Please don’t forget to rate us on iTunes. Your ratings will make it easier for others to find us when they’re looking for investing podcasts. Just click the Apple icon link above.

Transcript

Maria Bruno: Hi. I’m Maria Bruno, head of U.S. Wealth Planning Research here at Vanguard.

Joel Dickson: And I’m Joel Dickson, global head of Advice Methodology at Vanguard. Welcome to our podcast series, The Planner and the Geek, in which we will discuss topics that are important to individual investors.

Maria Bruno: And we’ll have some fun along the way. We’ll discuss everything from investing for retirement, to ETFs, to financial advice, and everything in between.

Joel Dickson: We hope you enjoy this episode­­­­­­­­­—and that you’ll consider subscribing to The Planner and the Geek

Joel Dickson: Hey, Maria, can you believe they let us come back to do another one of these episodes?

Maria Bruno: I know, what were they thinking, Joel?

Joel Dickson: Oh, I know. It should be fun.

Maria Bruno: What are we going to talk about today?

Joel Dickson: Well, I think we should talk about our favorite topic. You and I talk about it all the time. No, not rotisserie chicken.

Maria Bruno: Oh, I was actually going to say our bing cherry red Miata.

Joel Dickson: Oh yes, I like my bing cherry red Miata.

Maria Bruno: Glad you do.

Joel Dickson: No, I was thinking about our favorite retirement topic.

Maria Bruno: Don’t get me all excited.

Joel Dickson: Well, yes, what’s your favorite topic, and we’ll see if it matches ours?

Maria Bruno: We are talking IRAs today, Joel.

Joel Dickson: Oh, yes we are.

Maria Bruno: All right, good, good topic.

Maria Bruno: Well we are in the middle of IRA season.

Joel Dickson: IRA season being…?

Maria Bruno: January through April 15ish, depending upon when the filing date is.

Joel Dickson: Yes, because that’s when we see a lot of people make their contributions if they’re contributing to an IRA, right?

Maria Bruno: Yes, unfortunately.

Joel Dickson: Not fortunately?

Maria Bruno: Yes, unfortunately. When we see tax season, it’s the tax filing season, but you have until April 15 of this year, 2018, to make a 2017 contribution. But, we know the better path would be to make that 2017 contribution in January of 2017.

Joel Dickson: Or to have made the 2018 contribution already. Have you made your IRA contribution, Maria?

Maria Bruno: Correct. Sure.

Joel Dickson: No, you haven’t made your IRA contribution?

Maria Bruno: I’m getting there, Joel. I’ve got to push that button. I keep throwing away that sticky note. I know, I eat crow on this one, absolutely.

Joel Dickson: Yes. For people listening, Maria has actually authored research here at Vanguard about what’s called the “procrastination penalty” of IRA contributions. And the fact that we tend to contribute at the last minute, in essence, maybe 15 months later than when we were first eligible to make that contribution and potentially get the gains from that over time.

Maria Bruno: Well, let’s be clear, we’re talking about 2018 contribution. I did do 2017.

Joel Dickson: So it’s only been a couple of months.

Maria Bruno: Yes. I usually do it, within the first quarter I do it, so I am a little bit bad.

Joel Dickson: But that procrastination penalty is real, right?

Maria Bruno: Absolutely it’s real.

Joel Dickson: Yes. So people have materially less savings over time if they’re always making their contributions in April of the following year for the previous year.

Maria Bruno: Yes, I know, Joel, but this actually leads to a question that I get very frequently in terms of well, “I’m not sure whether I can contribute to a traditional IRA or a Roth IRA?” And the answer is, yes, as long as you have earned income you can make the contribution. There is some thoughtfulness to whether it’s a traditional or a Roth IRA.

Joel Dickson: Okay, we just leap frogged into what do you mean, different, traditional; Roth, and so forth.

Maria Bruno: Yes, we’re getting ahead of ourselves.

Joel Dickson: So, IRAs, individual retirement arrangements, right?

Maria Bruno: Correct.

Joel Dickson: So in large part they’ve become a very significant source of retirement savings since their introduction, basically about 40 years ago. Is that fair?

Maria Bruno: Correct, yes. I was actually just looking at some recent statistics from the Investment Company Institute, and they survey mutual fund assets. And about a third of U.S. households hold IRAs. So there’s probably about upwards to $9 trillion in IRA assets today.

Joel Dickson: That’s quite a bit of money. I think you could save for retirement or meet your retirement goals with that, huh? Would $9 trillion be enough for you, Maria?

Maria Bruno: That would be enough for me, just enough, yes.

Now, I think, you know, the number is large and that’s in part due to rollovers. So, often times, individuals, when they retire from their employer-sponsored plan via 401(k), they often do a rollover into an individual retirement account.

Joel Dickson: Or even when they just change jobs, change employers. It doesn’t have to be retirement, right?

Maria Bruno: Correct, right. Yes.

Joel Dickson: Yes, so IRAs have really, in many ways, grown. You know, there are two ways to get IRA assets. You contribute to it on an annual basis, like we were just talking about, or you switch employers or retire, and you take money out of what had been your employer’s plan, called a defined contribution plan, often a 401(k) plan, and roll it into an IRA. So most of the dollars, or most people that have an IRA, it’s usually because of the bulk of that coming from a former employer plan.

