Tax alpha with Raul Shah: Roth conversions

0:09Raul Shah:Welcome back to another episode of our new series, Tax Alpha. And joining us today is none other than our guest Raul Shah, the founder of DockShaw Financial, a value investing firm focused on helping everyday investors and retirees maximize their portfolio growth while protecting their retirement. their wealth from heavy taxation through advanced tax planning. Since its inception in 2023, the firm has generated just over 44 % annualized return for its clients. In addition to Rettwell's work in the markets, he is also an educator, a very sought after educator at Johns Hopkins University, where he teaches a tax planning course for that community.

0:52Raul Shah:Very excited to get Rettwell back on the show. Very excited to get more into tax tips for investors. Brett Will, welcome back. Raina, thank you so much. It's so great to be back. I love being on the podcast, and I could talk about tax planning all day. I probably bore a ton of people to death, but luckily for me, in this case, all the investors out there who listen are really interested in this stuff. There's so many great investors on Seeking Alpha. Some of my best personal investments have actually just come from the comments. They're going to love this Because not only are they going to learn more about tax planning, but more importantly, they're going to learn how to keep more of all of their well-gotten gains.

1:32Raul Shah:Absolutely. And I think even for those that may not know that they're interested in tax tips, I think every time tax season comes around or any time people are having kind of any planning towards what their investments may look like in the coming year, what they're looking for in the coming months, I think this is essential. And what I found is when you give people valuable insight and information, especially around something that everybody has to deal with, it's just very edifying and informative and helpful. And we've already heard from a number of people how helpful it has been that we've started this series.

2:08Raul Shah:So I'm psyched to keep on doing it. Again, we're going to be doing it the first week of every month. And today we are talking Roth conversions, which I've been talking a lot about. I have a young adult daughter and a conversation that we've had a bunch of times. So maybe set the stage for us. How would you start us off with the conversation around Roth conversions? Absolutely. So first, let me say this. Roth conversions are probably the most powerful tax planning strategy for pre-retirees and retirees and even a lot of just working individuals. I'm not exaggerating. You can save hundreds of thousands of dollars in lifetime taxes by understanding Roth conversions.

2:50And it's very simple. I'll break down everything in this video. I'll explain what they are. I'll explain when it makes sense to use them, when it makes sense to not use them. I'll also explain some of the very critical steps in order to do it. And then I'll also talk about a very important landmark study that Vanguard did that actually flips a lot of the foundational thought process about Roth conversions on its head. Okay, so let's talk definition, okay? Roth conversion, it sounds fancy, it's very simple. You have a traditional IRA, you have a Roth IRA. These are two buckets. Think of it like that, right?

3:26We call them accounts, but I want you for the rest of this video to think of them like buckets. Now, in the traditional IRA bucket, money that you ultimately would draw is going to get taxed at your ordinary income rate. There are exceptions to this, but for the majority of the cases, that's what's going to happen. In your Roth IRA, you pay tax to put money into the account, but everything grows tax free as long as you follow the IRS rules. So they're inverses of each other and they're just two buckets. Now, a conversion is moving money from the traditional IRA to the Roth IRA. It's as simple as a click on my end.

4:04When I do this for clients, which we do all the time, all I'm doing is pulling up through traditional IRA, pulling up the Roth IRA. We determine, we do the math, we run, we figure out how much we want to convert, and I just click a button and the money just magically moves to the Roth. That's the conversion. Now, why would we do this? We're not doing this because we're bored. We're doing this to do what's called a tax arbitrage. That's a fancy way of saying we want to pay less in our taxes over our lifetime. And Roth conversions enable us to do that. In fact, they're so powerful. Depending on your portfolio balance, there's a ton of successful investors who listen to Seeking Alpha.

4:40A lot of people here have millions of dollars in their account. You can save hundreds of thousands of dollars in lifetime taxes. Now, why would you do the conversion? Remember, I said it's a tax arbitrage. We're trying to save in taxes. Generally speaking, if you're in a very low tax bracket today, relative to the tax bracket you expect to be in retirement, what we can do is a conversion, pay the tax today at that lower rate in an effort to avoid that tax at a higher rate in the future. Because remember, in your traditional IRA, it's a bucket. It's just pooled untaxed income. That's all it is.

