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Why Retirees With Under $5M Should Avoid Roth Conversions | Eric at The PeakFP | YouTubeToText
YouTube Transcript: Why Retirees With Under $5M Should Avoid Roth Conversions
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Summary
Core Theme
Roth conversions, often presented as a guaranteed tax-saving strategy, are actually a gamble on longevity and future tax rates that frequently leads to financial losses for retirees, especially when financial planning software overestimates lifespans.
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Imagine that you've just retired and
your financial adviser tells you to put
$1 million on a hand of blackjack. Would
you do it? Well, for most retirees, Roth
conversions actually have worse odds.
And today, I'm going to prove it. My
name is Eric Amselog. I'm a certified
financial planner and the owner of Peak
Financial Planning. And in just the last
2 years, I've built more than 150
retirement plans. And by far, the most
common question I get is, should I do
Roth conversions? So, in the next few
minutes, I'm going to run three case
studies. a $1 million, $3 million, and
$5 million household to show how to
avoid a million dollar tax mistake that
financial software and advisers keep
recommending. We're going to use social
security data and income labs modern
guardrails to stress test Roth
conversion recommendations. And at the
end of the video, I'm going to give you
a simple checklist that you can use to
decide if a Roth conversion actually
makes sense in your plan. So, I'm going
to spend 90% of this video showing you
everything inside software and
spreadsheets. But before we dive in, we
need to start with some assumptions. And
if you stick with me, I promise that
your understanding of Roth conversions
will change forever. So, the first
assumption is that all three of the
tested households I'm going to show are
ages 62 and are fully retired. The
second assumption is that Social
Security is going to be the only
guaranteed source of income starting at
67 in all three scenarios. The third
assumption is that Income Labs is going
to be set to a 20% likelihood of needing
a spending adjustment, which is
essentially like planning for an 80%
probability of success. The fourth
assumption here is going to be that
smaller households have more pre-tax
savings and bigger households have more
after tax savings. And then finally, the
last assumption is that all the plans
I'm going to show are run for exactly 30
years, which is how long the top 20% of
retirees live according to Social
Security Lifetimes tables. Now, I've
already loaded all of these assumptions
into Income Lab. So, we're just going to
jump right in. In the first scenario
that I'm showing here on the screen,
Mike and Laura test have $1 million
saved, and almost all of it is in
pre-tax accounts. Now, Income Lab's
optimal recommended strategy here
recommends filling the 12% bracket with
Roth conversions. Now, the software
projects that they'd save about $92,000
in taxes and have the same amount in
additional net spending money in
retirement. And when I showed this to
Mike and Laura, this screen
specifically, their eyes lit up. They
said, "Eric, that is incredible. Why
wouldn't we do that?" And that's exactly
the reaction that most retirees and even
most financial planners have when they
see a screen like this with all these
pretty green boxes. And the $3 million
and $5 million versions of these plans
look are no exception. They look even
better. So, let's toggle through those
real quickly. At $3 million here, you
can see that Income Labs is recommending
conversions to fill the 24% bracket and
showing over $600,000 in projected tax
savings and additional spendable money.
Let's toggle to the $5 million plan
really quickly. At $5 million, it says
to fill the 32% bracket with a supposed
$1.2 million reduction in taxes paid an
additional $1.2 million in net income or
lifetime spending money. And so, the
bigger the portfolio, the bigger and
sexier the Roth conversion looks. But
here's the problem. These projections
assume extremely long lifespans that
very few people actually live. And Roth
conversions only start paying off very
late in retirement after you've already
passed the break even age. And so to
prove the point, I've rebuilt each plan
in Income Labs, but this time I just
shortened the time horizon from 30 years
to 25 years. Everything else stayed the
same. And for that, I have this summary
table right here just to make viewing
and clicking a little easier. In the $1
million plan, which you can see right
here, the software changes the
conversion recommendation to convert to
fill the 10% bracket and really
recommends only spending about $10,000
on Roth conversions as compared to the $118,000
$118,000
it recommended spending in the prior
scenario. Now, the translation of that
is that five fewer years of life turned
a six-f figureure Roth strategy into
pretty much nothing, right? The second
scenario here is the $3 million plan.
