Roth Conversions Explained: How They Work and the Tax Cost

A Roth conversion means moving money from a traditional IRA into a Roth IRA. The catch is that the converted amount counts as taxable income in the year you do it. In this episode, Ryan explains how to stage conversions over multiple years to manage your tax bracket, and why someone might want to act now if they expect their tax rate to rise in the future.

Ryan also runs a future-value comparison showing how starting a child's Roth IRA at 18 versus 32 makes a dramatic difference, which gives Aaron the chance to share news about his newborn son Arthur. This is education, not personal advice; work with a tax professional before executing any Roth conversion strategy.

Find "Your Fiscal Physical" the book on Amazon

If you have suggestions or feedback, please email us at: Podcast@AlchemyWealth.com

And, as always, Stay the Course!

Transcript

Copy Transcript Copied

Converting Traditional IRAs to Roth IRAs

Host 0:01

Welcome to the fiscal physical podcast . Join us each week as we sit down with the founder of Alchemy Wealth Management and author of your fiscal physical , Ryan Nelson . Tune in to gain valuable insights and practical tips as we simplify complex financial concepts into digestible lessons . From budgeting to retirement planning , this podcast is your go-to resource for mastering financial literacy .

Aaron Hoisington 0:34

Welcome everybody to this week's episode of the fiscal physical podcast . My name is Aaron Hoisinton , I am your host and I am joined by the founder of Alchemy Wealth Management , ryan Nelson , and we are excited to dive into this week's episode . Last week , ryan kind of filled the listeners in and gave me some great information on Roth IRAs versus traditional IRAs and I felt like we could have talked for hours on that specific subject here . But we're going to dive in this week a bit more because I have lots of questions for Ryan here . So hopefully the listeners can gain a little bit here , gain a little bit of knowledge that I know I'm excited to learn about . But first off , ryan , how are you doing ? Doing well , doing well . How about yourself ? I am doing good . I am feeling more fiscally fit .

Host 1:21

Or physically fit , whatever it is .

Aaron Hoisington 1:24

Everything about me is just getting more fit as we do this podcast more and more . So one of the questions I had , ryan , is we talked last week about traditional IRAs , roth IRAs , and I'm just going to paint a picture here for you and hopefully it makes sense for the listeners . If , say , I've been contributing to a traditional retirement account , a traditional IRA , throughout my life because I felt like it was the best for me at that point .

Aaron Hoisington 1:49

I'm like , hey , cool , or maybe it was the only option I had , like a work account or something like that , and I'm you know , I sit down with I'm doing my finances . Or I sit down with my financial advisor and I'm like , hey , you know , I don't know if this is the best option for me . Right now I have all this money built up in a traditional IRA . Can I convert it into a Roth ? Or when do I start contributing to a Roth , to kind of what makes best , you know , financial sense for me overall ? Is that even an option that people can take advantage of , or how would that really work ?

Ryan Nelson 2:20

Yeah , that's definitely a common question , I guess . So somebody will be contributing into one type of account for a period of time and then want to switch contributions to the other type , and you know what ? What details do they need to be considering ? So , yeah , so in this example , if you had built up sort of a nest egg in your traditional IRA and you've now determined that maybe you believe for your unique financial situation , a Roth IRA would be better , then that's pretty easy . You can just start making the contributions to your Roth IRA . I will say that there are income limitations , right . There are other factors to consider when deciding traditional versus Roth . So you should definitely do your , do your homework , do your research , consult a tax professionals , you know , consult a financial professional . But assuming you've made that decision to contribute to your Roth IRA , that'd be easy enough . You could just start making future contributions there .

Ryan Nelson 3:13

Now , like you said , you may have built up this sort of nest egg in traditional IRA that you say darn it , I wish I would have put that into a Roth . Like I didn't actually understand what I was doing . Now I'm a little bit more , you know , financially educated . I have this lump sum in traditional IRA , but I don't want you know , I don't want this to grow into this big sum of money that I'm now going to be taxed on . In the future . I would prefer it to be in my Roth balance right , and so you can do what's called a Roth conversion . So maybe you've built up a nest egg of $100,000 in your traditional IRA and you want to take that $100,000 and get it into your Roth . That's 100% doable . Again , it's called a Roth conversion . Now , by doing that again , if we think about this and you can always reference back to episode seven to get more details on this , traditional IRA versus Roth but if you think about that , the $100,000 in your traditional IRA you've not paid any taxes on right .