5:17That money is going to get taxed no matter what. You cannot escape it. You're going to have RMDs one day, which are required minimum distributions. The IRS will force feed you money out of your account if you don't take it in time. So if you're going to pay tax on that money, no matter what, why not choose to pay at a time when you're in a low tax rate versus when you're in a higher tax rate, right? It makes sense, right? Let's just use round numbers. If I have a million dollars and I'm in the 10 % tax bracket and in retirement, I expect have to be in the 20 % tax bracket. Well, why not take some of that money converted at 10 % and now I don't have to pay 20 % in the future, right?

5:57I've saved 10 % in tax on every single dollar that I've converted. You can realize this adds up very quickly on very large balances, very large accounts. Saving this amount of money would be a monumental tax saving. Now it's not always on this extreme and it doesn't apply in every situation, but that's kind of the general premise of the Roth conversion. So I'll kind of stop here and see, Raina, if you have any questions or if I should just kind of keep going in. Because the next thing I'm going to talk about is when they actually really apply. But I don't want to kind of go on a ramble here.

6:28Raul Shah:No, that's exactly what I was going to ask you. So that's a perfect segue. Get into it. Yeah. When and where should they apply? Okay. So really the golden question here, what we're looking at, what is our tax rate today and what's our tax rate in the future? That's the conventional wisdom. I'm going to talk about the Vanguard study that kind of changes this a little bit towards the end or towards the middle. But for now, I just want you to keep things simple, and I want to focus on those two numbers. What's your tax bracket today and what's your tax bracket in the future? Essentially, any situation in which you find yourself in an abnormally low tax rate today versus what you're going to be expected to be in the future, that's when you can think about doing Roth conversions.

7:07It doesn't mean you just go out and do it, but it means you think about it. So what are some situations where that exists? Well, let's say that you are a pre-retiree listening to this podcast. Okay, you've got no income. So you're in a very low tax rate, right? Let's say it's before Social Security. Let's say you retire at 56 years old. You have no pension. You've got no Social Security. You've got no income. And you've got maybe$2 million in your traditional IRA. Well, great. You can convert some of that to your Roth IRA. In fact, you can convert up to the standard deduction. If you're married, it's$32 ,200 this year.

7:41Tax-free. You just park it in your Roth IRA. The next bracket is a 10 % bracket. You could fill that bracket up and move 10 % into your Roth IRA, up to the 10 % tax bracket. Now, when you do this, again, you are choosing to pay a low tax rate today in exchange for not paying a higher tax rate tomorrow or in the future. What about an inheritance? right? Maybe your kids are like wildly successful and your current tax rate is lower than their tax rate. And you know that they're going to inherit your money at a time where they're going to be in a high tax rate. Well, maybe you want to pay the conversion tax today at your low tax rate so that your kids don't have to deal with that and they inherit that money in a Roth and then there's no taxes for them.

8:26What about moving from a low tax state to a high tax state? Maybe you know you're going to move from Florida to California. And so you want to move some of money out of your traditional IRA to a Roth IRA when you've got no state income tax versus in California when you could be in a very high state income tax environment. That's another example. There's a lot of viewers out there who listen to this podcast who are very generous with their donations. They're very charitably inclined. They love to give back to their communities. Those people use what's called donor advised funds and QCDs. It's qualified charitable distributions.

9:04So they write checks to charities and they get very big tax deductions in the year that they do that. It's a very common tax planning strategy that wealthy people use or even everyday people. I do this. I use this with clients all the time. I have a donor advised fund. It's nothing fancy. Sounds fancy, but it's not fancy. But the point is, is that your income drops when you make large donations because you get a huge tax deduction. So, aha, if my income drops, what happens? My tax rate's lower. So we could pair a Roth conversion with a donor advised fund or a QCD and we can take advantage of moving money from a traditional IRA to a Roth IRA at a very low tax rate.