And in this plan here, you can see that
now the software recommends converting
up to the 12% bracket rather than the
24% bracket. And instead of spending
$646,000 on Roth conversion taxes,
that's dropped down to $76,000. And the
translation for this one is that that
half million benefit literally just
disappears by shortening the plan by 5
years. And finally, in the $5 million
plan, the recommendations just
completely collapse from a $1.2 2
million benefit, which you can see right
here, and from converting through the
32% bracket, to converting just 231 or
spending just $231,000 on taxes and
getting a very, very small benefit, if
at all. And so, here's what this really
means. If you live 5 years less than the
software assumes, then Roth conversions
flip from being a six or seven figure
win to a potential six or seven figure
loss. And so now let's overlay this with
actual survival data because the key
point here is that Roth conversions pay
off the longer you live and we're
planning for everybody as though they're
going to live very long. But the
question is how long do people actually
live? And what is the probability that
this bet this gamble will actually pay
off? And so according to the social
security life expectancy tables, a
single 62year-old man has just a 14%
chance of living to 92. That is the
final life expectancy in the plans I've
shown. By the way, for women, that
chance of living to 92 is 23%. And for a
married couple, there's a 1 in3, so 33%
chance that at least one spouse will
make it that far to age 92. And so 2/3
of the time, Roth conversions that
require you to live to 92 will fail. And
said differently, if you framed Roth
conversions honestly, you would say, you
have a one-third chance of winning and a
twothirds chance of losing. would you
still make this million or this half a
million or this $100,000 bet depending
on what wealth bracket your household
fell into? Now, saying this out loud
almost feels illegal, right? It kind of
feels like I'm talking about the risk of
planning for a long life expectancy
feels completely taboo in financial
planning because we've all been
conditioned to think that we are going
to live a lot longer and that longer is
always better. But here's and I'm not
saying you shouldn't live longer. I'm
just saying we have to understand the
trade-offs. And here's the truth. In a
world where Roth conversions are treated
like financial gospel, they actually
increase risk when you assume a very
long life. And the craziest part is that
most financial planners and retirees
will never notice it or never get told.
So, in just a minute, I'm going to show
you a checklist to decide if Roth
conversions actually make sense for you.
But first, let's go back to this
spreadsheet that I had on the screen a
moment ago. See, a 62-year-old is twice
as likely to live until 87 as they are
to make it to 92. And so the odds of
living that additional five years drops
in half. The difference between planning
for a 30-year versus 25 years is not
just a technical setting. It's a
complete gamble with real dollars on the
line. And as you can see in the red
cells that I've just shown here, that
gamble can be massive. The gamble column
here is basically the difference in
dollars that the household would have
spent on taxes if they assumed they
would live 5 years longer. You can see
in the five million $5 million household
net worth scenario, that household would
have spent almost a million dollars more
on Roth conversions if they assumed they
had a high likelihood of living through
30 years as opposed to 25. And I'm not
saying they shouldn't, but you should
know that information, right? It's a
real gamble. Now, most financial
softwares and the advisers using it will
never reduce life expectancy in the
software to test what negative outcomes
might occur because they just assume
there are no negative outcomes, right?
Usually, you'd think that a shorter
lifespan means fewer years of
withdrawals, fewer years in retirement,
and therefore your portfolio lasts,
right? But when you introduce Roth
conversions, you're actually introducing
an expense that's actually a gamble
investment on longevity. And so, now
that we've seen how fragile Roth
conversion wins really are, let's talk
about a couple additional hidden risks
that almost nobody factors in. The first
is that Roth conversions are a gamble,
which we've been talking about. Not
they're just not an action with a
guaranteed return. But the way financial
planning software looks when you click
to a screen like this, it makes it
appear as though it is a guaranteed
return. There's no indication of
probability or likelihood of it working.
It just looks like it works. The second
hidden factor is, well, I'm going to,
you might say, well, I'm going to do
Roth conversions for my heirs, so it may
still be worth it. And that may be true,
but we don't actually know whether our
heirs will be in a lower tax bracket
when distributing than we will be while
converting. Now, it still may be wise to
convert. you may just be doing it at a
loss, which is totally fine if you plan
to think of the cost of the Roth
conversion as a prepaid gift to your
heirs. The third hidden factor here is
that the illustrations I've shown today
don't even include a time value of money
component. See, the financial planning
software calculates the benefit of the
Roth conversion as the tax you save once
you've passed the break even threshold.