Now there are other types of IRAs too, for example, for self-employed individuals and so forth. You might hear terms like SIMPLE IRAs, SEP IRAs, Individual 401(k)s; there are all sorts of other vehicles.

Maria Bruno: Yes, and, Joel, I think what I would mention there for our listeners, if they do want to go and learn some more, I mean, certainly, you can do an internet search. We do have information on vanguard.com that talks about the plans in more detail and the eligibility requirements as well.

Joel Dickson: So the two major ones though that you were just mentioning, the traditional and Roth. It might be helpful to sort of explain what the differences are there, or what do we mean when we talk traditional IRA and Roth IRA?

Maria Bruno: Yes, I think most of us are familiar with the traditional IRA. They’ve been around since 1977…

Joel Dickson: Eight, somewhere in that range.

Maria Bruno: You’re the Geek so I thought you knew the exact date.

Joel Dickson: I don’t know the exact date, that’s why I said about 40 years earlier.

Maria Bruno: Okay, okay. So with the traditional IRA, typically, the contributions are tax deductible, meaning that you can take a tax deduction in the year of contribution, the account grows tax deferred. Then later, when you’re in retirement and you make withdrawals, the entire pre-tax balance is subject to income taxation. They are also subject to required minimum distributions, mandated withdrawals annually, beginning at age 70½.

Joel Dickson: Basically, the government doesn’t want you to continue deferring taxes indefinitely.

Maria Bruno: Correct.

Joel Dickson: And so they force you to take out some of those dollars from that tax-advantaged vehicle.

Maria Bruno: But the benefit of that is that it grows tax-deferred through those savings years, absolutely.

Joel Dickson: So how does that differ from a Roth IRA?

Maria Bruno: So a Roth IRA, on the other hand, contributions are made with dollars that have already been taxed, meaning after-tax contributions, one doesn’t take a tax deduction when they make contributions, the account grows tax-free, and there are no lifetime mandated withdrawals.

Joel Dickson: So you don’t have to take money out because, I mean, you’re not accelerating or you’re not having additional tax that’s being deferred, if you will, from that Roth in the same way that it was from the traditional.

Maria Bruno: Right. And those are, relatively, it’s the younger sister, I guess, of the traditional IRA. They came about in 1998, so this year is?

Joel Dickson: This year is the 20 year anniversary.

Maria Bruno: Ding, ding, ding.

Joel Dickson: And I bet you didn’t know that there is a celebrity in your presence today.

Maria Bruno: Tell me more.

Joel Dickson: So I happen to be, or at least I’m claiming to be, the world’s first Roth IRA investor.

Maria Bruno: Thus the Geek.

Joel Dickson: Twenty years ago.

Maria Bruno: How does this come about?

Joel Dickson: So, back in 1997 there was actually fairly significant tax legislation, part of which established this new thing called a Roth IRA, named after a senator from Delaware, that would begin in January of 1998, hence, 20 year anniversary here in 2018.

Well, I was kind of working on tax issues at the time, and I kind of thought this Roth IRA idea was pretty cool for reasons that we’ll talk about, and I decided that I wanted to be like, the first day, I was going to invest. And, at the time, Vanguard had an Investment Center here in our corporate headquarters, where you could walk in and do a transaction on your account. And so, as I recall, the center opened at—I forget if it was 8:00 a.m. or 8:30 a.m.—but, in any case, I was in line before the doors opened, and I was the only person in line. And I walk in as soon as the doors open, go to the counter. I’m like, ”I need to make a transfer from my one account here because I’m funding a new Roth IRA.” And I’ve got the transaction confirmation, and so I am claiming—since I have the transaction confirmation time-stamped at something like whatever, six minutes after the Investment Center opened—that I was the world’s first Roth IRA investor.

Maria Bruno: Okay, so what you’re really saying, Joel, is that you were Vanguard’s first Roth IRA contributor.

Joel Dickson: Well, at least I’m claiming that. I can’t actually document it in any way, shape, or form, but I’m claiming it. So, yes, so I’ve been a Roth IRA contributor and investor for all 20 years.

Maria Bruno: Well, I converted my traditional IRA to a Roth in 1998; we’ll talk more about that.

Joel Dickson: Converted, what?

Maria Bruno: We’ll talk about that more. So I just had to go head-to-head with you on this one a bit. So I just want to go back—we talked about traditional versus Roth, right?

Joel Dickson: Yes.

Maria Bruno: I want to go back to the traditional IRA, right, because Roths were created in 1998, or introduced in 1998. Prior to that, and even currently, you can still contribute to a traditional IRA as long as you have earned income. It’s just a question of whether or not the contribution is deductible.

Joel Dickson: And this is an important point for the listeners. We had talked about traditional IRAs having sort of a tax deduction coming with it. But what you’re saying is that that’s kind of sometimes a tax deduction comes with the traditional IRA.

Maria Bruno: Right. So as long as you have earned income, you can contribute to a traditional IRA. The question is whether or not the contributions may be deductible. There are income phase-outs. And, again, you can go to vanguard.com to learn more, for our listeners.

Joel Dickson: Well, and not just income phase-outs with the traditional IRA but, also, whether you participate in an employer-sponsored plan.

Maria Bruno: Oh, correct, yes, that’s a good one. Good clarification.

Joel Dickson: Yes. Because, if you don’t participate in an employer-sponsored plan, then there are no income limits, and any traditional IRA contribution may be picked.

