Roth Conversion vs RMD: What Every High Earner Needs to Know Before Age 73

DANO WEIR: Daren, I'm going to read something to you.

DANO WEIR: Guy posts on Reddit just the other day.

DAREN BLONSKI CFP®: I didn't realize you were like a Reddit guy, man. Dude, you're getting tech savvy.

DANO WEIR: You're getting me down the rabbit hole.

DAREN BLONSKI CFP®: Seriously, man. Wow, impressive.

DANO WEIR: R slash retirement and says, I always put the maximum into my 401k. Now I realize I'm going to be paying high taxes when I need to take RMDs. I would have been better off only contributing enough to get that company match. And that post has 571 comments.

DAREN BLONSKI CFP®: Did you read all the comments?

DANO WEIR: I read some of them because some of them were GIFs, so I couldn't read all of them. Today we are talking about the RMD tax trap. Why high earners regret tax-deferred accounts, what actually goes wrong, and more importantly, what you can still do about it.

DANO WEIR: Financial confidence for your hip pocket. Money is really just energy. If you're checking out, It's All Money.

DANO WEIR: Hey, welcome inside the Sonoma Wealth Conference Room. We are Sonoma Wealth Advisors. My name is Dano Weir. I'm the Marketing Director. He is our Managing Principal, Co-Founder, Daren Blonski, CFP. Daren, we're talking about RMDs today for high earners.

DAREN BLONSKI CFP®: Favorite topics Wow, this is going to be great.

DANO WEIR: You're doing the same thing because you're like, what is this? We're going into the guts of planning here. We're getting technical today, and we're going to try to do so in a very approachable, understandable way. That is our approach, so let's start with a definition right up front.

DAREN BLONSKI CFP®: So RMD is? Required minimum distribution. So the government says, look, there might come a point in life where you put money in these things we let you put money in, but guess what? We want taxes before you die. So we're going to put an RMD.

DAREN BLONSKI CFP®: What's kind of unique about the RMDs is the age in which you have to take out RMDs keeps creeping higher because people are supposedly living longer. I think it's because the politicians are getting older and they don't want to take their RMDs.

DAREN BLONSKI CFP®: Or is that too tinfoil?

DANO WEIR: No, no, it makes sense. Especially with, you know, their trading information. Okay, let's talk about today's scenario.

DANO WEIR: I'm going to try to put a scenario in your head so that you can try to stay grounded with this.

DAREN BLONSKI CFP®: But it's a scenario, right? So keep in mind, this is not advice. Like we don't know what your unique situation is. And so we have to stay general. We have to say, hey, in general, here's a person like this. And it's a scenario and everybody's different. So call an advisor before you make a decision.

DANO WEIR: For all purposes of today's conversation, we're discussing things. So here's today's scenario. I'm 74.

DANO WEIR: I was born in 1952. And I have $1 million in a traditional IRA. Here are four traps. That an RMD in that situation could get me into. And the first one is the ordinary income spike. What is that?

DAREN BLONSKI CFP®: Okay. So think about this federal tax rules. We have kind of three basic. Buckets of taxes. There's lots of others, but three basic buckets. We have income tax, capital gains, and estate tax. We're talking about income tax, right? We have a marginal tax bracket system.

DAREN BLONSKI CFP®: What that means is you fill up buckets as you go, right? So each margin as you fill it up is taxed at a different rate, right? So when you say to someone, what's your tax rate? And they say, oh, it's blah, blah, blah, blah. It's 24%. Most often what they're quoting to you is their highest tax margin, that bucket.

DAREN BLONSKI CFP®: They're not quoting to you their weighted adjusted actual tax liability. Right. Most people have no idea because that's not what they show you. So once you figure out your weighted tax liability, which we have some really cool tools in-house to help people do that and understand how that works.

DAREN BLONSKI CFP®: What we're looking to do is at certain levels of taxation, sometimes in the, like, say if you're in the 15%, we want to fill that bucket to the very top in income, and then, and we're going to talk about this in a little bit, but no more.

