PODCAST: The Ins and Outs of IRAs with Ed Slott, CPA

(Image credit: Getty Images)

By Sandra Block, David Muhlbaum

published 23 August 2021

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Sandy Block: Right. This is a follow-up to legislation Congress enacted a couple of years ago and it makes a bunch of tweaks and protections of benefits, mostly benefits, I would say, to retirement savings and specifically the way you save for retirement through your employer. Basically it's designed to encourage, make it easier for people to save and there's a bunch of provisions in it that also include when you take the money out. But I think we're going to narrow in on a couple of them today.

Sandy Block: I don't know. I've been at this for a long time. Secure Act 2.0 is not exactly good, but one of the things, and we actually have a story about this upcoming issue. One of the things that Congress wants to create, which to me makes a lot of sense, is a national database where you could go looking for a lost or orphaned 401(k) plan, or maybe a pension plan if you've lost track of it. Well, it sounds really surprising that anybody would lose track of money they're saving for retirement. There's a company called Capitalized that estimates there's more than a $1 trillion dollars in assets in these forgotten 401(k) accounts. And typically what happens is someone changes jobs and they just don't get around to taking their 401(k) with them. And maybe if it was a small amount, they forgot about it. And maybe the company that they worked for no longer exists. Maybe it merged or got acquired or something like that.

Sandy Block: So, this money is just sitting around and you hope people will go get it, but it's really not good money management. You know, the investments in your old 401(k) may not really reflect your age and risk tolerance. You should be keeping track of this money because someday you're going to need it. So Congress wants to create a national lost and found database where you could go actually search for your lost 401(k). And once you get it, you can make smart decisions about what to do with it.

Sandy Block: Oh yeah. Yeah. And I think a lot of these are small accounts. I mean, think about how often people change jobs these days. You might have a couple of thousand dollars saved and you're three jobs in and you've forgotten about it, but it's still sitting there and it should be with you. You should know what's in it. You should be making smart decisions on how to invest it. And if you change jobs a lot, you can have a lot of plans all over the place. And I don't think that's really the best way to manage your retirement savings.

Sandy Block: A gift card. And yet they went in this direction more relevant is that it would make it easier to contribute to a Roth 401(k), which is a 401(k) that you fund with after tax money versus the traditional 401(k) that you fund with pre-tax money. And what the law would say is that if you wanted to put your money in a Roth, 401(k), your employer's matching contributions could go there too. Now, even if you want to put your entire contribution in a Roth 401(k), the matching money goes into a tax deferred account. So you're going to end up with you-

Sandy Block: Yeah, that's right. Two accounts that are somewhere in your past job. Although if you're thinking this hard about it, you're probably taking your 401(k)s with you when you go. But yeah, I think it would make Roth 401(k)s more attractive and people who really want to load up on this after-tax version of 401(k)s would be able to put their matching money there, too. So I think that's kind of an interesting provision that we'll be keeping an eye on.

David Muhlbaum: Welcome back to Your Money's Worth. For our main segment, we're talking with Ed Slott, who's joined us here before to discuss individual retirement accounts, IRAs, and how to make the most of these tax-advantaged savings plans. We're going to hope you're all saving, somehow, for that time when you can't work anymore or don't want to and so long as we're making assumptions, for purposes of what we're going to talk about here, we're also going to assume that you've got an individual retirement account. Now that's not a 401(k), which is a similar type of program, but one run by your employer. But there is a connection. The way lots of people end up with IRAs is because they leave a job and they either have to, or want to, roll over their 401(k) to an IRA. Then within IRAs, there are key differences between the two main types, the traditional IRA and the Roth IRA, which is named after the U.S. senator who cooked up the latter, William Victor Roth. I like to make sure he gets credit.

Sandy Block: So, as you can tell by David's intro, Your Money's Worth shoots for a pretty broad audience, but when it comes to IRAs, we at Kiplinger often go deep because people want specific guidance. And Ed has really helped us deliver that. He's a regular source of mine, and this is all online, folks, in droves. Your best bet if at any point we lose you is to search Kiplinger IRA basics. You'll get our frequently asked questions for those for both traditional and Roth IRAs. But Ed, before we get into why you'd have one or the other, or why you convert from one to the other, please give everyone a short explainer of the difference in how they work.