9:43And that benefits you greatly over a long period of time. So there's all these kinds of different reasons to do that. And I'll give you one more bonus one, which is during a market downturn. Not a lot of people have the guts to do this, but if the market crashes by 30%, and you convert some of those funds that are in your traditional IRA to a Roth IRA, well, now you have just got a 30 % bang for your buck. You moved stocks at a dirt cheap valuation into your Roth. Once those accounts or investments recover, that 30 % gain that would have been subject to tax in the traditional IRA, you've just wiped clear.

10:19These are different scenarios in which Roth conversions make sense. There's other ones too that are more niche, like preventing certain IRMA surcharges, which has to do with Medicare. The golden rule though, okay? You think about your tax rate today versus your tax rate tomorrow, but the golden rule is you have to fund the Roth conversion with outside money, okay? Because remember, you owe a tax in the year that you do the conversion, but you don't want to withhold money from the amount you're converting to pay the tax. So for example, if I'm converting$30 ,000 from my traditional IRA to my Roth IRA, and I owe 5 ,000 in tax on that.

10:55I don't want to pull 5 ,000 out and only move 25 ,000 and cut 5 ,000 to the government. Why? Because number one, if I'm under 59 and a half, I pay a 10 % penalty. That negates doing the Roth conversion. And also, you just took a huge chunk out of the conversion that was going to compound. So the math is no longer in your favor at that point. So you've got to use outside money, money that's sitting in your brokerage account, cash in your bank, something that is not necessarily being invested that you can fund that conversion. That's the key. If you can't do that, then you really can't really do a Roth conversion, even if you're in an environment where it makes sense.

11:33Raul Shah:I was going to ask if there's an ideal, like you talked about the golden mean, is there an ideal allocation between Roth and traditional? Are there numbers that you put behind that? And then I was going to also ask, I know you talked about different circumstances, but is there an ideal state as like a younger worker is starting in the workplace? Or let's say somebody changes jobs and all of a sudden makes more money or, you know, goes from a 30 year old salary to a 40 year old salary and hasn't really done that work. Like, I guess those are some of my questions lingering. Great question. So let's start with the first one.

12:11Okay. When When you're thinking about these conversions, don't necessarily think about age. That's not the number that matters. It does play a role, right? The longer you have for your Roth to compound, the more advantageous Roth conversions can be, okay? But that's not really the determining factor. We want to look at your tax rates today and your tax rate in the future, right? It's the arbitrage between the two that we're trying to capture, okay? So that's the most important thing. In terms of your second question, which is a really good question, it applies to people across the board. It applies to young people.

12:44It could apply to old people, pre-retirees, retirees. It could apply to, and it will apply to at some point during their life. Let me give you an example. Somebody listening to this is 30 years old, okay? And they're in a very high tax bracket, okay? They're very successful. Maybe they work in tech and they have a family. Okay, so now one of them, maybe the husband or the wife or both, they take paternity and maternity leave. All of a sudden, their income, what? Plummets. So now they're in a low tax bracket, even though they're wildly successful, even though they're young, the circumstances are such that they had a family and they're in a low tax bracket.

13:19So now they have potentially an opportunity to consider a Roth conversion. Now let's fast forward. Let's take somebody who's pre-retired, somebody who's maybe in their early fifties, who's looking to retire. They have an opportunity too, because once they decide to retire, once they're done contributing to their 401k or their traditional IRA, their income goes to zero at this point. or they're winding down and their income is just lower than it is normally. So again, they're in a lower tax bracket. Somebody who is already retired, who's maybe before taking their RMDs, before Social Security, or even during sometimes taking Social Security could make sense.

13:54They're in a lower tax bracket, potentially, than what they would be in the future. So there's situations across the board where this could apply. It's not just for one group.

14:04Raul Shah:Is it worthy to ask a question? Like, let's say somebody's making a million dollars, somebody's making like$100 ,000, somebody's making$50 ,000. Would you like have certain allocation percentages for that person in terms of what they're contributing to? Sure. So generally speaking, when I'm working with clients, you have to look at their income and you have to project what their effective tax rate is and their marginal tax rate is for the year. That's kind of your starting point. If somebody is making a million dollars a year, you don't want them converting money from their traditional IRA to the Roth IRA because their tax bracket is so high.