Ryan Nelson 4:07

And you were going to have to pay taxes on all that money at some point in the future . If you're choosing to move that or convert it from a traditional IRA to a Roth , that time in the future is now right . So if we take $100,000 and let's say we just convert the whole account balance all $100,000 over to a traditional IRA right now , that would all be effectively taxable income this year . So you'd want to look at what that might do to your tax bracket . It might jump you a bracket or two right . So as you start evaluating this , you might say , yeah , gosh , I wish I had moved all this money or had contributed this money to Roth in all those past years . Okay , you can't cry over the spilled milk like it is what it is . Now . Let's start evaluating . How do we get it converted ? And again , one of the biggest factors is just what's 100 in this example ? If it's 100,000 , what's 100,000 dollars of taxable income going to do to you ? Is it going to be jumping you up into unfavorable tax brackets ? That would maybe reverse your decision if you had been in those higher tax brackets this year . And so one strategy that you could implement and we do with lots of clients is doing it over a multi-year period . So you could theoretically , nothing says you have to convert all $100,000 . If you had a $100,000 account , you could convert $20,000 this year and $20,000 next year and $20,000 the next year , right ? Or you could just convert $60,000 one time and never convert the rest , right . You'd have a lot of flexibility there on how much you convert and when you convert it . So it'd be really important to partner with a tax professional or a financial professional or at least have a really good idea yourself of where you're at currently in your tax bracket and how much available income you can still have until you start bumping into the next tax bracket .

Ryan Nelson 5:55

And just because you bump into the next tax bracket isn't necessarily bad . You still may want to convert , right . But it's certainly a consideration you need to have right . And you may say , yeah , I'm fine converting all 100,000 . Yeah , it's going to bump me up a tax bracket and I don't care , I'm still comfortable . Even in that higher tax bracket , I'm still comfortable converting . And I'd rather do it now because maybe I think starting next year , my income is going to go up a lot or they're going to be lots of reasons for that . But yeah , so that'd be what's called a Roth conversion . It's fairly easy to do and I'd say that'd be . The main consideration is just what that lump sum being added to taxable income would do to your tax bracket this year .

Aaron Hoisington 6:30

Yeah , and I think you hit on a good piece that we're going to talk on a future podcast episode about the progressive tax system as well , and how it's set up , because you hit a really good point that most people are like oh , I don't want to get in that next tax bracket , like I don't want to do that in specifically for your situation might not be that big of a deal , like it's not like hey cool We'll discuss which was just mind blowing to me when I first learned about it , because I was like under the impression that like hey , everybody , you know if you have to pay taxes on everything , if you get in that next tax bracket which isn't necessarily true , but we'll cover that a little bit later in different episode , but that's very interesting to think about that .

Aaron Hoisington 7:06

You can convert that over and you mentioned in our last episode Uncle Sam's gonna get their taxes in some way or not . But if you're like , hey , I'm gonna be making more money in the future , I should do it now , because this is where my tax levels at or tax brackets at that just seems to make the best financial sense , if that was something that people are you know wanna dive into .

Ryan Nelson 7:28

Yeah , absolutely . And sometimes maybe somebody will be out of work for a short period of time in a certain year , so their income is gonna be lower that year . Hey , that might . That could theoretically lower their tax bracket this year , and it's just such a degree where it might make a lot of sense to do something like a Roth conversion . Another good example could be you know , maybe you have $100,000 and the market goes through a steep decline and next thing you know , you only have $70,000 in your traditional IRA , right , well , that might be a good opportunity to do a Roth conversion and convert it only at $70,000 . Right , and then you would only be paying the income tax on $70,000 , but you get all those shares now reinvested into your Roth IRA . So now , theoretically , if the market kind of rebounds back , you're getting all those gains tax-free in your Roth as well . So , yeah , there's lots of considerations to take into account for , like when the best time to do a Roth conversion is , and should you do the entire account balance or just a partial ?

Aaron Hoisington 8:22

Yeah , no , that's great man . That is some exciting stuff to think that it's the options out there , because you know your decision , that you make it . You know in your 20s , your 30s , it's gonna be different than what you're making in your 40s and 50s For sure . And so you're to know that you're not just locked into one of those options like , hey , cool , I'm making this decision , I'm checking this box and this is where I'm gonna live for the rest of my life , knowing that there's the option to switch over , whatever the situation is .