Ed Slott: This is a great point you bring out because most people miss this. There's a huge difference between IRAs and Roth IRAs. So now one huge difference comes down to one little three letter word, and that word is yet Y-E-T. IRAs are tax deferred as opposed to tax free. Tax deferred means you won't pay taxes on that money yet, but you will at some future time at some future date, maybe at a higher rate, maybe at a higher value, as opposed to tax free which is what a Roth is, which means you'll never pay taxes on that money. So that's why there's so much interest in Roths. Two words, tax free. People want a tax-free retirement, generally.

Ed Slott: Now versus yet. Yeah. Same kind of thing. Now means yet. You have to pay now, but with the other way, it's just growing. And if you're worried about that, you got to think long term, if you're thinking retirement or even beyond for estate planning, or wealth transfer to your beneficiaries. Remember, every day that goes by that you're holding an IRA, part of that is a debt owed right back to Uncle Sam, which — that's up to you. You don't have to pay that debt. It's not even like... I don't know if you know this., but he's not even your real uncle. So there's no requirement to keep him as your beneficiary.

Sandy Block: Well, I guess, this is one thing that we wanted to talk about maybe later, but I'll bring it up now. Does that mean that if you're really worried about tax rates going up in the future — and tax rates are as low now as they've ever been. We're running up very, very large deficits and the current administration is talking about raising taxes. Is that an argument for Roth over traditional IRA?

Ed Slott: Yes, absolutely. The Roth versus IRA is a straight play on the tax rates. Some people call it tax-rate arbitrage, like with stocks. There's a saying in stocks, buy low and sell high. It's the same thing here. It's all about the tax rates. The best explanation I ever heard, and this is from a comedian in the fifties that didn't know from IRAs or Roths, Henny Youngman. He said, "I'm putting all my money in taxes, the only thing sure to go up." He was right. That's the whole game with the Roth. You're betting, you're investing. You're buying the tax rate now while it's low, the foundational principle of all good tax planning, meaning keeping more of your hard-earned money sheltered from taxes is to always pay taxes at the lowest rates. And that may be right now. Right now, historically we have the lowest rates most people will ever see in their lifetime.

Ed Slott: Just to give you an idea how low they are, going back in history, the years people like me, maybe even Sandy, not you, Dave, you look too young, but the baby boomers, I'm talking about, the people born like me between 1946 and 1964. The top federal tax rate for every one of those years, just as a frame of reference to today, exceeded 90. 9-0. The top rate exceeded 90% for every one of those years except for the last year, 1964. That's because that's the year the Beatles came to America and everybody was so happy that they lowered the top federal rate all the way down to only 77%. So we can see that looking at our deficit and debt levels. I heard them talking just yesterday. One of the congressmen on a news show said, "We're increasing this deficit." I don't know if it's right. It sounded too bizarre, "by $4 billion a day."

Ed Slott: No, it's not the income limits because that's easily worked around with backdoor Roths, but it's the tax deduction, the allure of the tax deduction upfront. But to me every time, not just to me, this is just a fact, every time you take a tax deduction, it sounds good for the moment. Just like eating candy and ice cream and everything else. It sounds good for the moment, but every time you take a deduction, what a tax deduction is, in reference to an IRA, for example, is really just a loan. You're just taking a loan from the government that has to be paid back, plus whatever it earns and then some, because at some point that money must, by law, come out by your required beginning date, generally after age 72 now under the Secure Act. So you will be forced to pay all of those benefits back, but some people just look at... They're short-sighted and they look only at what am I getting now: "Look, I'm getting a bigger tax refund now."

It might pay to give up that deduction. Remember we're in low rates, like I said. Deductions are worth more at higher rates, not at lower rates. When rates are lower, deductions are worth less, not worthless, worth less, so you may want to look at foregoing that deduction to have your account build tax free. So all the earnings accumulating and accruing in your Roth IRA accrue 100% for you. So you never have to worry about the uncertainty of what future higher taxes could do to your standard of living in retirement.

Sandy Block: But Ed, I want to maybe get you to elaborate on what you just referred to because there are income limits on who can contribute to a Roth. And you don't have to be super rich to be ruled out. But as you mentioned, there's a way around that. Maybe you could talk about the income limits and how people can avoid them. Because I actually think from talking to David this morning, he may be in a position to do that.