Maria Bruno: Well, it’s not if you participate, it’s whether or not you’re eligible to participate, if you want to really be technically accurate.

Joel Dickson: Yes, that’s correct.

Maria Bruno: So, no, that’s a really good point. So often times the question is whether or not I should make the contribution to a traditional IRA or the Roth IRA.

Joel Dickson: Basically, which one to choose.

Maria Bruno: Right.

Joel Dickson: And how do you make that choice. And that’s where, yes, I mean, that’s the question that you always get, right. Okay, so I hear about traditional IRA, Roth IRA, how do I make the choice? I think a lot of times the knee jerk reaction that people have when faced with that choice is, well, you’re telling me with one I get a tax savings now, and with the other I don’t. Therefore, I’ll choose the, in this case, the traditional IRA. Or I can contribute to my 401(k) plan.

Maria Bruno: Right, it’s that immediate gratification of that tax deduction, not really thinking through, okay, well wait a minute, what’s my situation look like today, and then I get tax-free growth as opposed to tax-deferred growth. And, by the way, I don’t have to take distributions.

Joel Dickson: Yes, this is where I think, in many ways, it’s helpful, just a real quick example. In the IRA contribution, annual contribution amount that you are allowed today is $5,500 if you’re under age 50. So, if you think about this choice of a traditional and a Roth IRA, I’m going to make the math a little bit easier and just say that you have a 50% tax rate; we can argue about how relevant that is, but it’s just to make this point.

So $5,500 contribution, in a traditional IRA, I get the full benefit of that $5,500 going into the account because, in essence, it’s pre-tax dollars. Let’s say that that investment doubles over time while it’s in there, so it goes to $11,000, but, as you had mentioned earlier, you have to pay the tax when you take the money out. And let’s just say you take the money out at one point in time, that $11,000 is fully taxable. If it’s still that you have a 50% tax rate, it’s worth $5,500 to you at the end of that period.

Now let’s take the case of the Roth. So you make a $5,500 contribution, but it’s after tax dollars that you can contribute, so if that $5,500 is your income, if half of it’s taxed, you’re only contributing $2,750 into that Roth IRA. It doubles over time, just like the previous one; that is it’s in the same investment within that IRA. So it’s at $5,500 but, assuming you meet the conditions of not having the account taxed at the end, you still have $5,500.

So the point being in either case, you have $5,500. So if the tax rates don’t change, you have the same expected amount from the traditional and the Roth down the road. And that’s where I think sometimes people get a little bit confused is, “Oh, well I get the tax deduction now.” Yes, but it’s on the back end you get the offset in terms of the Roth. And that’s why this rule of thumb tends to be out there when I’m making the choice between a traditional and a Roth IRA, the rule of thumb is well, do you think your tax rate is going to be higher or lower than it is today? If you think it’s going to be lower, maybe the traditional IRA looks more favorable. If you think it’s going to be potentially higher, then the Roth IRA might look more favorable. Do you know what your tax rate’s going to be in the future?

Maria Bruno: Can’t predict it. I may have a sense, but you can’t predict it, right? You don’t know for certain. Or you don’t know what the federal tax landscape can look like. That’s your point.

Joel Dickson: Yes, your own personal situation, what the tax rates might be. In many ways it’s akin to this idea of why do you diversify an investment portfolio. I don’t know if U.S. stocks are going to perform better than non-U.S. stocks or bonds or cash or so forth. And, instead, you try to invest in many different asset classes or many different investments to diversify that risk that you don’t know what’s going to be the best performing approach.

I think there’s a similar story here, this concept of tax diversification when you’re thinking about the IRAs. So, in many ways, the right answer may not be one or the other but, in fact, both because, by investing in both, or contributing to both, or having both over time, you can help mitigate that risk that, well, I don’t know what my tax rate’s going to be in the future.

Maria Bruno: So when we get asked the question which, the answer is yes.

Joel Dickson: Yes, the answer is yes, exactly.

Maria Bruno: Joel, I honestly get a lot of questions around, “Well, you know, how can I be sure that the Roth IRA isn’t going to get taxed down the road?” So there’s this uneasiness sometimes that still exists out there with investors around the concern of the tax treatment of Roth IRAs changing. And my response often to that is, “Well there’s no guarantee that there may not be changes to traditional IRAs, for instance, as well.”

Joel Dickson: Right.

Maria Bruno: So we make our decisions based upon what we know today.

Joel Dickson: To the best of our ability today.

Maria Bruno: Right. And I think that’s where tax diversification really lends itself nicely to this in terms of holding different account types because they’re taxed differently along the way and, also, when you make withdrawals as well.

Joel Dickson: Yes. And, in fact, there have been a number of different rules applied to IRAs over time. I mean, many years ago there was actually an excise tax on traditional IRA withdrawals if they were over a certain amount.

Maria Bruno: I remember that, yes.

Joel Dickson: And that doesn’t apply today, but there have been other proposals of maximum amounts that could be, ultimately, contributed or in the balances of these. We don’t know what the tax situation will look like or the rules and so forth, we kind of have to just plan based on how we do today.

Maria Bruno: So let’s talk a little bit around maybe, as you go through as an investor, through life stages, to think through traditional versus Roth. So let’s talk about young investors briefly. So I think that’s an easy one, or a relatively easier one, where I think the cards are stacked toward the Roth IRA, in these situations. Because young investors are presumably in a lower tax bracket. So the benefit of the tax-free growth far outweighs a small tax deduction that they would get today.