DAREN BLONSKI CFP®: In this case, the trap is you're basically, when you have to take an ordinary income, you're stacking income on top of all your other income, and that spikes the income. And when you spike the income, Guess how much tax you're paying on that money coming out as a requirement of distribution? The highest margin because you've already filled up the other buckets.

DANO WEIR: So is it not? Wait, are you saying that an RMD is income and not investment income?

DAREN BLONSKI CFP®: It's exactly. So it's ordinary income.

DANO WEIR: If I have that million dollars in a brokerage account and I make. $100,000, that's $100,000 capital gain. If I pulled out that $100,000, then I would be paying the capital gain. If it was over a year, it would be long-term capital gains, 12% or something like that.

DAREN BLONSKI CFP®: 15 long-term, 20 short-term. And it's the difference between what you invest in and what you made is the capital gain.

DANO WEIR: Okay, so that would be from a brokerage account. You're saying an RMD in that same scenario, that $100,000 is income if it's an RMD?

DAREN BLONSKI CFP®: If it's an R&D, R&D is income to you.

DAREN BLONSKI CFP®: Right. Okay. So think about that. Like if you're at the 25% tax bracket, 34% tax bracket, federally, whatever it is, you're paying that highest number you're on. So it's basically, you put all this money, you save what this guy is talking about on Reddit, I saved all this money, and then I have to pull all this money out when I finally get Social Security and my pension. Like firefighters, it's brutal.

DAREN BLONSKI CFP®: A firefighter contributing to a 457 and maxing that out on a pre-tax basis is usually a mistake. Because firefighters, their income doesn't really go down in retirement. It stays pretty steady. Now, Very few people have pensions now, but if you have a pension coming, this is a big issue for you. If you don't have a pension, it might be an issue because it's going to stack on top of Social Security.

DANO WEIR: IRMA, I-R-M-A-A, income related monthly adjustment amount. A Medicare surcharge. That's our second trap, the IRMA ambush.

DAREN BLONSKI CFP®: So what's important here is not the IRMA stuff. What's important to know is that as you get higher income, more taxes come in. You have overrides, right? We have a regime of taxation in this country where it's like tax the rich more, right? It's the Robin Hood story. Tax the rich. And sometimes it's...

DAREN BLONSKI CFP®: Makes sense. And sometimes like what we're doing in California, we're like, hey, let's give all the billionaires a 5% tax. Guess what? They're all leaving the State. You're not going to get your 5%. So there's always this push-pull, right?

DAREN BLONSKI CFP®: Like, and what happens is you make more money and come into more and more now the middle class. You're going to pay these surcharges and different taxes. Well, if all of a sudden this big RMD comes out of your account because you're 74 years old and you've got to pull out a bunch of money. Well, now you just bump into that surcharge area.

DANO WEIR: Yeah, it's your Medicare Part D and Part B premiums potentially going up.

DAREN BLONSKI CFP®: Yep.

DANO WEIR: So it's just...

DAREN BLONSKI CFP®: And there's others that will be impacted too.

DANO WEIR: Yes.

DANO WEIR: There is...

DAREN BLONSKI CFP®: Alternative minimum tax, AMT is another one.

DANO WEIR: Yeah, and there is to what you're talking about. It doesn't feel like it because if you're sitting at $100,000 net worth, if you have a negative net worth, life is hard. We acknowledge that. And if you look at someone who's got a million-dollar net worth, a $10 million network, that just seems like way up there, and it is.

DANO WEIR: But there's also a massive chasm between a $10 million net worth and an $800 million net worth. Net worth. And there's sort of this valley of death where you have the 10 to 100 million dollar people who get hit and hammered with some of these taxes as, quote, the rich. But then once you get really to the 800 billion dollar...