Ed Slott: Oh, okay. Well, first of all, let me make it clear to listeners, there's two flavors of Roth, like ice cream, chocolate and vanilla. There's two flavors. The big money is in the conversions. We're talking about contributions here, which are limited by income and the amount you can contribute, which is nutty in the tax code. For example, you're limited to a maximum contribution each year, $6,000 or that's for '21. It changes a little each year. $6,000 per year or another thousand, if you're 50 or over. So $7,000 altogether, and only if you're under these income limits Sandy talked about, and I'll give you the limits. I happen to have them. I knew you would ask. So I happen to have them.

Ed Slott: I keep my little handy lists. We make up our little lists here just for this. All right. So for 2021, if you're married, joint, your income exceeds $208,000. So that's a pretty high limit. But if you're over that you cannot contribute to a Roth. If you're single, it's $140,000. If you're over that, you cannot contribute to a Roth, but there's ways around that. There are no income limits like that if you want to contribute to an IRA, but now you're going to say, "But Ed, you just said, don't take the deduction." Right. You contribute to a non-deductible IRA and then that can be converted to a Roth. So you're back in the same place, but you got there a different way. So that's why it hits me that having a... This is just a comment and opinion, having income limits, like these limits to who can have a Roth for the lousy $6,000 or $7,000 seems ridiculous, when if you wanted to, you could convert a billion dollars to a Roth IRA.

Ed Slott: All right. It's like the question, how do you become a billionaire? All right, first have a billion dollars. But he didn't do it that way. First, what he did was legal. I know that several senators are all up in arms about it. They released a data report, came out last week about people with $25 million or more in Roth IRAs and IRAs. But that's a very slim portion. That's like saying, look at all these lottery winners that have hundreds of millions of dollars. That's one out of millions and millions of people. But you hear about that one. You don't hear about all the people that may have taken risks and lost that money. So what he did back in 1999, he didn't make that much. The story, and I'm going from as everybody else is, the ProPublica report, because that's where we got a lot of that information from. The story is he only earned about seventy-odd thousand that year.

So he was under the limit to have a Roth contribution that year. And the most you could contribute that year was $2,000, which he did in 1999 and contributed the max. He was allowed to in 2000. And in 1999, the amount was $2,000. He contributed the maximum he was allowed to contribute for 1999, which was $2,000 that year. And it's interesting. That's the only money he ever contributed to his Roth IRA, $2,000. That year he took $1,700 of that $2,000 and invested in the startup PayPal. And he got the stock at 1/10th of 1 cent per share. So he bought 1.7 million shares and the rest, as we say, is history. It took off. Totally legal. Now, if you can find a stock like that and use the money in your Roth IRA, have at it. The key is finding that stock. So many people may have speculated and lost money and you never heard about them.

I don't know if speculating that much with your retirement savings is a good idea for most people. It worked out for him, but he's not out of the woods yet. People might say, "$5 billion." Sandy, you just said it and I said it earlier. That's growing tax free and is Roth IRA, $5 billion tax free. But not yet. Like I used to say on PBS, or they had me say, "But wait, there's more." All right, first, he can't touch that money until he's 59 and a half, because I think he's only in his early fifties, I think I saw 53 or 54 years old, something like that. So he can take his $2,000 out, no problem. But the other $5 billion of earnings, he'd have to wait until he's 59 and a half. But even if he does, because let's assume he has other money, hopefully somewhere, maybe they'll start a GoFundMe page for something to live on until he hits 59 and a half.

All right. So now he's in his sixties and the $5 billion may be worth #$10 billion by then. Who knows? Because remember, it's not just PayPal. He invested in other things all through that account, knowing anything he earns in there will be tax free for him forever, but here's the kicker so to speak. It's not going to be tax-free forever. There's something called an estate tax and Roth IRAs are... you can't get them out of your estate, even though they're tax free for income tax. So everybody is saying tax-free. Income tax free. Who knows what the estate tax will be on a $10 billion Roth IRA that's included in the estate? And that's... I said maybe at 60. Let's hope he lives a long and healthy life. Maybe by 80, it'll be $30 billion. I don't know what the estate tax at that point may be, but between estate tax and now maybe state estate tax, a lot of that could go right back to the government.