Joel Dickson: Yes. I mean, yes, another way of saying that is that many people starting out in their careers may be in a very low tax bracket, 15% or something. And so the tax deduction that you’re getting may be fairly minimal relative to the tax you’re foregoing in the future when you were to take that money out. There’s a much higher chance that your tax rate is probably higher in the future if you have a low tax rate now.

Maria Bruno: Right. And one of the things that the research team here at Vanguards looks at is investment choices with IRAs. And one of the things we’re seeing is actually investors are actually practicing this, but we’ve seen is that for investors under the age of 49, $9 out of every $10 that goes into IRAs, goes to Roths. So that’s pretty enriching.

Joel Dickson: I’m sorry, what was that, how many, how much?

Maria Bruno: 90%. So 9 out of every 10 dollars.

Joel Dickson: That are contributed.

Maria Bruno: Correct.

Joel Dickson: I think this gets to this distinction, Maria, that we were talking about earlier, between contributing versus the amount of assets in IRAs that may come from rollovers from other retirement plans.

Maria Bruno: Right. So when you look at the assets, when you look at industry assets, for instance, yes, you’re going to see much higher balances in dollar terms with traditional IRAs than you would see in Roth.

Joel Dickson: But the flow, as you said, is going more and more in terms of annual contributions toward Roth accounts.

Maria Bruno: Oh right, yes, we’re seeing this at the industry level; we’re also seeing it at Vanguard. 2 out of every 3 dollars that are contributed are going toward Roth.

Joel Dickson: Right. Yes, people certainly seem to look at it as a potential and additional option to their savings plan.

Maria Bruno: Right. What’s also interesting is that we’re also seeing that Roth IRA owners are more likely to contribute to their IRA, so that’s a neat fun fact as well.

Joel Dickson: Yes, so it’s sort of savings on top of savings, if you will.

Maria Bruno: Yes. And then, before we move off of young investors, the other thing that I like to talk about with Roth IRAs and sometimes I get smacked with that wet noodle by my readers with blogs and things like that, is the ability to access Roth contribution dollars. So there’s this neat liquidity feature with the Roth IRAs that we don’t have with traditional IRAs, and that’s the ability to tap contributions tax and penalty free.

Joel Dickson: Right, which is actually a difference between the traditional IRA and the Roth IRA.

Maria Bruno: And it could be a very attractive difference in terms of flexibility. And I’m not advocating that investors should go out and tap their contributed dollars, but the flexibility is there, that if you’re thinking about, particularly with the young investor who has limited resources in terms of how to allocate their dollars, and they may be making decisions in terms of saving for retirement and maybe an emergency reserve. Well, contributing to a Roth IRA, knowing that you can tap those monies if you need to, can be useful.

Joel Dickson: Yes. I think it’s just important to highlight exactly this, which is that when you make a withdrawal from a Roth IRA, regardless of how old you are or so forth, those first dollars coming out are any contributions that you made. You’ve already paid tax on those because those were after-tax contributions.

Maria Bruno: Right. So you’re not going to get double taxed on that.

Joel Dickson: Right. So if you’ve contributed over the years $10,000, kind of that first $10,000 that you take out of the Roth, there’s no additional tax liability due to that.

Maria Bruno: Right. And I actually, I guess I practice some of what I preach. I had converted the small IRA I had in 1998; we were able back then to spread out the tax liability over four years. So it was a nice little perk for those who were interested in converting. So I actually did contribute, I had contributed to my traditional IRA, converted to a Roth, and then, later, actually pulled some of those dollars tax and penalty free when I purchased my home.

Joel Dickson: Oh, okay.

Maria Bruno: So I tapped that, I went through the financials and things like that. But, for me, I felt it was a prudent choice because it gave me a little bit of liquidity that I desired at that time. But I was still saving amply though within my 401(k) and my Roth IRA at the time.

Joel Dickson: Right. Now the rules on a conversion are a little bit different because before you can take that money out with additional taxes that might incur, it has to be five years.

Maria Bruno: Yes. So, Joel, since we’ve used the word “conversion” twice so far in this podcast, I think we need to define what a conversion is.

Joel Dickson: Let’s be clear, you’ve used that term twice. What is a conversion?

Maria Bruno: Well, I was trying to move us along. So a conversion is, literally, taking a distribution from your traditional IRA and transferring the proceeds to a Roth IRA. So there’s two ways that you can, as an investor, access a Roth IRA. You contribute outright or convert from your traditional IRA to your Roth IRA. However, it triggers a taxable event, so those proceeds from the traditional IRA are subject to income taxes.

Joel Dickson: So, it triggers a taxable event but, now, going forward, then every additional dollar, once it’s in the Roth IRA, assuming again you meet the conditions for it being withdrawn tax-free in the future, every additional dollar now would not be taxed, whereas every additional dollar of a return, if it were left in the traditional IRA, would be taxed because it’s taxed at income tax rate.

Maria Bruno: Yes, yes, yes. And this is a tough one because, literally, it flies in the face of a lot of the financial planning principles in terms of defer, defer, defer income taxes as long as possible. Here, you’re actually making a decision to accelerate an income tax liability, but you’re doing that to gain future economic benefit of free growth.