DANO WEIR: Range well now you're so so wealthy you potentially have access to some relationships that allow you to do you know pay even less or no tax be like trump and pay 700 in tax correct so it just as i think it's something to consider when you're talking about quote tax the rich is that and what what is in a world where a double double is not ten dollars like what is rich these days in the reality is like we're playing against two different rules.

DAREN BLONSKI CFP®: Like there's a different set of rules for people that can afford professionals that know how to play the game. Yeah. There just is. So the other thing I think is important to keep in mind about this trap too is a lot of these income additional taxation on higher income.

DAREN BLONSKI CFP®: They're not going up with COLA, meaning they're not raising as things inflate.

DAREN BLONSKI CFP®: When they put the laws into place, you know, that person said $150,000 was making a lot of money then. But then inflation goes up and all of a sudden $150,000 you can barely live on in California. So that becomes problematic because then what's happening is just taxing bigger and bigger population.

DAREN BLONSKI CFP®: And they do that on purpose, right? It's a game of hot potato, right? Like when these politicians create these taxes, they have analysts and they have actuaries that sit there and figure out how many people in the population are we going to target with this one?

DAREN BLONSKI CFP®: How much revenue is going to go back in on this one? And what do you think the political implications of this tax are? That is set very strategically by the politicians.

DANO WEIR: We need to pay for that new L. A. Rams stadium. So how are we going to know? I don't know if that was tax-favored funded or not.

DANO WEIR: Trap number three, the Social Security taxation cliff. So most people know Social Security can be taxable, but a lot of people don't understand how the formula works. So when you start looking at a combined income that includes this, you could be looking at up to 85% of your Social Security benefit becoming taxable if the RMD is included.

DAREN BLONSKI CFP®: That's right. So basically, if you're living above poverty level, your Social Security is going to be taxed at 85% is the way you think about that. Because if in California, your income on a married couple is $44,000 and $34,000 for a single, you're at a poverty level probably or pretty close.

DAREN BLONSKI CFP®: You're counting your dollars. And then if you exceed that in income because then all of a sudden your requirement of distribution comes in, now 85% of that $34,000 or $44,000 is now taxable. So then that stacks on those taxes again, right?

DAREN BLONSKI CFP®: Not only is that money coming out of the RMD at a higher tax rate because it's your highest bucket, but then you also then penalize the other chunk of income you've got. So it's really a screwy system. And the way...

DAREN BLONSKI CFP®: Taxation between Fed and State is set up and I the best way I think about it growing up we lived across from this field and there's this house that someone had like built like multiple additions on to the house in Petaluma in Petaluma and this house was like you know at one point probably a really beautiful Victorian house but now it had like an addition here an addition here I know you've seen those houses right in Petaluma there's a bunch of them yeah and they just don't fit And it works.

DAREN BLONSKI CFP®: It kind of holds everything up. But the structural integrity of the entirety of that thing is probably questionable on a lot of levels.

DANO WEIR: In an earthquake area.

DAREN BLONSKI CFP®: Yeah. And that's how I look at our tax code, right? It's like lobbying comes in and we'll stick a shed here. And we'll add on this here and we'll put this here. And then it doesn't quite talk through consistently. And then we end up with this unfair taxation schedule, which is the person who's literally at poverty level making $34,000 to $44,000 a year, 44 if you're married, 34.

DAREN BLONSKI CFP®: If you're single, all of a sudden now have to pay 85% more. They have to pay 85% tax on that $44,000 or $34,000 respectively because they pulled money out of their IRA or their 401k, did what they should have been doing their whole life, which was saving for their retirement. Glad I followed that advisor's advice. He just sent me a tax bill. That's why.

DAREN BLONSKI CFP®: A shameless promotion of how we do things here at Stoma Wealth. That's why we're so keen on interlocking the taxes with the wealth management. Because most brokers, most advisors out there, they literally have no conversation with the tax person.

