EP 5 – How Roth DCP Conversions Work
Understanding Roth DCP Conversions and Their Impact on Your Retirement Tax Bill
In this episode, we explain the newly launched Roth DCP and how it affects retirement planning benefits for public employees and teachers. The main focus of the discussion is the strategic potential of Roth DCP conversions as a tax planning opportunity.
Ethan underscores the possibility of significantly reducing your lifetime tax bill by correctly applying this strategy. He provides detailed examples explaining the process of Roth conversion, its immediate and long-term tax implications, and why it can be a financially prudent move. He encourages listeners to get professional consultation before implementing the strategy and promotes their investment service for DCP account holders.
Outline
00:21 Introduction to the Roth DCP and its Benefits
01:01 Understanding Tax-Deferred and Tax-Free Accounts
01:32 Explaining the Roth DCP Conversion Process
02:20 The Impact of Roth DCP Conversion on Your Tax Bill
03:24 The Long-Term Benefits of Roth DCP Conversion
05:18 The Effect of Future Tax Changes on Your Retirement Savings
08:03 The Importance of Proactive Tax Planning for Retirement
09:22 How to Get Help with Your DCP Investments
Transcript
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Hello and welcome to another episode of the Washington State Retirement Planning Podcast. I’m your host Ethan Meikle and here we talk all about the Washington State Retirement Planning benefits. So whether you’re a public employee or a teacher, I got you guys covered in all things you need to know about your retirement planning benefits.
So in today’s episode, we’re going to be talking about the brand new 📍 📍 📍 DCP that launched on October 1st. So I’m going to talk about what the Roth DCP is, how it works, and specifically we’re going to spend most of today talking about the Roth DCP conversion, which is a tax planning opportunity that can potentially have huge impacts on you.
If you can apply the strategy correctly. I know most people will kind of overlook this strategy, but I’m here to tell you that , if you start to implement this tax strategy right now, you can easily shave off five to six figures of your tax bill over your lifetime. And I’ll walk you through a couple of different examples of how that’s even possible.
All right. So without further ado, let’s dive right in.
When it comes to the tax piece, remember that with DCP We have never been taxed on this money yet. This is what’s known as a tax deferred account. Same thing with 403b’s, plan 3, 401k’s anything you haven’t been taxed on this money yet, falls into this bucket here. And then we have something called tax free accounts.
You want to think of this as anything to do with the word Roth, and now that we have Roth DCP, it falls in this bucket over here. So tax free accounts, you pay the taxes initially, then it’s going to grow for you from that point forward, completely tax free. 📍 So when we do a Roth conversion, what we’re doing is taking money from our current DCP account, And putting it into the new Roth DCP account.
So money’s moving from one pot to the other. Now, when we do this, we have to pay the taxes on the money that comes out. And the taxes due is depending on what tax bracket you fall into. So it may or may not make sense to do it this year. Depending on what your future tax situation might look like. So before you will pull a trigger on this you want to have somebody do an analysis to see What future retirement income you’re looking at when they add up things like your pension Your social security any kind of rental income They want to add all up to see where you are in the future And if you are going to change brackets, and if so, how much?
So that’s the first equation that needs to be done. Now when we do this Let’s, for example, let’s say we’re going to move something like 10, 000 over here. So what’s happening is 10, 000, it’s coming out of this DCP account, and it’s going over into this Roth. So when it’s all said and done, you’re gonna have 10, 000.
In this Roth DCP account. Now taxes, let’s say you’re paying 20 percent taxes on this. So on this is to generate a 2, 000 tax bill. Now the taxes in this conversion have to come from your bank account. You can’t have it with help. You can’t say, Hey, convert 10, 000 hold to just put eight in the Roth DCP. No, no, no.
The whole 10, 000 is going to move over. You’re responsible for putting the 2, 000. And giving it to the IRS through an estimated tax payment. Now it’s best to go ahead and make the estimated payment before the Q4 deadline, which I believe is January 14th. If you don’t do it before then you could be looking at an underpayment penalty because government doesn’t like to wait till April to get the taxes from you.
All right. So that’s essentially what’s happening with the conversion, removing money from one pot to the other and paying taxes on it. Now, why in the world would they want to do this? And how’s this going to save you taxes in the long run? Well, If we didn’t do this and we said, Hey, I’m just going to let it sit there so I can continue to grow.
I don’t want to pay taxes right now. Anyways, taxes are high. Well, if we were to wait, let’s say 15 years and you’re 10, 000, then becomes 30, 000. You still have to pay taxes on all that money. If taxes are the same, you’re paying the same 20 percent of that number. Now your tax bill is looking like 6, 000. So congratulations.
We waited, we tripled our money. We also tripled our tax bill. So that’s what happens when you put off doing kind of conversions. 📍 📍 For the Roth account. Now, if you did the Roth, same situation, right? Same investment, same time period. It’s still going to grow the same. You’re going to have 30, 000 here, but because we paid our tax, our 2, 000 tax initially, This 30, 000 is yours 100 percent tax free because you already bit the bullet on it.