Joel Dickson: Yes. And I think that’s a very important point because that’s where we have been told, it’s sort of been thrown into us, don’t pay taxes until you have to. Don’t pay taxes until you have to. We already talked about the contribution decision and how that might be affected. But, in many ways, it’s the exact same analysis, or very similar analysis about “should I do a conversion or not?”, and there might be reasons to do it for tax diversification, like we talked about, or even just sort of multi-year sort of tax planning because, at the end of the day, you want more after-tax return or after-tax wealth, all else equal. So, yes, that’s something, that’s a discussion that I try to have with my mom all the time because she has a fairly amount retired, fairly decent-sized traditional IRA, and probably more proceeds than she’s going to spend in her lifetime out of it. And I’ve tried to convince her that a conversion to a Roth IRA might be a good idea because, honestly, neither I nor my brother wants a traditional IRA to be passed to us after she passes away because you then start having to take it out—just like these required minimum distributions—there are those after the IRA owner passes away.

And that tax rate of her kids is actually higher than what her tax rate is today. And so we’ve been trying to convince her with the sort of excess proceeds to say, ”Why don’t you do a conversion, pay the taxes, because it’s actually better off for everybody.”

Maria Bruno: How’s that going?

Joel Dickson: It hasn’t been going well. It’s like, “Wait, why should I pay the taxes?” especially because she’s not the one deriving the benefit.

Maria Bruno: And I think there’s two wrinkles in that story. One is you’re assuming you’re going to outlive your mother.

Joel Dickson: Yes, well that’s not a guarantee, you’re right.

Maria Bruno: And second that she’s not going to change her beneficiaries.

Joel Dickson: Yes, well.

Maria Bruno: All right, let’s also talk about another reason why a conversion could come into play, and that is for high-income earners who can’t contribute outright to a Roth IRA. As we’ve mentioned earlier, there are income phase-outs on eligibility for Roth IRA contributions. So for high-income earners, one way they can go about doing a Roth—essentially, making a Roth contribution—would be to do a two-stepped process. First, make a contribution to a traditional IRA. It wouldn’t be tax-deductible because the income phase-outs have already been exceeded.

Joel Dickson: If they’re eligible in an employer-sponsored plan, yes.

Maria Bruno: And later they can convert to a Roth IRA. So I call it a contribute and convert strategy as a way to make a Roth contribution.

Joel Dickson: So people often will refer to this as a backdoor Roth contribution, right?

Maria Bruno: Correct, right. So that’s another financial planning strategy for individuals who are looking for tax diversification and they may have too much income to be able to contribute outright.

Joel Dickson: But, yet, they still want to take advantage of the features of a Roth if they can, or a tax-advantaged account.

Maria Bruno: Yes, and I think then, the other strategy would be for individuals who have large amounts of dollars in tax-deferred monies and they want that tax diversification. They may, over a series of years, do partial conversions, where they can over a scheduled period of time, for instance, diversify their portfolio and equalize that balance between traditional and Roth.

Joel Dickson: Yes, there are a lot of different conversion strategies. I mean, we can start talking about ways to manage. You talked about the required minimum distributions from IRAs, traditional IRAs, right. And by doing some conversions, you may actually be able to lower your total tax liability over your lifetime by converting early and paying some tax and avoid, potentially, additional taxes from the required minimum distributions bumping you up into different tax brackets once you have to start at age 70½, taking those distributions.

But I wanted to get back to this backdoor sort of process. So are there any additional complications though for doing this backdoor? It sounded really easy the way you were doing it.

Maria Bruno: Oh, yes, that’s an important point, Joel, in that it works very cleanly if you don’t have other IRAs that you’re not converting, but many individuals do. They might have rollovers and have large deferred balances, and they may not be doing those conversions. The thing you want to think about, if you’re approaching a backdoor Roth, would be what the IRS calls the “aggregation rules.” So when you do a conversion, even though you’re not converting all of your IRAs, for the purposes of calculating the conversion taxes due, you need to aggregate all of your IRA balances.

So even though you might want to convert a small piece or just a contributed amount, you have to look across IRAs and aggregate those for the purposes of calculating the tax liability. The IRS is not letting you cherry pick what you can convert, essentially.

Joel Dickson: So an example here might be if I’m contributing $5,000 for a traditional IRA nondeductible; that is it’s taxable money because I’m over the income limits, which is this case of the backdoor contributions. I’m contributing $5,000 but I already have $5,000 in a traditional IRA that it’s pre-taxed money, let’s say, a rollover from a prior employer. I now have $10,000 total but I just want to convert this $5,000 after-tax into the Roth. I can’t just convert the $5,000 and say there’s no tax effect on that because it would look at my total IRA balance of $10,000 and say half of that is taxable, half of that is not taxable. So whatever amount I convert, whether it’s $1 or $5,000 of the entire $10,000, half of that conversion amount is taxable, so I’d have an additional tax liability, right?

Maria Bruno: Right, right. So you just want to be careful if you have other IRAs you’re not converting. But it’s a good point and it’s one to, if you’re thinking about it, to stop to think about your tax situation. It doesn’t mean that you shouldn’t necessarily do it; you just need to think about the overall tax consequences of doing so.

Joel Dickson: Yes. We’ve been talking about a lot of different conversion strategies, whether it’s backdoor, this contribute and convert, maybe in retirement there might be conversion approaches. Are there other times, I mean, other times that conversions might make some sense?