DAREN BLONSKI CFP®: They might have one call a year with your tax person, but they're blind. To the entirety of what's going on. And it's not what you make that counts, but what you keep that matters. And that's the reality. So unless your tax professionals are talking to your advisors, it's not working.

DANO WEIR: It's all fine because I'm just going to leave this to my son. I'm just going to leave this to my daughter. So this is their gift. This is their inherited IRA, our trap number four. The inherited IRA 10-year rule. How could giving someone an inheritance actually be a trap?

DAREN BLONSKI CFP®: You know, Dan, I actually had this very conversation yesterday with a client. Okay? Six kids in the family. Client calls me. His dad passed away really unfortunately. Well, unfortunately, we had this whole discussion around what's the best way to die. And he passed away as a heart attack in his favorite chair right after working on his farm.

DAREN BLONSKI CFP®: Like, that's a pretty good way to go. But neither here nor there, he passes away. He's got a million and a half sitting in an IRA that he just pulls distributions on every year. And then that RMD comes out because he was 84 years old. It comes out of here and that's what he used to augment his income from the farm.

DAREN BLONSKI CFP®: Fast forward, dad now gave his beneficiary to his six children, which was the right way. You never want to send beneficiary of an IRA to a trust because it makes it all immediately taxable. And this happens all the time. We see it.

DANO WEIR: Is this traditional or Roth?

DAREN BLONSKI CFP®: Traditional.

DANO WEIR: Okay.

DAREN BLONSKI CFP®: So traditional IRA, if you make a trust or an entity a beneficiary, it becomes all taxable on distribution at death. Which we just talked about brackets. If all of a sudden you've got a million and a half coming out, guess what top bracket you're hanging out in? Half is gone by the time you do Fed and State.

DAREN BLONSKI CFP®: So point being, Dan, is client calls me, six kids inheriting. They're all excited to get a sixth of the $1.5 million count. Then I told him the rest of the story. The rest of the story was, well, guess what? You guys got 10 years to get money out of that account, and it's going to stack on top of your income.

DAREN BLONSKI CFP®: So whatever you end up distributing to you, that's going to add additional income because it's income. It's ordinary income. They're going to start busting those bands, adding in more taxes. And then on top of that, just to make it worse, because dad was already taking his RMD, They have to take it every year.

DANO WEIR: You have to do it too. Right?

DAREN BLONSKI CFP®: Whereas at least if dad wasn't still an RMD, there would be some flexibility on those 10 years. If you don't do it, federal government says, give us half. So when you inherit an IRA, there's a lot of technicalities around it. Now it used to be the stretch rule. You had your whole life to stretch distribution of that, which in theory, then you just a little bit was coming on the top of your buckets.

DAREN BLONSKI CFP®: But now you got to divide it by 10. Has no care in the world. World what your income is, you're going to pay the highest bracket. So it's kind of like a, so when we talk with clients now, and it's hard because I'm talking with a parent, say, who's 84 years old, and I say, you got a million and a half.

DAREN BLONSKI CFP®: We probably need to get more of this money out. But Darren, I don't want to pay taxes on that money. I say, but your tax rate is likely much lower than your children. Tell me about the situation with your children. It's hard to get to because most parents go, hey, Johnny, what's your tax rate? You know, like not going to happen.

DAREN BLONSKI CFP®: So we're trying to like make some guesses about what might be happening there because it might make a lot more sense now for the parent to actually take full distribution or convert, which we'll talk about in a minute, convert some of that traditional IRA so that the kid, when they inherit it, doesn't have to pay taxes on it. That's family planning. That's estate planning.

DAREN BLONSKI CFP®: That's generational planning. Those are, if you have a big IRA, It's more important than ever. If your advisor's not talking to you and you've got a big chunk of money in your IRA about what the strategy is to get that thing through distribution, you are being disserviced because it is one of the areas where you will get nailed when you pass or your children will.

DANO WEIR: Let's go to my scenario, which was I'm 74. I've got this traditional IRA that's a million and you're my son, Darren.