Aaron Hoisington 8:47

And you mentioned a great line in I don't know if there's already this episode of the one before where it's more of an art than a science sometimes and I think that that's really plays a role in a Roth conversion kind of examining those factors and being like cool , what works best for you and how can we artfully do this in the best way that benefits everybody ?

Ryan Nelson 9:05

For sure 100% Awesome .

Aaron Hoisington 9:08

I think that's a great spot to leave this one here and we wanna make sure we plug to go back and listen to episode seven just to kind of give you the basis of a Roth IRA versus traditional IRA . You don't really have to listen to this podcast in chronological order , but sometimes it's beneficial and I think this is one of those episodes where you can go back , learn all about that , come back and you'll be like , oh wow , now I know what they're talking about specifically and how it could potentially be something they can take advantage of . Definitely Awesome . We'll hang tight with us and we'll be back on the other

Starting Young in Personal Finance

Aaron Hoisington 9:38

side .

Aaron Hoisington 9:38

And now to put the personal in personal finance , oh , All right , we are back on this side of the fiscal physical podcast into our personal section here , and this one is actually very personal for me . I don't know how many of the listeners know , but I recently just had well , my wife had a kid my son Arthur . Congratulations , thank you , thank you . It's been a wild ride . Kids are no joke , I'll tell you that , and they are expensive , but thankfully we have this podcast here .

Aaron Hoisington 10:11

And I was thinking , listening back to our Roth conversations and I know that when I've mentioned a couple of times , when you taught my wife and I about what a Roth is , immediately my first thing , my first thought , was wow , I wish I would have known this when I was 18 years old , when I could have contributed way more . I'd be 15 years into contributing to a Roth , versus five or six or whatever . Is there an option for your kids to start them early with ? I don't know if it's a Roth or traditional IRA , but say my son , who's now nine weeks old at the record of this podcast , if I was like I'm gonna start you a retirement account right now because I know that this would be a great option for you in 65 years , you'll thank me . Is that even an option to do .

Ryan Nelson 10:58

Yeah , yeah , good question and a question we get fairly frequently . I mean , before I address that question specifically , I'm going to maybe touch on another piece real quick , that you can touch on . And it was just about starting a Roth early and you said , oh , I wish I would have started when I was 18 , right , so let's just throw some theoretical numbers around here . So I just got a future value calculator here pulled up in front of me and you can just plug in all sorts of different numbers . Okay , purely a calculator right .

Ryan Nelson 11:26

And so if I said that we started with $0 , so let's say you started when you were 18 , you started with $0, . Let's say you added to this thing for , let's say , 50 years , so 18 to 68 . So let's pretend just a theoretical retirement of 68 , because again I like round numbers . So we contributed to this thing for 50 years . Let's say you got 7% returns you could plug in any other numbers you want into another future value calculator and let's say you added 500 bucks a month . So if you started at age 18 , you saved for 50 years , so from age 18 to 68 , you got 7% annualized returns and you added $500 a month . That account would grow to approximately 2.7 million . So you would have put in 300,000 , and 2.4 million of it would have come from gains . Wow , again , it being in a Roth , that 2.4 million of gains would all be tax free , right ?

Ryan Nelson 12:21

So , yeah , the value of starting at age 18 is huge . Now let's say if , instead of starting at age 18 , you start at age , let's say , 15 years later , so instead of age 18 , you start at age 32 . Okay , so what do you think ? Maybe that account balance would be Instead of 2.7 million , what do you think ?

Aaron Hoisington 12:39

I'd probably guess 1.6 .

Ryan Nelson 12:43

1.6 , yeah , good guess . So instead of putting in 300,000 , you would now have put in 210,000 , so you'd put in a little bit less and you'd have 15 years less time . So if you start with $0 , you start at age 32 , or 33 , sorry so again 35 years later . So you'd be investing $500 a month at 7% returns . Your account balance would grow to 900,000 .

Aaron Hoisington 13:06

Whoa that extra whoa 15 years is huge , right ? Oh my goodness .