Maria Bruno: Yes, I actually do want to go back to that because I think we talked more about the relatively easier situation with young investors. But for those folks that are nearing retirement, the decision often becomes, “Well, how should I direct my contributions?” Think about the tax diversification opportunities if you can. But then, once you’re retired, to gain that tax diversification, the only thing you really can do is do partial conversions, for instance, convert those traditional IRAs to Roth IRAs.And, actually, it could be a very good financial planning strategy because, for some individuals, particularly if they retire early, they may be in a relatively lower tax bracket between the ages of 60 and 70.

Joel Dickson: Sorry and, also, they may now have a little bit more certainty, once they’ve stopped working, or they have that earned income no longer coming in, of what their future taxes might look like relative to their current taxes.

Maria Bruno: Correct, because of what their income looks like, but then, also, predicting what RMDs could look like, right, because that’s the big one, is when you think about investors today with large deferred balances, once they reach age 70½, it’s a good thing; they’ve accumulated large balances. But the IRS starts mandating these distributions so those dollars will be taxed. And that coupled with, potentially, individuals that defer Social Security until age 70, there could be a pretty unwelcome tax bite come age 70, and there your options are relatively limited. So one strategy can be to actually accelerate those withdrawals through Roth conversions, for instance, gaining that tax diversification, lowering your tax deferred balances, and then the subsequent RMDs off of those balances.

Joel Dickson: Because the RMDs are only out of that traditional IRA and you’ve taken that down over time, right?

Maria Bruno: Exactly. So the key there then is to use those years as planning opportunities to accelerate some income, presumably at a lower marginal bracket to help equalize those IRA balances. We’re actually seeing evidence of this with our IRA shareholders; I’m calling this the “Roth conversion zone”. We’re actually seeing Roth conversions increase between age 60 and 70, doubling at age 70.

Now, granted, the numbers are still really low across the board, but we are seeing a peak come up at age 70, and that leads us to think that investors are starting to understand the benefit of this tax diversification during those years.

Joel Dickson: And there are some other elements, too, of not just the RMDs but to the extent that you have less taxable income because it comes in the form of a Roth IRA withdrawal. Things like your Social Security taxes, Medicare premiums, and other items that are related to how much taxable income you have may be more beneficial as well.

Maria Bruno: Correct. So my message is for individuals who are thinking through this or might be interested, I mean, this is really where the number crunching comes into play, working with a financial advisor can really be beneficial. Because there may be some opportunities for, for instance, maybe if an individual is charitably inclined as well. So balancing some of these strategies where you accelerate income, where there may be some charitable offsets or things like that too. So some things to think about.

Joel Dickson: Yes, I mean, there are any number of reasons why, from year to year, a tax situation for an investor in retirement may be higher or lower, and having both types of accounts now, you can sort of strategically withdraw to sort of optimize that tax situation.

Maria Bruno: Yes, so my point here is like, should everyone go out and do a Roth conversion? No. But should everyone consider it? Absolutely, if tax diversification isn’t there, think through it, at least if it’s something to rule out. If not, then think about this tax diversification and how best to balance that out.

Joel Dickson: Yes, a lot of that information is out on vanguard.com. Maria, you’ve written a number of blog posts on this topic and others with respect to IRAs. We have a colleague in the industry that likes to talk about this topic in much the same way that we find ourselves talking about it at times. A financial planner, a fee-only Financial Planner by the name of Allen Roth, who talks a lot about IRAs and Roths and conversions.

Maria Bruno: And it would only be appropriate that we had a discussion with Roth on Roth.

Joel Dickson: There we go. He was here at Vanguard just a while back and, luckily, we were able to sit down with him and probably hear some similar themes that what we’ve been talking about, but it’s good in many ways to hear it in multiple perspectives because there are a lot of issues involved with IRAs and getting people to think about the relevant pieces of their own financial plan or situation to help make this decision, I think is very helpful in hearing that from Allan as well.

Maria Bruno: All right, let’s hear what Allan has to say.

Joel Dickson: So, Allan, we’ve been sort of talking a little bit about Roths, your namesake type of a financial investment. Was the Roth IRA named after you?

Allan Roth: No, I came from the Rothschild family.

Joel Dickson: Oh, nice!

Allan Roth: No relation, obviously. But, yeah, the Roth IRA is a brother/sister product to the traditional IRA. And in the traditional, you get the tax deduction when you contribute and then you pay taxes after it grows. The Roth is just the opposite. You don’t get the deduction now, but if Congress doesn’t change laws, then it can grow; and when you take it out, you never have to pay taxes on it.

Joel Dickson: Congress never changes laws, do they?

Allan Roth: Of course not.

Joel Dickson: Yeah, exactly.

Allan Roth: I don’t predict markets or politics.

Joel Dickson: Well how do you think about the use and this choice of whether traditional or Roth IRA or 401(k) from that standpoint for those that have that option as well?

Allan Roth: You know, whether it’s a 401(k) or IRA, they can either have traditional, they can have Roth; and my answer absolutely is yes, meaning that you need both because it’s a form of political diversification. We never know what tax laws will be. We never know what our tax bracket will be upon retirement, etc. So, it’s a way of getting some diversification just like owning broad index funds and bonds and different asset classes.