DAREN BLONSKI CFP®: Wow.

DANO WEIR: I'm gonna give this to you. I just died.

DAREN BLONSKI CFP®: Yep.

DANO WEIR: You're inheriting my IRA now. You make $150,000 a year. And so you have to, as you're saying for this fourth trap, if I'm understanding it right, you have to take $100,000 a year for 10 years.

DANO WEIR: Your tax bracket.

DAREN BLONSKI CFP®: Hypothetically, it's way more complex than that. But yes, hypothetically, it's a very generic vanilla scenario you're talking about.

DANO WEIR: Yes. If you're making $150,000 a year, you're... Let's just guess on the taxes on that. That's 24%.

DAREN BLONSKI CFP®: I don't know. It depends on what State you're in. Yeah, okay, okay. Don't even go there.

DANO WEIR: Okay. A chunk of that $100,000 that you're taking is going, basically that $100,000 you're taking because of what you're making, you're going to have to pay. Very high taxes on because you're making $150,000.

DAREN BLONSKI CFP®: Not necessarily very high because you could be in a no tax. You could be only making $34,000 a year.

DANO WEIR: But I'm saying you make $150,000 a year.

DAREN BLONSKI CFP®: Yes, I'm paying in my highest bracket.

DANO WEIR: Versus if you were 70 by the time you had to take those RMDs, you would be only having your Social Security income, right? So meaning to get it from the million dollars in the IRA to money you can actually use, when it happens to you when you're making a lot of money, you end up with less than if you made it, then you took it when you weren't making a lot of money.

DAREN BLONSKI CFP®: Yeah. I mean, essentially that's the essence. So here's the core message. The core message is if you're a parent, you've got a big IRA.

DAREN BLONSKI CFP®: You need to have a distribution strategy and you need to be thinking about whoever's that beneficiary, if it's your children, whoever, that that beneficiary, what their tax rates are, because it might make a lot more sense for you to pay the taxes than that kid to pay 50% when you could have paid 15%.

DANO WEIR: Exactly. And so let's talk about some of those strategies. So those are your traps. And now we've got some moves. We've got some plans and some actions for you. The first one is the bracket fill strategy, which you've touched on a little bit. Fill that in for me. What is the bracket fill strategy?

DAREN BLONSKI CFP®: No pun intended. So this is one of the things we do with our clients. So we build out their lifetime tax, expected tax. So we project out based upon all the variables they give us their income. And then we look at the years in which they'll be at their lowest tax rates before things like Social Security kick in, pensions kick in.

DAREN BLONSKI CFP®: We bring all those variables in there and we say, look, in this year, you're going to be in the 15% tax bracket. But you're only going to fill up half of that bucket. So in that year, we're going to take money out of that traditional IRA and fill that 15% bucket up. Now, if you tell me, you know, my kids are really successful. One's a doctor and one's an engineer. I'm going to say, what do you think they're making per year?

DAREN BLONSKI CFP®: Like, well, they got a nice pad here in Sonoma and they drive a Ferrari. I'm like, well, then we're going to distribute more at your 24 rate and fill that bucket up because he, she. Has got a 50% rate, right? So that's that field bucket. So based upon your circumstances, we're going to project and make some best guesses on, you know, you should pay the taxes, not little Johnny or Sally.

DANO WEIR: Move number two, the QCD, Qualified Charitable Distributions. How can charity be a quote RMD killer?

DAREN BLONSKI CFP®: So we have lots of clients who are charitable inclined. We have clients who pay tithing to their churches.

DAREN BLONSKI CFP®: One of the things you can do is write a check directly out of your IRA effectively that counts as a distribution. The cool thing about that is say you take $100,000 out in your RMD. Believe it or not, there are people taking $100,000 a year in distributable income out of their IRAs and more.

DAREN BLONSKI CFP®: That check can be written straight to the charity. The charity gets the $100,000 in full benefit. You get your RMD check completed for the year, so you're not technically taking RMD. You're not paying half of it in taxes.