David Muhlbaum: So Peter Thiel was pushing the limits of Bill Roth's little savings invention, it seems. Maybe he should make a donation in Roth's name? Just a thought, but it wasn't so long ago that many more people looking to convert to a Roth were doing some tax strategy of their own. And what I'm talking about here is what was called Roth do-overs. The idea was you could convert to a Roth and then in the same tax year, change your mind. People could undo some or a part of it, depending on what was best for taxes based usually on what stock prices were doing that year. This was complicated but popular, but that's gone now, right, because of the Tax Reform Act of 2017. So now, what happens to someone who converts to a Roth and then they can't pay the tax bill for it? They're just stuck?

Ed Slott: Yeah. You're stuck. There's no question. That was a major change and we used to do that strategy. We used to tell people, "Convert everything," and then when we have the numbers in, we'll show you how much to unconvert, or the word was "recharacterized," to undo it. There's no second chances, no do over. So what you have to know about Roth conversions is first, do an accurate projection of the income tax so you know what the bill is going to be. Once you convert, the tax is going to be owed even if the market crashes. So convert what you can. Maybe a better strategy for most people is to do a series of smaller annual conversions over time to smooth it out, almost like dollar-cost averaging into a Roth IRA and use up the lower tax brackets. That's probably a better long-term plan.

Ed Slott: Oh, because it's tax free again. The last thing you want to worry about, especially as a surviving spouse who's now filing single at higher rates, it's great to have a source of tax-free income in retirement so it doesn't boost their tax brackets and in turn cause them to have a higher tax, more taxes, eating into maybe limited income. Having that income from a Roth IRA... And remember a spouse is exempt from all the changes in the Secure Act, limiting the stretch IRA and all that. So the spouse could do a roll over and treat that Roth as his or her own. And one of the great things we didn't talk about yet about a Roth IRA, there are no required minimum distributions during your lifetime.

Ed Slott: So let's say that wife, we were talking about, the widow, let's say, if she doesn't need money, she doesn't have to take, but whatever she takes will likely be tax free, not increasing her rate, not increasing her Medicare charges or her Social Security taxation, or all the other things that are affected if she had inherited a traditional IRA and been subject to required minimum distribution.

Ed Slott: Right. Well, the tax code lets people have a break. Even with an IRA you can defer and defer and defer. But as I said before, we made our deal with the devil with that. We took the tax deduction upfront and as with any deal with the devil, there's a day of reckoning and they have a name for that date. It's called your required beginning date. In essence, that's the date Congress decided, we're sick and tired of waiting for you to drop dead and we want our money back. That's at age 72. A technically April 1st after you reach age 72, where it has to start going back the other way and taking your money out, and those are called required minimum distributions, based on your age.

Ed Slott: Right. You know what? I've had clients that I've done this with. I can think of many people and even some older people who may say, "I'm in my seventies. Should I pay tax on a Roth conversion?" I said, "If you're doing it for yourself, no. The cost versus the limited benefit, given your shorter life expectancy, it's not worth it. But if you're doing it for the next generation, children or grandchildren, even if they only have 10 years past the time of your death, what you're doing in essence is giving them a gift. But it doesn't count as a gift for tax purposes. You're paying a bill in essence that they would have had to pay if you didn't convert and they had to take it all out in 10 years, bunching all that income into 10 years."

Ed Slott: All right. Well, okay. I don't know if this is the best, but I get this question from readers and I am sure you get it all the time when you extol all the benefits of a Roth IRA, someone comes to you and says, "There's deficits climbing," as you said, "$4 billion a day or whatever. I'm afraid if I put all this money in a Roth that Congress is going to turn around and say, 'I have to pay taxes on it anyway.'" What do you tell people when they don't trust that the Roth that they're investing in today will be the Roth that they will be able to take tax-free income from tomorrow?