14:41They're in the 37 % tax bracket. You don't want them paying 37 % in tax today if in the future their tax rate is going to be 24 % in retirement because now they're losing 13 % on every dollar that they convert. And to make matters even worse, there's a time value to money. Money when you're young is worth a lot more money when you're old. And I'm not talking about inflation, which is obviously true. I'm just talking about the time value of money, being able to do things while you're young and you're healthy and you can enjoy them. So money when you're younger is always more valuable than money when you're older.

15:16So even certain people who, like if we drop your example down to, let's say someone making$150 ,000 a year, even if a Roth conversion was advantageous for that person, you still have to, as an individual, ask yourself the question, do I want to pay that conversion tax today to have more money when I'm 70? Or would I rather take my family and my young kids to Disneyland or Disney World, right? So you can't just, that's why financial planning is so personal. And when I work with clients, two people in the exact same situation, which would never happen, but it's hypothetically, could have a different recommendation for their own tax planning because it all depends on the person.

16:02Does that answer your question?

16:03Raul Shah:I think so. Yeah. You know, it's one of the first things that I felt like I really understood when I started working at Seeking Alpha. I was reading a lot about it was right in 2008. So like, you know, all this talk about housing and mortgages and all this stuff. And it was like, should you rent? Should you buy? And there is no I mean, And obviously, if you have a certain amount of this, that and the other, but like there is no hard and fast answer. There is no black and white takeaway. This is better than that. Like you said, it has to do with life, which is very subjective, which is very individual.

16:34Raul Shah:How many kids you have, what you want to do with it, et cetera, et cetera, et cetera. Like when you meet with clients, what is is the first thing that you get into, like their lifestyle and then seeing how they want to live their life? And is that the most important thing to predicate these decisions on? Yeah, another great question. And just kind of going back to what you said, you know, I remember those debates people would have with mortgage and rent all the time. And, you know, I remember telling people, I have even tweeted about this before, your personal financial decisions are just that, right?

17:06They're personal. There are always going to be things that perhaps mathematically or logically make more sense. But that doesn't always mean that it's right. And that's hard for a lot of people to grasp. Give an example. Let's say that you want to rent in New York City because you love the city and you can't afford a home. And maybe your apartment is really close to where you work. okay you're not building equity if you're renting but what about the value of being in the city that you love so much or being close to where you work or having these great restaurants around you right so it's always personal so you can't just go out and claim that it's it's it's you know um that one thing is objectively better across the board and that leads into your second question which is financial planning the heart of that is is not numbers okay it's understanding your motivations what drives you what legacy do you want to leave behind you know you have to almost keep asking one layer deep when you ask people questions like if i'm talking to someone who is thinking about becoming a client and i tell them okay what are your goals and they say well you know i want to have this much uh when i retire okay great but that's not really that's not the end point right like because money is just money right it's just a piece of paper right why and then you start getting into oh well you know i want my family to be taken care of okay what does that look like oh oh, well, you know, I want my kids to have this much money in their inheritance.

18:32And I want my mom or dad not to worry about healthcare costs. And I want my wife, right? Okay, now we're getting somewhere, right? So it's very important to understand that before you start recommending actual tax planning stuff. Because remember, going back to rent versus buy, even if something mathematically makes sense, even if I sit down with you and I tell you, hey, a Roth conversion saves you this much money, you might value taking your kids to Disney World. And that's perfectly fine. You get a limited amount of time in life with your kids. So those decisions are much more important than the numbers that are presented.

19:08Raul Shah:I love a little holistic thinking. If I could maybe interject for one second, we talked about kind of when Roth conversions could make sense. I just want to touch really quickly on when they really don't make sense. So number one, when you don't have cash to fund the conversion, right outside cash, you don't want to be cutting a check from your conversions to fund the tax and then pay penalties, you don't want to do it because it just negates all of the benefits, right? You also really don't want to be doing Roth conversions when you're in peak earning years. If you're in the 35%, 37 % tax bracket, don't kill yourself doing this because you're going to want it with less money in the future.