DAREN BLONSKI CFP®: When we have clients who have big distributions who are charitably inclined and let's say they write a $50,000 check every year to wherever, the Pets Lifeline or Boys And Girls Club, whatever, if they're writing that checkout, they should be pulling out of that IRA giving directly to the charity rather than being taxed and then sending it through.

DAREN BLONSKI CFP®: So you give it to the charity. When you give it to the charity. The charity gets the full benefit. Instead of paying $50,000 in taxes to the government and then giving them $50,000, the charity's got $100,000. It's a game changer.

DANO WEIR: Move number three, how do you protect your heirs? How do you avoid that inherited RMD issue?

DAREN BLONSKI CFP®: Well, so we've talked about this move number three. And what I always tell people, and this is the hardest thing in families, and that is the financial decisions are easy, the emotional ones are often hard.

DAREN BLONSKI CFP®: And the more clear and transparent you can be with your family about your money, if you're planning to leave them money and understand what their tax rates are at a family level, that will help your advisor strategize the distribution process.

DAREN BLONSKI CFP®: Because like I said earlier in the episode, it could make way more sense for you to pay the taxes than your kid. So to the degree you can engage your kids and like, hey, I know this is too much.

DAREN BLONSKI CFP®: And maybe I'm asking too much, but I'm trying to put some estate planning stuff together. Can you give me a sense of what your tax rates are? Because that'll help inform how I do my estate planning. That's a great question to understand and for your advisor to understand so they understand how to advise you in your best interest.

DANO WEIR: So the title of today's episode, what every high earner needs to do before age 73 because of RMDs. Let's answer that question explicitly. That what is it that they need to do?

DAREN BLONSKI CFP®: So what they need to figure out is what their conversion window is. There's periods of time in your financial life where your income will just naturally be lower because maybe you stopped working, Social Security hasn't kicked in, pensions haven't kicked in. There's all kinds of things.

DAREN BLONSKI CFP®: Mom's still alive and that big RMD's not coming to me. Where it makes sense to start converting money that's in a traditional IRA to a Roth IRA. A good financial planner will map out your tax life, expected tax obligation over your lifetime, and show you where the most likely windows are to do the converting.

DAREN BLONSKI CFP®: Usually it's like three years and it's somewhere in between, let's call it 66 and 73, right? Because if you think about it, at 66 and some months, your full retirement age for Social Security comes in and so you start getting the Social Security payments.

DAREN BLONSKI CFP®: You might prolong that until 70, depends on your situation, but your RMDs aren't getting forced to come out on you until 74, until 73, depending on your situation. And there's windows there that a planner needs to really dial into.

DANO WEIR: If that is sounding like your age range, if that is sounding like, hey, I have always wondered about this.

DANO WEIR: Darren mentioned a good financial planner. We are Sonoma Wealth Advisors, and this is what we do. If you've enjoyed this conversation today, if you'd like to see how we can help your specific situation with this very problem, build a complete, comprehensive, holistic financial plan for you.

DANO WEIR: Sonoma Wealth.com. That's our website. That's where you book your wealth analysis. It's a free conversation. It's private. It's confidential. We can learn more about your situation and how we can help Sonoma Wealth.com book your wealth analysis. Thank you so much to our clients, to our future clients for finding this episode.

DANO WEIR: Make sure to subscribe wherever you are, whether it's on YouTube, Spotify, or Apple Podcasts. We'll see you next episode. Thanks for watching and listening to It's All Money. We hope today's episode shared information to increase your financial confidence. Now is the time in the show for the voiceover with a bunch of words at the end.

DANO WEIR: Listen close though, you might find out something you didn't know. It's All Money is powered by Sonoma Wealth Advisors. Sonoma Wealth Advisors helps individuals and families in Northern California and across the country with building, managing, and sustaining wealth. Sonoma Wealth is a comprehensive, holistic finance solution.

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