Ed Slott: I'd like to say right now, bam, that's the question! That is the best question. You know why? I do lots of consumer programs. Over the last year and a half, of course, we've been doing them all virtually, but for years I've been doing that exactly as Sandy says. I extol the virtues. I love tax-free. You'll love tax-free. The Roth is great. And somebody will always stand up, not as nicely as Sandy, but they will say up, "Yeah, but can you trust the government to keep their word that Roth IRAs will always be tax free?" And here's my answer, "Of course not. You can't trust these guys as far as you could throw them. Look what they did with the Secure Act. They upended 30 years of tax law that we relied on, the stretch IRA, the estate plan, lots of other rules, but it's here now. But I'm going to tell you the secret why it won't be touched, my opinion.

Secretly — now don't spread this around, I'll say it low — secretly, Congress loves Roth IRAs. If you look at all the legislation that's happened in the last 10 or 15 years, it's all been pro-Roth. It started in 2010. I don't know if you remember. Before 2010, if you wanted to convert big money, you couldn't. If your income exceeded a hundred thousand dollars. They removed that income limit and they were awash in money. The money just poured in. The floodgates opened and they said, "This is a good deal. We can use this to fill budget gaps." So ever since then, they've been adding things like the Roth 401(k), expanding that. Back under the Obama administration and even with the Trump administration and even now there was this term that was bandied around by Congress, called Rothification. They wanted everybody to Rothify because — here's Congress' thinking and lucky for us, the people in Congress are the worst financial planners in the world because they're such short term thinkers.

They say, "This Roth thing, it brings in money up front because the only money you can get into a Roth is already tax money." And they realized that if more people went to Roths, they would get less tax deductions and the government would get more money. Short term! But if everybody on earth or in America did Roth IRAs, they'd all be tax-free millionaires and the government would get nothing when people cashed in at retirement or even for beneficiaries. But they don't think long-term. They only think in short budget cycles. So they secretly love the Roth. And I'll give you another example. The new bill, Secure 2.0 is also pending. It has lots of this Rothification, expanding Roth access in company plans, but where they put the Roth provisions, the expanded Roth provision is at the end of the bill.

You know what's at the end of every tax bill? How to pay for it. It's called revenue provisions. And that's where they put the Roth. They know it's the golden goose. So they're not going to break it, my opinion, because they think it brings in tons of money, which it does. They wanted, under Rothification, in case somebody doesn't know what I mean by that, that was something Congress came up with. They wanted to take people's deductions away. They didn't want any more 401(k)s. They wanted people doing Roth 401(k)s so they wouldn't take deductions, ergo, the government would get more tax money upfront. That's how they think. But I would tell you this. They might find a way to trim around the edges. In other words, they're not going to double tax people because that would kill the golden goose, but they might say, "Yes, it's tax free, but we're going to treat that like tax free, for example, municipal bond interest," something like that.

Ed Slott: If you take a certain amount of that down, maybe we'll make more of other income taxable, like the 3.8% tax on net investment income. Those other things like what we call stealth taxes, tied to a level of adjusted gross income where you start to lose deductions, credits, exemptions, or other benefits. So they might trim around the edges there, but I don't think they can go too far or they're going to lose their golden goose that's providing them all this money with people going heavier into the Roth IRA. But it is the question that everybody asks. I'm telling you: It's here now, take advantage of it. We don't know what the future is going to bring, but the answer to Sandy's and everybody's question is, no, you cannot trust Congress and CPA, accountants always had this saying, "Tax laws are written in pencil."

David Muhlbaum: That will just about do it for this episode of Your Money's Worth. If you like what you heard, please sign up for more at Apple Podcasts or wherever you get your content. When you do, please give us a rating and review and if you've already subscribed, thanks, please go back and add a rating or a review, if you haven't already. To see the links we've mentioned in our show, along with other great Kiplinger content on the topics we've discussed, go to kiplinger.com/podcast. The episodes, transcripts and links are all in there by date. And if you're still here because you want give us a piece of your mind, you can stay connected with us on Twitter, Facebook, Instagram, or by emailing us directly at podcast@kiplinger.com. Thanks for listening.

Topics

Podcast Roth Ira Conversions

Block joined Kiplinger in June 2012 from USA Today, where she was a reporter and personal finance columnist for more than 15 years. Prior to that, she worked for the Akron Beacon-Journal and Dow Jones Newswires. In 1993, she was a Knight-Bagehot fellow in economics and business journalism at the Columbia University Graduate School of Journalism. She has a BA in communications from Bethany College in Bethany, W.Va.