100% of that bonus. So every year you own the contract, the indexed annuity contract, you get a little bit more ownership interest in the bonus they paid you until after 10 years you own 100% of it. So this is some of the things one needs to think about before they pull triggers on long-term locked up monies like annuities.

Speaker 1:

What happens if life throws that curveball? What happens in year four, when life throws that curveball that we can't predict is going to happen and you need to access more than 10% of your Roth retirement monies? What happens then? Well, let's say I needed to access all of the money and let's say I met all the simple rules of Roth IRAs so that I didn't have to pay penalties, I didn't have to do any of these things and that every dollar I withdrew was supposed to be tax-free. But instead I forfeit whatever remaining amount I don't own on the bonus I received. I forfeit that money and I'm going to pay some type of penalties because, remember, I want all my money because of that life event. I'm going to take out 100%, meaning I blew through that 10% free withdrawal feature, meaning that every dollar above 10% is going to earn a penalty for early removal.

Speaker 1:

They don't talk about the yeah buts when it comes to the indexed annuity, and listen, those vehicles are pretty cool, they work pretty well, but most people that own them don't really understand what they own and most people that are speaking to a financial sales professional, an insurance agent, that's creating hooks in the water when it comes to looking for their new prospect clients. And they start with tax-free Roth retirement conversions. Sort of interesting how we have to mislead in order to get you to talk to us, in which case now we can have a conversation to show you how much we care and what products we bring to the table to help you achieve what you want to achieve. Kind of an interesting concept. Tax-free Roth conversions are a sales tactic to get you in front of an insurance agent that has most likely a fixed indexed annuity that has a big bonus on the contract to pay you and they're using that tool to convince you to do a Roth conversion. Now, oh, by the way, they get paid a nice commission when you buy that annuity for your Roth conversion. Hopefully that helps. Hopefully it starts filtering out some of the things you see in social media.

Speaker 1:

There's a lot of advertising out there from financial services. The advertising obviously is the lines in the water. They're sitting there trying to hook individuals to get interested in what they have to say. It's all obviously fine, but when it comes to financial decision making, most of us it's not our bailiwick, it's not what we love doing and getting into a conversation with an expert to convince you to invest in the product. We get back to the bullshit on stilts framework of financial services as it is. If you recall, mark speaks to why so much bullshit on stilts is out there. And it's because most financial service industry discussion starts with the product. So we have to make these huge claims, these outsized promises and guarantees and so forth, because we're going to talk to you about the product that's able to achieve some of those benefits. All right, so that's the Roth tax-free conversion. So this is about developing your bullshit sniffer. It's not all bad agents out there. There's some incredible agents that do incredible work. So certainly not demonizing the agents that utilize these advertisements to speak to consumers Nothing wrong with that but you as the consumer, developing your sniffer around the BS that comes from product-centric conversations. That's what this is about. So no, going in Tax-free Roth conversion, I'll put money on it.

Speaker 1:

95% likelihood you're going to be speaking to an insurance agent that's seeking to position and sell a fixed indexed annuity. Knowing a little bit more about it helps you decide. Maybe there are some big questions like do I own the bonus money outright or not? Question two when do I own 100% of the contract bonus? Three, what are early withdrawal penalties associated with this fixed indexed annuity? Four, what happens to the bonus money and the amount I can withdraw if life hits me in the head and I need to withdraw substantially every dime within the annuity contract before the end of the penalty phase normally about ten years, maybe longer.

Speaker 1:

Just some good questions to think about, know about, wonder about and don't be shy. Pose those questions right up front, ask them and if they don't explain it to you real well where you understand it, hey, ask them again. Ask them to explain it differently. Test the professional whether they can speak in a language that you understand and that might be a professional that's well fitted to your needs. Hopefully that helps out the tax-free Roth conversion. It's out there, it's real, and just know what you're getting into when you sign up for more information 15-minute free consult and whatever Certified badass. Thanks a lot for joining us. We'll see you next time on Bullshit on Stilts. Have a great day.