So while some people might look at this and say, hey 30, 000 and 30, 000 that’s the same, this 30, 000 already has taxes taken out of it, this one still hasn’t. So if you were to take off 6, 000, you really only have 24, 000. In this account and that was assuming taxes stay the same. What happens if taxes go up?
You’re obviously gonna be left with a lot more money. So this is just an example of How the Roth conversions work and how it can save you taxes Now this was just showing a small amount obviously right of thirty thousand dollars So in this case you saved about four thousand dollars in taxes By doing this conversion, if this was 300, 000, you’d be saving close to 40, 000.
And if you, then again, the longer you wait, the bigger this bill again, for most people is can be well over a hundred thousand dollars, right? But what happens if taxes go down or I’m going to make less money down the road? So my tax is going to be lower. So I’ll just wait to do it then. Well, let’s take a look and see how that actually works for people.
So let’s assume that we have 400, 000 sitting in our pre tax accounts. Could be DCP, could be 403b, plan three, whatever it is. It’s some account that we haven’t been taxed on this money yet. Now, let’s assume to make math easy that your tax bill is 25 percent of this money, so you already don’t have 400, 000, you still owe a quarter of it to the IRS, which means your tax bill on this is 100, 000.
Now, if we wait to do any kind of Roth conversion or think we’re going to pay less tax in the future by making less money, remember that tax can only do one of three things. They’re either going to go up, they’re going to go down, or they’re going to stay the same. Now, when we wait, our money obviously grows, or at least that’s what we like it to do.
Now, if you use the rule of 72, if you earn 7. 2 percent interest, your money is doubling every 10 years. So 10 years from now, this person would expect to have something like 800, 000 in here. And if they wait another 10 years past that, earn the same 7. 2%. They’re going to look at about 1. 6 million in this account.
Now let’s do some math here. If taxes stay the same and we have 25 percent tax here, but our account is twice as high, that means the tax bill is now twice as high. So the tax bill here is 200, 000. Now let’s just say what happens if taxes go down, right? Let’s say you drop to 15 percent taxes. Well, 15 percent taxes of.
800, 000, you’re now looking at 120, 000. So just because we drop tax brackets, doesn’t mean we owe less taxes because they’re now our accounts now higher. So you can see this is now 20, 000 more than it was 10 years earlier. Now, if taxes go up, let’s say the 30%, obviously that means more taxes in this case, it’s going to equal 240, 000.
So you really have the choice of, you know, we can start converting now and pay 100, 000 in taxes. We could wait. Taxes are the same. We could probably double. We’ll pay 200, 000. We can see if we go down and pay 20, 000 more, or if taxes go up, we’ll pay 240, 000 more. So it’s your choice on, you know, if you want to put it off down the road or start taking action now.
And if you really put it off and went to this 1. 6 million, all these numbers are just going to double. So now you’re looking at… 480, 000 here, 240, 000 and 400, 000. So I said at the beginning retirement taxes are a huge bill and can easily be in the six figures. This is what I’m talking about here.
You can see that you could potentially owe the size of a mortgage to the IRS, just by simply doing nothing and waiting down the road. So it’s quite important to take action in terms of your tax planning and start looking at things like this new Roth DCP conversion to actually see Is now a good time to do it.
If so, how much, because chances are down the road, your account’s going to grow, your tax environment’s going to change, and you could be left paying more taxes than you realize. And this is our goal is to help you guys minimize your life, lifetime tax bill. So you’re doing a Roth version today, 100%. You’re going to be paying a lot more taxes today than you would have if you didn’t.
But if we extend the time horizon and look down the road, 10, 20 years. You’re going to be saving upwards of six figures in taxes alone. And this is off just off of a 400, 000 account. If you guys have more than that, you can bet your bill’s going to be bigger than this. So I hope that helps you guys understand the purpose of the Roth conversion.
And why it’s important is start taking action. , figuring out if it’s a good idea, should I do this? You know, how much should I do? How do I fill out the form? How do I make sure it actually gets reported correctly to the IRS? Because remember, this is the first time DRS is doing this.
So any of our financial planning clients, this is something that we do every single October like clockwork is going through this exact calculation to see Is should we do the conversion? And if so, how much we run it by the cpas to get their stamp of approval and then we’re on our way
Alright, so that wraps up today’s episode on the Roth DCP conversions if you’re someone All right, so that wraps up today’s episode on the Roth DCP and how to do Roth DCP conversions and the tax benefits you can have For you remember that it’s important that we when you do this that this is an irrevocable move So make sure you consult with a professional before pulling the trigger on this one Now if you guys need help with the investments inside of your DCP account, remember that we do have An investment service that tells you exactly what to buy and when to sell it inside of your DCP So if you want to get signed up on that just head over to our website wa TRS, PERS, that’s WashingtonTRSPERS.
com. And on there, on the top hand side, you’ll see the advice button. Click on that and it’ll redirect you right to the service so you can learn more about it. As always, if you guys have any questions, feel free to drop them in the comments. I read all of them myself. And until next time, remember that your future depends on what you do today. 📍