Joel Dickson: Yeah, I mean that’s the real point, right? I mean in many ways tax rates are a risky uncertain outcome just like investment returns of the future, right?

Allan Roth: And so much of investing is admitting that we don’t know the future and our instincts usually fail us.

Maria Bruno: Allan, I want to get your thoughts. So, Joel and I talk a lot about Roths, not surprisingly, but one of the unique features with Roths is that you can access the contributions. And I had blogged about this recently, and I got smacked with a wet noodle by some of my readers around this in terms of the flexibility that a Roth IRA affords an investor. Would appreciate your thoughts on that if you agree, disagree in terms of using a Roth as a multitasking type or an off-label type account.

Allan Roth: Yes, I think that it’s true. You can tap the Roths before you’re 59½. It gives you more flexibility in that you don’t have to start tapping it at 70½ with the required minimum distribution. But with that said, tapping a Roth is really the last money that I tell clients that they should spend. It’s their most valuable money. It will never be taxed again. It can grow tax-free.

Joel Dickson: Yes. We got into this debate about whether you could use it as, for example, as you’re trying to accumulate when you’re young as an emergency spending account from the standpoint of, as opposed to you think about somebody that may save 10% of their income. You know, and, hey, we say, “Get this emergency reserve together. And you should have 6 to 12 months of an emergency reserve.” Well, that’s 50% to 100% of your income. If you’re doing that 10% a year, it takes you 5 years before you’re even investing long-term. So how do you think about some of that?

Allan Roth: You know, first of all, whether you should have 6, 9, 12 months, if you work for the federal government, if you’re a tenured professor at a school or university, you may not need that much. If you’re working with a startup company, you probably need an emergency reserve. So typically, especially when someone’s young, their tax bracket is typically lower so Roths are pretty attractive because they’re not getting as big of a deduction.

Using it as an emergency reserve, you know, if mom or dad won’t lend you any money, if otherwise you’re going to be living under a bridge, that would be the reason I would tap it. Otherwise, I would try to leave it alone.

Joel Dickson: Yes, I mean I think I have to have an emergency reserve just because Maria will say something, and I could get fired for what might come out of my mouth.

Maria Bruno: Yes, that’s your concern about being fired is that I will say something.

Joel Dickson: Yes, exactly. It’s all your fault.

Allan Roth: And the rumor is that I’m paying her to say that to get you fired.

Joel Dickson: Yes.

Maria Bruno: No, Allan, I agree with you. I mean it comes up primarily with young investors who are constrained in terms of saving for retirement and also liquidity concerns. So, I usually will bring up the Roth IRA as one, Roth versus traditional for the reasons that you mentioned. Roth is probably a better vehicle. And, oh by the way, you can tap that in the event that you need it, but it certainly is a retirement account first and foremost.

Allan Roth: Yes, I mean as a last resort tap it.

Joel Dickson: Actually, you know, though, I think people have gotten this fairly right. I mean we actually see data here at Vanguard, 85% of contributions to IRAs made by millennials are made to Roths.

Allan Roth: That’s cool. I didn’t know that. That’s wonderful news.

Joel Dickson: And it’s about two-thirds overall of all clients. Now traditional IRAs just tend to be larger in terms of assets because it’s still the typical rollover vehicle as people leave plans and so forth, but the adoption of Roth has actually been fairly significant.

Allan Roth: Yes, I have more money in my traditional than I do Roths because traditionals have been around a lot longer.

Joel Dickson: Oh yes, no doubt. One thing that we talk about a lot, too—and you talked about the political diversification during like the contribution pieces of this—but also like smoothing out or diversifying the tax liabilities as you’re getting to retirement or trying to deal with multiyear tax planning issues, RMDs, and so forth. Can you talk a little bit about how you think about using Roths to help as we kind of get near that retirement phase?

Allan Roth: Yes. I mean, typically, a Roth is more valuable money than a traditional because a traditional is really a joint partnership. The account holder owns a piece of it and the federal and state government owns a piece of it because taxes are going to have to be paid. So, your contribution to your Roth is more valuable than the traditional.

Joel Dickson: For the same dollar contribution, for example, you would make.

Allan Roth: Right. And then during, I almost always recommend delaying Social Security to age 70, and the RMDs don’t begin till 70½. So, there’s some great opportunities if you retire before 70 years old to start moving money doing multiple Roth conversions at a lower rate, which lowers your RMD and gets more money in that diversified more valuable tax wrapper.

Joel Dickson: Yes, you had mentioned Social Security and delaying Social Security. What’s the reason for delaying Social Security that you often see?

Allan Roth: Well, according to the work that I’ve done, there’s only one inflation-adjusted immediate annuity that you can buy right now. I think it’s Principal. And the work that I’ve done shows that delaying Social Security is like buying a deferred inflation-adjusted annuity at about a 45% discount on what you can buy in the open market. So, what I tell people at age 62, we can add in what they would have gotten to their safe spend rate, and they can withdraw it from their portfolio because what they’re really doing is buying that deferred annuity, inflation-adjusted annuity because seven years later, eight years later you’re going to be getting a whole lot more and increasing with inflation. What could be better than that? Longevity risk you decrease with that.

Joel Dickson: Yes, when we talk about doing the distributions from the Roth to maybe fill that back gap, but there’s also all sorts of things of converting from traditional to Roth which is an option that can also be done to help with smoothing out these tax bills or freeing up other contributions to tax-advantaged accounts, right?