But that's actually inaccurate because
in reality, money early in life is worth
more than money later in life. And so to
be truly honest about the actual
financial payoff of Roth conversions,
you would have to apply a time value of
money factor and financial planning
softwares and those that rely on them
don't actually receive that. The fourth
and final note here is which could be a
whole video on itself truth be truth be
told is that financial planning software
does not show the substantial increase
in risk that occurs as a result of the
huge increase in spending and
withdrawals caused by the upfront cost
of the Roth conversion. See, depending
on the size of the Roth conversion,
retirees could unknowingly expose
themselves to significant extra
withdrawal rate and sequence of returns
risk that or they just might have to
make huge sacrifices to quality of life
in early retirement in order to
subsidize the cost of those Roth
conversions. But who really cares about
the quality of life when you're young,
healthy, and in the best part of your
retirement when you could prepay the
government taxes and get a gold star for
having a higher end of life after tax
legacy if you live till age 95. And if
you couldn't catch my sarcasm there,
I'll just say it out loud, which like
that's crazy, right? The translation
here is you could just end up
sacrificing the best years of your
retirement just to prepay the IRS money
for no reason. And so with all of that
said, here's a simple checklist that you
can use to evaluate whether a Roth
conversion actually makes sense in your
retirement plan. And it can. I know I've
come on strong in this video, but the
truth is there are place for Roth
conversions in retirement planning. So
the checklist is as follows. If you have
less than $2 million, ask yourself, do
you expect your guaranteed retirement
income to exceed your pre-retirement
income? And if the answer is yes, that
means consider a small conversion
because you're probably going to be in a
higher tax bracket in retirement than
you were before retirement because your
guaranteed income would exceed your
pre-retirement income. And if you answer
no, then most likely you're going to
want to skip Roth conversions cuz it's
almost always going to be a net negative
in your lifetime. If you have between $2
million and $4 million in retirement
savings, then you ask yourself, do you
have after tax money to live on while
converting or to apply to the cost of
the conversion? You might also ask
yourself, can you retire early enough to
create an income gap before social
security starts so you can do Roth
conversions before extra income sources
kick in? You might also ask yourself, is
there a widow penalty risk in your
household? Meaning, do you have a a
spouse, for instance, a a wife who is
significantly younger than a husband and
might live several years or many years
longer than their husband? And then the
final question you'd ask is, will Irma
or RMDs push you into higher brackets
later? And if you can say yes to most of
those things, then it may be worth
modeling Roth conversions. Now, finally,
if you have $4 million or more in
retirement savings, then Roth
conversions probably do deserve a look,
primarily for legacy planning purposes
and not necessarily maximizing your own
retirement lifestyle. But you'll find
that there are more cases once you reach
that threshold of wealth where Roth
conversions will financially make sense
while you're alive. The other obvious
area where Roth conversions will make
sense while alive or Roth contributions
rather would be when you're younger,
right? just start every year you start
doing Roth contributions, the more
likely they are to pay off because you
have a longer period of life ahead of
you within which the investment will pay
off. And so at this at the end here,
here's the bottom line. Roth conversions
are not the sure thing strategy that
they're sold as. They are a bet. They're
a bet on how long you'll live, what tax
brackets will look like, and what your
heir's situation might be. And most of
the time that bet will fail. One client
told me after we ran this analysis, I
thought I was being smart prepaying
taxes, but it turns out I was just
giving the IRS a bigger gift. And that's
the moment it really clicked for them.
Now, that doesn't mean Roth conversions
are always bad. It just means you need
to treat them for what they are, which
is an investment or a gamble that only
makes sense under very specific
circumstances. And if you don't want to
gamble your retirement on a coin flip or
on a blackjack hand, then click the
first link in the description below this
video to watch my free webinar on the
fourstep system we use at Peak Financial
Planning to stress test retirement
strategies. Thank you as always for your
time and attention. And if this video
gave you some clarity, hit the like
button so it reaches more retirees who
need to hear it, and subscribe for more
deep dives just like this one. I'll see
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