Ryan Nelson 13:11

So that's the difference again 35 years of contributions versus 50 years of contributions . The difference you contributed is not that much , 210,000 versus 300,000 , that difference is just the power of compounding and the power of time . So that extra 15 years brought your account balance from theoretical 900,000 to 2.7 million , right , so huge . So , yes , the value of starting young , there's no question about it . So then you might parlay this and say yeah to compound on your question . That's incredible , like I wish I would have started age 18 instead of now . But then you also might say well , gosh , I just had my son . How do I start him at age zero ?

Host 13:47

At age one , right Cause , that's just gonna be even better .

Ryan Nelson 13:50

And so , yeah , so to answer your question directly yes , you can . You know , kids can contribute to a Roth IRA . They do need to have a social security number and this is the big , and they need to have earned income . So I see I've probably been asked this question no joke half a dozen to a dozen times online . Or I've been asked probably half a dozen to a dozen times from clients who have seen something online Right , mostly I've seen it from TikTok , but , yeah , potentially other things Instagram , something like that and they're kind of being told that they can contribute to their kids' Roth IRAs .

Ryan Nelson 14:31

The kid has to have earned income to contribute to a Roth IRA . So one example of that is , let's say , let's say that I wanted to go do some marketing material for alchemy wealth , right , and I wanted to maybe start promoting doing college savings , and so I wanted some pictures of a baby . I could go hire Arthur right as a model so I could take some pictures of him , put it in my marketing material , put it on my website , and pay him wages that would be appropriate for the work he's doing , sure , and then he then would have earned income . He could take that money , put it into a Roth IRA , but he would need that earned income to do so , and the income has to be appropriate for the work that he's being done Like if , somehow , if you were a business owner and you paid him to clean up your shop , it's like oh , is a one-year-old really cleaning my shop ?

Host 15:25

So we get floors like I don't know .

Ryan Nelson 15:26

That sounds like you're maybe getting into a little gray area that I wouldn't want to mess with , right , but yeah , a one-year-old could theoretically be a model , I suppose right , but so I'd say the work has to be appropriate , the compensation has to be appropriate , and then if there is earned income , yes , they could contribute to a Roth IRA .

Aaron Hoisington 15:46

Yeah , no , that's great , and I mean in my situation currently I don't have extra money to put in his Roth IRA . I'm barely keeping food on the table here but . I think that there's situations when that you might want to , like I said , the power of . We just painted the picture of compound interest in time .

Host 16:01

Right .

Aaron Hoisington 16:02

It seems seemingly unmatched it comes to the financial world overall . So I mean , the earlier you can start these things and obviously hindsight's always 20-20 . I'm like oh cool . I'd love to go back and do this , but the best I can do is give advice to not only our listeners but to everybody out there , just in general , to start early .

Host 16:21

Oh yeah .

Aaron Hoisington 16:22

You're not going to be mad at yourself if you started too early .

Ryan Nelson 16:26

Yeah , I would say future , you will never be mad at past you for saving more money . Right , and this is a quote . You'll probably hear me say it like 100 more times . I probably say it every day . I don't even know if it's true , but supposedly Albert Einstein was credited with saying the most powerful force in the world is compound interest .

Aaron Hoisington 16:43

Again , I don't know if it's true or not , but I love the quote and it just rings so true , yeah , no , that was great and that was definitely a personal section for me , specifically with having a son recently and hopefully I'm going to make him very fiscally fit in his future there . But thanks everyone for listening

Podcast Alchemy Wealth Discussion

Aaron Hoisington 17:03

. If you guys have questions , comments , concerns whatever it might be , please email us at podcastalchemywealthcom with any topics or anything you guys want to share . We'd be happy to discuss them on the air here . And anything you want to say , ryan , for me , I'll let this one go . Stay the course .

Host 17:22

Thank you for joining us for the Fiscal Physical Podcast . Until next time , happy listening and , as always , stay the course . If you have a question or topic suggestions , please email us at podcastalchemywealthcom . If you enjoyed today's discussion , subscribe to the podcast to ensure you never miss an episode , and consider leaving us a rating and review on your favorite platform . This helps other listeners like you find the show . For more resources , you can visit Alchemy Wealth Management's website at wwwalchemywealthcom or find your fiscal physical the book on Amazon . We'd be remiss if we didn't mention that personal finance is just that Personal . Please don't take anything we say is advice . The preceding content is for informational and entertainment purposes only . It's not an offer or a solicitation , nor should it be construed or relied upon for tax , legal or investment advice . It doesn't consider your personal financial situation or objectives and may not be suitable for you .