Allan Roth: During those years between retirement and taking RMD and Social Security, there are lots of different options. Another option is you can recognize a long-term capital gain at a 0% tax rate. By the way, I’ve argued investing is simple. I never argued taxes were.

Joel Dickson: Yes, taxes are extremely complicated at times, aren’t they?

Allan Roth: They are.

Joel Dickson: Though gives us some opportunity at the same time. I just want to clarify something that, you know, as we go through this because we love to sort of think about what the current rules are and so forth and you talk about we never know what might happen in the future. And, you’re right, Congress could change these things. And even under the current regime, though, there’s still some risk, you have to be careful about how Roths could be taxed. I mean it’s not like they’re never taxed or never would be taxed?

Allan Roth: We could do something like a consumption tax, which would be like the Fair Tax Act, where you are taxed when you spend it. So, if you convert it to a Roth or contribute it to a Roth, you’re paying taxes twice, so it absolutely can backfire. Which, again, I don’t believe solely in Roth, I don’t believe solely in traditional, I don’t believe solely in taxable. I believe in different pots of money.

Joel Dickson: Yes.

Maria Bruno: I get that question a lot in terms of concerns around Roth or Roth conversions in that while there’s no guarantee that these monies might not be treated different down the road. But there’s no guarantee that traditional IRAs may not be taxed differently as well too. So, we know the tax regime that we have in place today and, much to your point is investing in different account types will give us tax diversification for the future.

Allan Roth: Yes, I mean this may seem far-fetched, but politics often is. The government could say, “My gosh, we’ve got a big deficit, we’ve got a large amount of debt, we’re suddenly going to make everyone’s traditional have to pay taxes out of that,” and they’ll be converted to after-tax type of things and no longer on the Roth. Anything can happen.

Joel Dickson: Let’s just hope you don’t end up in the legislature there, Allan, with that proposal.

Joel Dickson: I just wanted to clarify too because even under the current tax rules, I mean if you don’t hold that Roth IRA for 5 years and/or take out the earnings, for example, before 59½, there may be tax and potentially penalty due.

Allan Roth: Yes, unless special hardships. I mean I hate to say it, but everything I’m saying there’s exceptions, exceptions, exceptions.

Joel Dickson: Exactly.

Allan Roth: Seek competent tax advice, blah, blah, blah.

Joel Dickson: There’s the episode title for this one, “Seek competent tax advice, blah, blah, blah.”

Maria Bruno: Blah, blah, blah.

Allan Roth: You don’t like my saying, I’ve always said, “Investing is simple, never said taxes were”?

Joel Dickson: Yes. No, that’s certainly true.

Joel Dickson: So that’s actually quite a bit of information I think that we’ve thrown out. I mean, I know in some ways it’s second nature to you and me in thinking about this because, in some ways, this is your favorite topic, isn’t it

Maria Bruno: Well, I think, yes, we can go down that path pretty quickly, both of us, in terms of talking about Roth and traditional.

Joel Dickson: Well it’s one of my favorites too.

Maria Bruno: I know, it’s one of mine, too, and it’s one of Allan’s. And I think he touched upon a lot of salient points.

Maria Bruno:  Okay, our one key takeaway

Joel Dickson: Yes. Go for it.

Maria Bruno: I’ll take it, tax diversification.

Joel Dickson: Yes, and what does that mean at the end of the day?

Maria Bruno: Yes, holding both.

Joel Dickson: Holding both. It’s not a question of either or in many ways, right? It’s how do you think about maybe both, whether it’s IRAs or their companion approaches because, often times, investors can do traditional or Roth 401(k) investment in their employer plan. It’s the same general idea.

Maria Bruno: You know, I think the consensus was, yes, it makes sense to tax diversify. The question is how do you do that as an investor. And I think we had some good conversation around that.

I would also encourage our listeners, if they do want to learn more, to visit vanguard.com. I think we have a lot of really good stuff on our website, both in terms of information as well as research and blogs and webcasts on the topic.

Joel Dickson: I agree. And you’ve written a number of things that folks can find fairly easily on our website.

Maria Bruno: And the comments, also, when you think about blogs, the comments are great.

Joel Dickson: Oh, the comments are great.

Maria Bruno: And I really learn a lot from my readers as well. And it also gives us suggestions of things to talk about and further address.

Joel Dickson: Agree. Well, thank you again to those that are listening for listening to our The Planner and the Geek podcasts on investing. And please join us the next time as we talk about further topics of interest for individual investors.

Maria: We hope you enjoyed this episode of The Planner and the Geek.  Just a reminder that you can find more episodes of The Planner and the Geek on iTunes and on vanguard.com.

Joel: Or, simply subscribe to our series and you won’t miss an episode.

And please don’t forget to rate us on iTunes. Your ratings will make it easier for others to find us when they’re looking for investing podcasts. Please join us next time for another episode of The Planner and the Geek.

Important information

Allan Roth is not affiliated with Vanguard, and Mr. Roth’s opinions may not necessarily represent those of Vanguard.

Diversification does not ensure a profit or protect against a loss.

All investing is subject to risk, including possible loss of principal.

We recommend that you consult a tax or financial advisor about your individual situation.

© 2018 The Vanguard Group, Inc. All rights reserved.