19:41Another big mistake people make is if you're going to donate money to charity, leave the money in the traditional IRA. Because if you start doing conversions to move it to a Roth IRA, well, you're going to pay tax on that. And the charity pays no tax. So as soon as they inherit it, whether it's from a traditional IRA or a Roth IRA, charity doesn't give a damn. There's no tax. So don't cut part of what the charity is going to get by trying to do a conversion, paying tax to the government and then giving the charity less. Okay. Another mistake people make is they don't consider Irma surcharges. Okay.

20:10So when you're 65, you're going to Medicare, your income matters. And Irma looks two years back at your income. So when you're 65, your income at 63 determines your Medicare premiums. So if you start doing tons of Roth conversions at 63, you could wind up paying thousands of dollars more a year in Irma surcharges, and then you just negate the whole benefit of a Roth conversion. So situations like that, you want to make sure that you keep in mind. I just wanted to mention that because I wanted to show you the other side of the coin, too. No, no.

20:38Raul Shah:Appreciate that for sure. Appreciate that. Vanguard, right? Okay, so Vanguard originally did this study in 2022, and then they revamped it in 2025. And, you know, they really did such a good job of showing that it's not so much. First of all, it's called the better strategy. It stands for break even tax rate. This whole podcast, I was talking about looking at your tax rate today and looking at your tax rate in the future. There's a bit of a caveat here, though. It's not necessarily those two numbers, although it's very simple to understand. What matters actually is your break even tax rate. And there's a formula to calculate that.

21:14I'm not going to get into that right now. But there are situations in which even if your tax rate is higher today and expected to be lower in the future, that a Roth conversion mathematically still makes sense. So if I kind of walk you through an example here that we've got somebody named John, okay, and they're in the 24 % tax bracket. And let's say that he expects to drop to the 22 % tax bracket in retirement. Now, conventional wisdom would say don't even think about a Roth conversion because you're losing 2 % on every dollar that you convert. Now, let's just kind of take a look here at a little bit of an example.

21:45Let's say he's got 100K in his traditional IRA,$24 ,000 in his brokerage account. We just keep the math easy here. If he converts all of that$100 ,000 today to his Roth IRA, he's going to pay 24 % in tax on that. Now, technically, there's brackets. You have to factor. I'm just keeping the math very simple. If he uses the$24 ,000 in his brokerage account to actually fund that conversion, he's actually going to wind up with more money in retirement given a long enough time horizon because that brokerage account, remember, these are buckets. An IRA is a bucket. A Roth IRA is a bucket. A brokerage account is a bucket.

22:21But the brokerage account is a leaky bucket because every year you're paying tax in that account, whether it's qualified distributions, qualified dividends, non-qualified dividends, interest, capital gains, short-term, long-term. There's always going to be some level of tax drag in that account. And so what winds up happening is that if you think about this just kind of logically, if you've got$24 ,000 in the brokerage in this case, right? And you use that to pay the Roth conversion tax, what have you done? Well, you've moved now this$100 ,000 to the Roth IRA, and now you've put this shield around it where that money is never going to get taxed again, and there's no tax drag in the account.

23:02So if you've got a long enough time horizon, you're actually, there comes a point, a break-even point where you actually wind up with more money even though your tax rate was lopsided to begin with. And in this example, I think Vanguard, I think the break-even point in this case is 19%. So it doesn't necessarily matter what your tax rate is today always versus what is in the future. What matters is your break-even tax rate versus what it is in the future. So that is just kind of more of an advanced niche thing. But I respect the audience of Seeking Alpha so much because they're on top of things.

23:39You go to the comments, You know, you go, everybody's always pointing out these different nuances that I had to at least mention this. I don't want to get too bogged down in the calculations and stuff, but you know, it's, it's, it's really good to look this up on Vanguard. They've got a lot of, you can read the study. They've got a calculator on their website just to get familiar with it. But I had to mention that at least.